Municipal defaults should remain rare, ebooleant’s fischer says

Philip Fischer, managing principal in eBooleant Consulting LLC in New York, was formerly head of municipal-bond research and the Global Index System for Bank of America Merrill Lynch. He recently exchanged e-mails for an interview in today’s issue of the Bloomberg Brief: Municipal Market newsletter.

Q. What’s your outlook on the municipal-bond market?

A. The muni-bond market has experienced a set of structural changes which have removed institutional arbitrage, and limited liquidity is forcing muni yields higher. The stress on state and local budgets will continue, especially in an era of Washington budget cutting and slowing economic activity. Nevertheless, defaults should remain rare as the issuers need to protect their access to capital more than ever.

Issuance will remain relatively light for some time. The headline risk to the market from tax proposals will remain a constant.

Q. In a recent white paper, you write about the “faulty” premise that tax-exempt bonds are purchased disproportionately by the rich to avoid paying taxes. So who are muni investors?

A. Policy makers tend only to see the muni market through the lens of the tax code. For the investor, however, tax issues are merely one factor in investing. The first rule, and one which individual investors widely follow, is to diversify one’s holdings.

The data on the distribution of investment income of different types is, at first glance, a bit surprising, but it shouldn’t be. The investable assets of the country, i.e. the market portfolio of stocks and bonds, is split up roughly according to income. As a result, the returns to investing in different types of bonds is distributed proportionately across the income of different groups.

Taken as a whole, individuals with discretionary income, particularly the mass affluent, will continue to be the dominant buyers of tax-advantaged municipal bonds.

Q. How are municipal bonds perceived by these investors?

A. This is an era for caution in investing. There are few speculators left among muni-bond investors. Individuals hold municipals because they believe they are safe investments. Issuers should be especially proactive in communicating with them now. Investors know that the status of an issuer’s debt is often the canary in the mine, and poorly performing debt may well signal other fiscal problems.

Q. What effect will President Obama’s jobs bill, which proposes to tax formerly tax-exempt income, have on these perceptions?

A. Investors will view retroactive taxation of muni income as an unconstitutional taking of wealth. The administration should expect that both foreign and domestic investors will watch this bill with some concern.

Q. What are the odds for adoption of some legislation on tax exemption?

A. The odds for adoption of new tax legislation are low in the short run, but changes to the tax code will probably be a recommendation of the supercommittee. There is a reasonable probability of a change in the composition of Congress in the next election, which may make this a moot issue.

Q. If adopted, how will the bill affect muni yields?

A. Passage of the current version of the jobs bill would drive yields higher, perhaps much higher, for munis and for other governmental debt in the U.S. Maintaining good investor relations should be an active element in the governmental policy of a debtor as large as the U.S. The jobs bill does not qualify as maintaining good investor relations.