- The Washington Times - Tuesday, September 9, 2008

Wall Street has some election-year advice for its customers: Load up on municipal bonds because income taxes for the wealthy are bound to rise.

With a record budget deficit of $482 billion awaiting the next president, strategists are betting either Sen. Barack Obama, Illinois Democrat, or Sen. John McCain, Arizona Republican, will be forced to increase charges for top earners. That would boost the value of the tax exemption on income from state and local government debt, which has eroded since President Reagan made cuts a pillar of his administration when he took office in 1981.

“Tax rates are going to be higher no matter who’s elected,” said Craig Elder, the fixed-income analyst in the private-wealth division at Milwaukee-based Robert W. Baird & Co. Inc., which oversees $60 billion for individuals. “If you’re in the top tax bracket, munis are your strong buy right now.”

Mr. Obama plans to boost costs for couples earning more than $250,000 a year by rolling back the highest two brackets to where they were before President Bush‘s tax cuts were passed in 2001 and 2003. The top rate will return to 39.6 percent, according to Mr. Obama’s campaign Web site.

Mr. McCain says he would leave the top bracket at 35 percent when Mr. Bush’s measure expires in 2010 and push through more reductions, including a lower rate for corporations. Investors say congressional opposition and a national debt of $9.62 trillion, an amount equal to 67 percent of the nation’s gross domestic product, will derail Mr. McCain’s plan.

‘Money to be made’

States including California and New York, wrestling with deficits caused by the slumping economy, also have proposed raising taxes to pay for government services.

“If you’ve got a two- or three-year, or preferably a longer time horizon, I think there’s money to be made in the muni market,” said George Strickland, who invests $3 billion in municipal bonds for Thornburg Investment Management in Santa Fe, N.M.

Any source of demand would provide a respite for the $2.66 trillion of municipal bonds outstanding. The securities are headed for their worst performance since 1999, returning 1.26 percent, after losses on debt linked to subprime U.S. home loans cost the biggest bond insurance companies their AAA credit ratings. That led some investors to sell the tax-exempt bonds those companies backed.

The return on muni bonds this year compares with a 4.13 percent gain for Treasuries, according to Merrill Lynch & Co. index data.

Short-term bump?

“Tax rates may drive some kind of outperformance, but it will probably be a short-term bump,” said Matt Fabian, an analyst and managing director with the Concord, Mass.-based research firm Municipal Market Advisors. “It’s very easy to overstate the benefits to munis from a tax increase. They are already extremely attractive on an after-tax basis. Do you need it to be extremely, extremely attractive?”

Top-rated, 10-year municipal securities yield 3.73 percent, or about 99 percent of what Treasuries with comparable maturities offer. The historical average is about 87 percent, according to Municipal Market Advisors. For an investor in the top income bracket, the after-tax return on the bonds is 2 percentage points more than Treasuries.

Bigger bargain

Higher rates may make the bonds even more of a bargain, said Bill Keller, who oversees a group of money managers who handle accounts for people with more than $1 million to invest at Pittsburgh-based PNC Financial Services Group Inc.

“There’s going to be a greater demand in the next 12 or 18 months as people say, ‘Hey, we can benefit from municipal bonds,’” Mr. Keller said.

About 59 percent of the interest from municipal bonds in 2006 was paid to households that earned more than $200,000, according to the most recent data from the Internal Revenue Service.

The number of returns claiming interest from munis dropped after Mr. Bush’s cuts, to 4.42 million in 2004 from 4.66 million in 2000, IRS figures show.

Higher taxes make state and local bonds more valuable compared with U.S. government debt because investors can keep all of their income from the securities.

“Munis have been attractive even to those not in the max tax bracket,” said Kenneth Naehu, who oversees fixed-income investments for Bel Air Investment Advisors LLC in Los Angeles, which manages $5 billion. “Higher taxes would just increase the demand.”

Relative value

When Mr. Reagan’s first term began, yields on a group of municipal bonds that mature in 20 years, as measured by the Bond Buyer 20 Index, were about 79 percent of what 30-year Treasuries paid. Now the municipal yield is 104 percent of Treasuries. The top marginal rate was 70 percent when Mr. Reagan was elected, double what it is now.

Mr. Obama would raise costs for families earning more than $250,000 by rescinding Mr. Bush’s cuts for those in the top two brackets and increase the capital gains tax for people with incomes above that level. Currently, married couples who earn more than $200,300 and file joint returns pay 33 percent, with the 35 percent marginal rate kicking in over $357,700. The proceeds would pay for other programs, such as the expansion of the child tax credit, according to a description of the plan on Mr. Obama’s Web site. Mr. McCain would make Mr. Bush’s cuts permanent.

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