How to Play a Transition Away From Munis

The other day, I made an offhand comment on these pages that I thought one day the Build America Bonds (BABs) program would eventually replace the tax-exempt municipal market. This caused a flood of emails from readers, so I wanted to answer some of the common questions in more detail, and offer some ways to trade a potential transition.

First, some explanation. For many years there has been talk within the Treasury Department and the Internal Revenue Service that the tax exemption for municipal bonds is an inefficient subsidy. It allows the wealthiest individuals (and thus the highest taxpayers) to earn income without paying taxes. At current tax rates, top-bracket earners avoid paying 35% on that income.

Meanwhile, state and local governments were not getting the full benefit of that tax exemption. Municipal bond rates have historically only been about 15% to 20% less than Treasury rates. So the subsidy (in the form of allowing munis to issue bonds tax-exempt) cost the Treasury 35%, but only about half that cost was reaching the intended target. Some argued that the tax exemption should be revoked and that instead, municipalities should just be paid directly. That way the whole subsidy reaches the correct beneficiary.

Notice that this is exactly how the Build America Bonds program works. Bonds issued under this program are fully taxable, but the issuer receives a direct pay subsidy equal to 35% of the bond's coupon. Ostensibly the purpose of the BABs was to expand the demand for municipal credit, but it also opens the door for an alternative structure of the municipal bond market generally. This isn't a conspiracy exactly, just a simple observation that the BABs program exactly mirrors a longstanding proposal to eliminate the municipal tax exemption.

This brings up many questions. Is elimination of municipal tax exemption politically feasible? Fact is, issuers love the BABs program. They actually make more money by accepting payment from the feds than they were saving by selling bonds tax-exempt. Who would object? So yes, over time I do believe it's politically palatable to use a BABs-like system as a replacement for the current municipal market structure.

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Tom Graff is a managing director of Cavanaugh Capital Management, a registered investment adviser in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.