Municipal-bond tax breaks face court challenge

US Supreme Court weighs whether states can give residents who buy munis preferential tax treatment.

If you've long viewed the municipal bond market as a sleepy, safe tax haven, with rarely much ruckus, you might want to consider what's brewing there now.

The US Supreme Court is scheduled to hear a case Nov. 5 that hits on a cornerstone of what makes this market attractive: a longstanding practice in many states of exempting interest on their own bonds from state-residents' income tax, while taxing interest on muni bonds issued out of state.

By definition, municipal bonds are those issued by state or local governments to raise money to finance projects and operations. While so-called "general obligation" muni bonds help fund everyday activities of state and local governments, "revenue bonds" finance specific projects, such as highways, airports, hospitals, and single and multifamily housing.

Such bonds have been popular, especially with those in upper-income tax brackets: As long as investors hold bonds issued by a government entity or agency in their own state, the bonds' interest payments are typically free of federal income tax, and in most states free from state and local income taxes as well.

Indeed, 43 states, including Kentucky, have tax laws that give preferential tax treatment to their own state's bonds over those issued out of state.

But in the case of the Kentucky Department of Revenue v. Davis, retirees George and Catherine Davis of Kentucky deem that arrangement unfair. In their argument, such preferential tax treatment obstructs interstate commerce in violation of the US Constitution's dormant Commerce Clause.

Kentucky appealed to the US Supreme Court after the Kentucky Court of Ap­­peals in January 2006 ruled in favor of the Davises. Although many muni-­market participants (and many legal experts) expect the high court to side with Kentucky and maintain the status quo in this matter, a decision favoring the Davises' position would jolt the muni market, many experts hold.

"It's the biggest case ever [for the muni bond market], because it has the potential to totally change" market dynamics, says Len Weiser-Varon, public finance partner at the law firm of Mintz, Levin, Cohn, Ferris, Glovsky & Popeo, in Boston. Whereas the muni market is now "an in-state market in many states," a ruling for the Davises "has the potential to" make it into "a much more – almost exclusively – a national market."

Certainly, prices of muni bonds would be among the first affected. But de­­clines in those markets would quickly spill over to the market at large, "influencing the overall benchmark yield curve," says Matt Fabian, managing director of Municipal Market Advisors in Concord, Mass. As prices decline by perhaps a point or more, bond yields could rise "by 10 to 20 basis points, on average, immediately." A basis point is 1/100th of a percent.

In addition, experts say states would need to start grappling with difficult choices – and ones that could take time to adopt. States would either have to tax interest on every state's municipal bonds or tax interest on no state's bonds.

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.

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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It's wise to be wary of these bonds

Although experts disagree about the climate for buying municipal bonds now, some issues don't look like surefire buys regardless of one's broad market view.

Among the issues that could be stung by a Davis victory in the Supreme Court: Munis of Puerto Rico, whose interest payments are currently tax-free at all government levels in all US states. The prices of these bonds are comparatively high, says Matt Fabian of Municipal Market Advisors, because their interest is tax-free to investors across the United States, giving them wide appeal. But if the Davises win their case in the Supreme Court, that broad tax advantage could be jeopardized, making those bonds vulnerable to a sell-off, he says.

But those bonds so far haven't been hurt, a factor some market pros link to doubts about a Davis victory.

Bonds with ties to the housing market could also be a concern.

According to Mr. Fabian, these housing-related bonds include: Land-secured bonds based on future housing development, whose credit quality has been hurt by the subprime lending woes; multifamily housing project bonds, backed by revenue from apartment projects – a problem because of the surplus of rental properties now on the market; and bonds that help finance nursing homes. In the last case, Fabian says, such "bonds are backed partly by the entry fees people pay when admitted to a nursing home. The ability to pay these fees depends on people being able to sell their homes, which is a problem in the current housing market."

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