Muni bonds could be in big trouble

The tax-exempt status of municipal bonds, which makes them particularly attractive to high-net-worth investors, is up in the air as Congress wrestles with the fiscal cliff. “This election makes the administration's proposal for a 28% cap much more plausible,” said Matt Posner, legislative coordinator at Municipal Market Advisors, at the Bloomberg Portfolio Manager Mash-Up in New York on Thursday. “In the Senate, even before this election, there was bipartisan talk already that this 28% idea had legs.” Any changes to the tax status of the bonds could send notoriously fickle municipal bond fund investors fleeing for the exits. “There's going to be a negative reaction [to a change in the tax-exempt status of munis] and it could lead to sustained redemptions,” Peter Coffin, president of Breckinridge Capital Advisors Inc., said. Municipal bond investors have shown already that they're susceptible to factors that have nothing to do with the underlying fundamentals of the market. In late 2010, for example, a massive sell-off in the market was triggered by analyst Meredith Whitney, founder of an eponymous firm, who predicted a near-apocalyptic scenario for the asset class. To date, the raft of defaults predicted by Ms. Whitney has failed to materialize. But sustained withdrawals would mean sustained losses in municipal bond funds. Because of their illiquid nature, the performance of municipal bonds is largely tied to flows into and out of the funds. That illiquidity could get even worse if the tax exemption were threatened, as it would make the narrow investor base even narrower. “If you start limiting the exemption you're only going to make the market less efficient and more vulnerable,” Mr. Coffin said. Although the form is uncertain, some kind of a change to the tax exemption seems fairly likely, given the fiscal challenges the government faces. Mr. Posner, said the most likely scenario is a cap on the amount of interest high-net-worth investors can deduct. “There are a lot of vectors moving toward limiting the tax exemption,” he said. In the short term, some of the selling pressures brought on by the potential changes could be offset by so-called crossover buyers, such as institutions, which don't benefit from the tax exemption but still find the current prices attractive. Investors aren't the only ones at risk if the tax exemption is altered. Small issuers may find it harder to find buyers for their bonds, thus increasing borrowing costs and putting more pressure on their ability to pay back the debt. The possibility of altering the tax status of municipal bonds was first raised by the National Commission on Fiscal Responsibility and Reform created by President Barack Obama in 2010. (Bloomberg News contributed reporting to this story)