Municipal-bond tax breaks face court challenge
US Supreme Court weighs whether states can give residents who buy munis preferential tax treatment.
from the November 5, 2007 edition
Page 2 of 3
What seems clear is that relatively high-tax states, such as New York, California, and others, could be the bigger losers. Currently, muni bonds of such states are particularly attractive to in-state investors. This captive audience typically accepts lower interest rates on in-state bonds because they won't have to pay taxes on interest from these bonds. Lower interest payments mean lower borrowing costs for issuers.
But if states cannot give preferential tax treatment for their bonds, their captive audience may seek better buys elsewhere. Some believe that would steer many investors to portfolios of nationally diversified muni holdings.
"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.
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