By Karen Pierog - Analysis
CHICAGO (Reuters) - A win by Barack Obama in November's U.S. presidential election could be bullish for tax-exempt bonds, and may lower state and local government borrowing costs, given his call for raising taxes on higher-income earners.
Wealthy Americans are key investors in the $2.6 trillion municipal bond market, where interest earnings on the debt are shielded from federal income taxation. Higher taxes on income or equities will likely find more investors beating a path to munis and tax-free income.
Any increase in demand for municipal bonds could lower borrowing costs for states, cities, school districts, hospitals and other municipal issuers.
"I think it's almost a sure thing we'll be living with higher taxes in a year or two," said George Strickland, a managing director at Thornburg Investment Management in Santa Fe, New Mexico.
"That's got to be good for tax-free municipal bonds," he also said.
Continued Democratic party control of Congress would likely spell the end of President George Bush's tax cuts, which expire at the end of 2010, no matter who wins the White House.
Strickland said an Obama win could accelerate the tax cut sunset, but he added that marginal tax rates probably won't rise above levels under President Bill Clinton.
Obama, a Democratic U.S. senator from Illinois, has said he favored letting the tax cuts expire for Americans making $250,000 or more a year and raising the capital gains tax for higher-income earners, while exempting small investors. He would use the money to pay for a middle-class tax cut of $1,000 a year.
That contrasts with John McCain, a Republican U.S. senator from Arizona, who wants to maintain the Bush tax cuts, lower corporate tax rates, double the tax exemption for children and phase out the alternative minimum tax.
If the Bush tax cuts are not renewed by the end of 2010, the maximum rate on capital gains will go back to 20 percent from 15 percent, while the 15 percent maximum rate on dividends will revert to the ordinary income tax rate, according to a recent municipal market commentary from Citigroup. In addition, the top rate on ordinary income will return to 39.6 percent from 35 percent.
Tom Spalding, a portfolio manager at Nuveen Investments in Chicago, said the subsequent rise in rates on capital gains and dividends would boost the attractiveness of municipals versus equities, he said.
"It makes the pre-tax equivalent yield on munis very, very compelling," he said.
Strickland said the end of the tax cuts combined with potential mass upgrades of muni ratings by Wall Street rating agencies to make them consistent with corporate debt ratings would "create a perfect storm for municipal bond outperformance."
As for McCain, his proposal to end the alternative minimum tax could benefit muni issuers such as airports, housing authorities and student loan agencies that are required to sell some of their debt subject to the tax due to substantial private-activity components in their deals. But AMT bonds make up only a small percentage of the overall muni market.
The universe of investors who are increasingly subject to the tax would no longer have to shun AMT bonds and spreads between existing higher-yielding AMT and lower-yielding non-AMT bonds would probably tighten, according to Chris Mier, a managing director at Loop Capital Markets in Chicago.
He added if McCain removes the AMT requirement for muni issuers, those issuers would save on borrowing costs through lower yields.
(Reporting by Karen Pierog)
