By Karen Pierog
(Reuters) - Tax policies proposed by the two presidential candidates may differ in several ways, but both could roil the $3.7 trillion U.S. municipal bond market, popular with wealthy investors and vital for the financing needs of states, cities and other issuers of tax-exempt debt.
Demand for munis, which offer investment income free from federal taxation, may be reduced if the proposals floated by either incumbent Democrat Barack Obama or Republican challenger Mitt Romney were to take effect.
That would push borrowing costs up for all municipal issuers that rely on the market.
Major tax reform encompassing munis would be the first since 1986. As Washington grapples with trillions of dollars of debt, comprehensive changes to the tax code appear likely, regardless of who is in the White House.
That prospect has set off some alarms in the muni market.
"The two candidates are presenting very different and frankly very confusing tax proposals as they relate to municipal bond interest," said Chris Mauro, head of U.S. municipals strategy at RBC Capital Markets.
An election guide for credit investors published by Morgan Stanley last month warned that "both policy sets are likely negative for munis' tax value and a headwind for performance."
LOWER RATES, FEWER BREAKS UNDER ROMNEY
Romney would lower all income tax rates by 20 percent while balancing those cuts by ending some yet-to-be-identified tax breaks, which could include munis, for high earners.
"Bottom-line, it seems it is going to be very hard for him to achieve what he wants to achieve without putting most of the very large tax expenditures in play and munis are one of the top 10 tax expenditures," Mauro said.
A January report from the U.S. Congress' Joint Committee on Taxation estimated that tax expenditures from public purpose and other muni debt would total around $230 billion between 2011 and 2015.
The Republican candidate's intention to eliminate taxation on capital gains, dividends and interest income for taxpayers with adjusted gross incomes below $200,000 would likely reduce demand for tax-free debt and push yields up, according to a recent report by Cadmus Hicks, a Nuveen Asset Management managing director.
Those taxpayers accounted for $35 billion, or about half of the tax-exempt interest individuals reported to the Internal Revenue Service in 2010.
Romney's plan for the below-$200,000 earners would also put corporate and U.S. Treasury debt, which typically offer higher yields than municipal debt because of their taxable status, on an even playing field with tax-exempt munis by freeing all of it from taxation, Morgan Stanley noted.
Still, investors with incomes greater than $200,000, who accounted for $34.2 billion of tax-free interest two years ago, may have room to expand their holdings of muni debt without demanding inflated yields, according to Hicks.
TAX BREAKS CAPPED UNDER OBAMA
Obama intends to keep the Bush-era tax rates for families making less than $250,000. The tax rate for annual incomes over that amount would be increased and the value of the muni tax exemption would be limited to 28 percent.
Higher rates for the wealthy would make tax-free munis more attractive to those investors, but capping the muni tax exemption would curb enthusiasm for the debt. Romney has also floated the idea of a monetary cap on tax deductions, but it is not clear if munis would be included.
What worries traders and dealers in the muni market is that Obama's 28 percent cap would include existing debt in the secondary market, a move that would slash the value of outstanding bonds.
"Under the proposal as they presented it, there would be no grandfathering," RBC's Mauro said. "All bonds would be subject to this 28 percent cap. The whole market would have to readjust its pricing."
According to a recent paper issued by the National Association of Bond Lawyers, the cap would reduce the value of a $1,000 bond maturing in 10 years to less than $950 -- a more than 5 percent drop.
Mauro said the Obama administration has suggested that the 28 percent cap would not be "rock solid" and that it could be even lower if certain deficit reduction targets are not hit.
"That would be debilitating for the municipal market because there would be so much uncertainty about how you would price in that tax risk," Mauro said.
ENDING THE ALTERNATIVE MINIMUM TAX
Both Obama and Romney would end the alternative minimum tax, which was enacted to put a floor on the amount of taxes paid by the rich but is hitting an increasing percentage of taxpayers every year.
The AMT is applied to earnings from a small percentage of muni bonds sold by issuers such as airports and housing authorities that have substantial private-activity components in their deals.
Obama's plan would require households earning over $1 million a year to pay a minimum tax of 30 percent.
The uncertainty surrounding the different proposals and the prospect of drastic change has led many market participants to circle the wagons to protect tax exemption. For example, Municipal Bonds for America, a coalition representing dealers and issuers, was launched last week by the Bond Dealers of America to defend tax exemption.
Peter Hayes, head of BlackRock's municipal bonds group, said while the wealthy generally benefit from investing in munis, eliminating tax-free muni bonds would hit all taxpayers in the form of higher borrowing costs for governments.
But intense lobbying may stave off changes to tax exemption, particularly if the control of the federal government remains split between the political parties, he said.
"Because there is so much uncertainty and because the possibilities are so vast, it may actually in the end be hard to get anything done around tax policy or tax reform," Hayes said.
(Reporting by Karen Pierog, additional reporting by Patrick Temple-West; Editing by Dan Grebler)