California muni bond market could see supply and demand shift under Obama proposals

From the Los Angeles Times' Money & Company blog:

The huge California tax-free municipal bond market has a lot riding on proposed tax changes in President Obama’s budget.

The administration’s call to restore higher tax brackets for the nation’s top income-earners, by allowing President George W. Bush’s tax cuts to expire as scheduled next Jan. 1, could fuel more investor demand for tax-free bonds. That would be good for current bond owners, and for muni issuers, if the result is to push down interest rates on new bonds.

But Obama also proposes to reduce the federal subsidy for a new breed of taxable muni bonds -- so-called Build America Bonds -- that some state and local borrowers began to issue a year ago in place of tax-free securities.

That lower subsidy could give borrowers, including California, less incentive to issue the taxable bonds. If they shift their borrowing back to the tax-free market, that would mean more supply of standard munis, which could put upward pressure on market interest rates.

For the country’s highest-income earners -- singles earning more than $200,000 and couples earning more than $250,000 -- the White House’s proposal to restore the top federal tax bracket of 39.6%, up from the current 35%, almost certainly should boost the appeal of tax-free munis. They’re the last legal tax dodge for many investors.

In the 35% tax bracket, a tax-free yield of 4.5% is worth the same as a 6.9% yield on a taxable investment. In the 39.6% bracket that 4.5% tax-free yield would be worth the same as a 7.4% taxable yield.

Obama also proposes to restrict high-income-earners’ tax deductions, which would give them more incentive to seek out investments that produce higher after-tax returns.

Meanwhile, the administration’s proposed changes to the Build America Bonds program could have a significant impact on the California muni market: The state and its municipalities have been big beneficiaries of that year-old program....MORE