Municipal-bond tax breaks face court challenge

"It's [widely] agreed that if Davis is upheld, there will no longer be a tax reason for investing in single-state muni funds. But there will be a diversification reason for investing in national muni funds," says attorney Weiser-Varon. As a result, he predicts "there will be a movement of assets from single-state funds to national funds."

All the while, some bond issuers might find it more difficult and expensive to sell bonds to finance projects, some say.

Given the potential disruptions from a Davis victory, some close observers expect such an outcome to trigger Congressional action – moves aimed at nullifying the Supreme Court's decision. But at this juncture, it's unclear whether, or how soon, after the court's ruling Congress might act.

Despite the potential market effects if the Davises prevail, muni investors have so far reacted little to the case. Experts cite widespread expectations that the Supreme Court, for a variety of reasons, won't rule for the Davises.

Of greater concern in recent months, especially this past summer, was the market upheaval spilling over from the subprime leading debacle. Experts say that a muni market swoon in August helped dampen this year's total returns of muni mutual funds. Specifically, data of Lipper, a tracker of mutual funds, show that this year through Oct. 17, 1,940 funds in Lipper's muni bond universe posted an average 1.37 percent total return. That compares with a much higher 4.17 percent total return for all of 2006 and a 3.43 percent annualized total return for the three years ended 2006.

With a ruling in the Davis case expected sometime in the first half of 2008, market pros seem to be honing their views about how, or whether, to strategize around the case.

On one hand, Mr. Fabian of Municipal Market Advisors sees reasons for some caution at this juncture. "At this point, I would wait for a decision on the Davis case," he says. Those who wish to buy now "should overweight shorter-term and variable-rate products, like money markets. But if they're going for fixed-rate issues," he suggests they "stay with maturities of eight years or less. As he explains, "Liquidity remains strong in these muni issues, and prices should be less volatile than with longer-term issues." In fact, he says, "bonds in this area should better resist event pressures," such as a ruling in the Davises' favor.

Those who already own muni bonds should hold them, to avoid trading costs. "I wouldn't sell anything based on what's happening now," Mr. Fabian says.

But a more gung-ho John Mous­­seau, portfolio manager at Cum­berland Advisors in Vineland, N.J., recommends buying now before typically heavier year-end buying sets in. Part of his rationale centers on the ample supply of these bonds, due to more issuances this year versus in 2006. That comparatively abundant supply is one factor keeping munis' prices relatively low now, while their yields currently hover not far from those of comparable US Treasury securities – whose interest payments are taxed at the federal level, he says.

As for the Davis case: "In the end, that case talks about relative yields of munis to each other," Mr. Mousseau says. But to him, investors should be more focused on the bigger economic picture. "If you believe that interest rates [generally] are high and the economy is slowing down, you should own bonds now. Any effects of the Davis case are secondary to interest-rate levels and movements now."

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