The municipal bond market is changing fast, and may become an entirely different market in the next five to 10 years. In the future, new municipal issues may well be taxed, but since they still will be issued by cities, counties and states, they will be classified as municipal bonds.
These are some of the interesting thoughts of Kit Taylor, the executive director of the Washington-based Municipal Securities Rulemaking Board.
Taylor points to the damage that Congress and the Reagan administration have inflicted on the tax-exempt industry during the last eight years. The Tax Reform Act of 1986 eliminated the ability of commercial banks to deduct 80 percent of the interest expense incurred to carry new tax exempt securities, acquired after Aug. 7, 1986. This resulted in removing the largest buyer of munis, the commercial banks, from active participation in the new issue market.
As recently as 1985, banks owned 35 percent of all the outstanding municipal bonds. By the third quarter of 1987, they had reduced their holdings to 22.5 percent of the market. Their place was taken by individuals and by mutual funds, which by the third quarter of 1987 had increased their share of municipal ownership to 57 percent of the market.
It has been well documented that the Tax Reform Act of 1986 brought about the drastic reduction in the new issues volume of municipals. In addition, by reducing the role of banks in the market, the secondary market of older outstanding issues has become a lot less liquid.
This fact was borne out in April and September last year, when mutual funds had to redeem shares in their funds and were forced to liquidate large bond positions. They turned to the dealer community to sell their bonds. The dealers, faced with buying these large positions, were unable to resell the blocks to the public. This caused interest rates to move higher as the dealers recoiled from buying more bonds and simply lowered their bids.
The end result was a very volatile market, with rising interest rates and huge losses for both the funds and the dealers. Perhaps if the nation's 14,000 banks were still able to buy munis, the bloodletting would have been minimal.
With the large reduction in the new-issue volume, Taylor believes that there will be a further contraction in the number of broker-dealers and bank-dealers in municipal bonds. The volume has dropped from $204 billion in 1985 to $94 billion in 1987, and some analysts see a $75 billion year in 1988. It's the old story of too many dealers bidding for too few new issues.
Consequently, some dealers have worked for "nothing" just to win an underwriting. But where that is the extreme, most new issues are won with a very narrow "spread" or profit. This would be fine if there were no market risks involved. But with risks, even a small loss will wipe out the narrow spreads (or cushions) that dealers are now forced to work for.
As to the long-range outlook for the municipal market, the crucial point for Taylor is how the Supreme Court will render its decision concerning a case in which the state of South Carolina has brought suit against the government for requiring all issuers of muni bonds after 1983 to issue registered bonds. If the bonds are not registered, then the interest on all new muni bonds issued in coupon form would have to be included as taxable income.
South Carolina claims that under the "reciprocal immunity" doctrine derived from the U.S. Constitution, the states cannot interfere in the operations of the federal government, nor can the federal government interfere in the operations of the states. Consequently, taxing the interest on municipal obligations would impair the ability of the states to finance their operations. This is the fundamental basis for tax-exempt bonds and the point on which South Carolina rests its case.
Taylor fears that the Supreme Court may decide that the federal government may tax the interest on state and local issues, which will seriously damage the further issuance of municipal bonds. It will take time to bring all this about if in fact that is the opinion of the court. All previous issues will certainly be grandfathered, and the taxing of new muni issues would be phased in over time.
In effect, this would raise the rates on muni bonds, the amount of interest that state and local governments would have to pay on new issues and the costs of projects to the public, and it would most certainly lead to higher state and local taxes.
Finally, municipals remain the last legitimate tax shelter for the wealthy. Congress has shown little concern for and very little understanding about the capital-raising process in the United States. Considering their need for revenue, it would only be a continuation of recent policies for the treasury and congress to do away with tax exempt bonds.
If they are successful in their endeavor, the $750 billion outstanding municipals will become more valuable than ever.
James E. Lebherz has 28 years' experience in fixed-income securities.