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Muni Tax Break Escapes Debt Supercommittee

Last month, President Obama proposed his America’s Jobs Act of 2011, which included a provision that would reduce the tax break for muni bond investors. In short, individuals who earn more than $200,000 a year ($250,000 for married couples filing jointly) would have to pay the difference between the value of the tax exemption of a 28% rate payer and that of a 33% or 35% rate payer.

However, just last week, Investment News reported that the US debt “supercommittee” – the 12-man congressional task force charged with finding ways to lower the nation’s debt – would not recommend reducing the tax break enjoyed today by municipal bond investors.

(CLICK HERE to log in free and read the Investment News report, October 2, 2011)

If the tax break was reduced, the lower overall return would behoove municipality issuers to increase rates, which would in turn increase the cost of the infrastructure projects these bonds are meant to fund. Furthermore, the move could persuade high-end investors, who make up the majority of the muni bond investment market, to look elsewhere for high-yielding dividend investments.

But since we can be reasonably confident that the tax break will be preserved, a review of the current state of municipal markets offers some interesting prospects. According to a recent analysis by CNBC.com, the municipal market has experienced less than $1 billion in par value worth of defaults so far this year (which equates to about three-quarters less than during the same time period in 2010).

Muni bond experts quoted in the article say that, assuming yields remain low, these securities are inexpensive relative to US Treasury bonds. In addition, new issues are beginning to flood the market since interest rates have dropped further, and because there is significant improvement in the stability of this market, investor demand is also increasing.

(CLICK HERE to view video of the “Muni Watch: Time to Invest?” report from cnbc.com, October 5, 2011).

In its October On the Markets commentary, the Global Investment Committee at Morgan Stanley Smith Barney observed that there are substantial differences in the muni market today than a year ago. For example, both state and local governments have done a great job closing budget gaps and states have produced seven consecutive quarters of growth. This has helped to reduce investor anxiety regarding the credit quality of issuers. When looking at quality, keep in mind that credit spreads for bonds rated below AAA are significantly wider than historical averages, which provides a favorable risk/reward tradeoff and the potential for higher income.

(CLICK HERE to view MSSB’s most recent On the Markets commentary, October 2011)

Overall, the municipal market is extremely diverse, and credit ratings may not be up-to-date in terms of improved quality. This market inefficiency can offer substantial credit at reduced risk – which may not be apparent to the broader market. If you’re interested in taking a more in-depth look at the muni bond market for your own portfolio, please give us a call!

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