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Suit Says Muni-Bond Taxes Are Unfair

States tax interest on other states' bonds, but not their own. Can they do that?

Is it lawful for states to tax the interest on municipal debt issued by other states when they exempt their own muni bonds?

Forty-two states currently do. But the practice is being challenged in a case that has made it all the way to the U.S Supreme Court. The outcome could upend the $2.4 trillion municipal bond market and threaten financing for infrastructure projects by state and local governments.

It would also have serious ramifications for mutual funds that invest in muni bonds.

Municipal bonds are issued by state and local governments. They typically finance projects that private industry won't, such as the building of roads, bridges and other forms of infrastructure. States exempt them from taxes to make them more attractive than debt issued out of state.

This is a big deal in high-tax states, such as New York and California. They can get away with paying less interest because the returns are still attractive compared with taxable bonds. (New York started the whole thing by exempting its own muni bonds when it enacted a state income tax in 1919.)

Last year, a Kentucky state court ruled for the Davises, a couple of private investors in the state of Kentucky. The court said that the tax exemption is discriminatory to the other states issuing muni bonds and unconstitutional because it violates the Commerce Clause of the U.S. Constitution. The Commerce Clause has been interpreted to say only Congress may regulate interstate commerce, not the states.

The U.S. Supreme Court heard oral arguments last week. It is expected to rule in the first quarter of 2008.

Muni bonds would remain exempt from federal income taxes regardless of how the court rules.

If the court rules against Kentucky, forcing states that tax out-of-state munis to tax in-state bonds as well, municipalities in places like New York and California would have to start paying higher interest rates to attract investors. This would increase the cost of funding new projects.

Of course, existing bonds issued by municipalities in high-tax states would suddenly look a lot less attractive if they were taxable. Prices would fall as investors dumped them in favor of new bonds with higher coupons.

Meanwhile, the prices of bonds issued by municipalities in states like Texas, which has no income tax, would rise because their higher coupons would suddenly look more attractive to investors who have to pay taxes on all munis.

Since bond yields move in the opposite direction of their prices, yields on existing munis issued in places like New York would rise and yields on munis issued in places like Texas would fall. Daniel Loughran, a senior portfolio manager of

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Oppenheimer Rochester NC Municipal Bond (OPNCX), expects the yields for both groups would quickly meet in the middle, which could be as large as a 0.20% move.

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Matt Fabian, senior analyst at Municipal Market Advisors, an independent research and strategy firm, points out that California and New York issue more debt that other states, and so have a bigger influence on the benchmark yield curve. "So, overall it would make munis look weaker," he says.

Of course, if investors had no incentive to buy muni bonds from a particular state, there would be no further need for single-state muni bond funds. Loughran says fund companies would probably merge funds like his into national funds if the court rules in favor of the Davises.

In 2006, state muni bond funds held $155 billion, or about 40% of the $365 billion in total assets under management in muni-bond mutual funds, according to the fund industry's trade group Investment Company Institute.

Loughran doesn't expected there to be a rush to liquidate munis, however. He says the yield equalization would affect bond prices by 1% to 2% in either direction.

There is one wild card. Hedge funds have become big players in the muni market. These securities provide the foundation for a strategy called tender-option-bond programs. Hedge funds (as well as the proprietary desks at investment banks) buy long-term, higher-yielding muni bonds, often using leverage, or borrowed money. They put the munis in a trust, where they are used as collateral to issue short-term commercial paper paying a much lower rate of interest.

Fabian says investors with leveraged tender option bond programs could face margin calls if they suffered a 0.1% or 0.2% drop in the value of their munis at the same time as Treasury bonds rise. They might be forced to liquidate their holdings to raise the cash. This could flood the muni market with securities, sending prices down further.

Investors got a taste of what this might be like in August, when a number of hedge funds hit by the mortgage crisis

sold munis to raise cash.

While the impact on muni prices would be temporary, it could be exacerbated if open-end muni bond funds are forced to sell into a weak market to meet requests from investors for redemptions.

It doesn't appear the muni bond market is expecting any change in the status quo, however. The spread, or difference between yields, on bonds issued in high-state taxes and low-state taxes hasn't budged. "The spread was 0.25% a year before the case and it's 0.25% now," says Loughran. "The market is telling you it doesn't think the risk is great that the verdict will be upheld and the status quo overturned."

Michael F. Smith, co-chair of the appellate group at Butzel Long, a Washington, D.C., law firm, says the Internal Revenue Service in the 1970s took the position that states can exempt their own bonds. Butzel Long filed a friend of the court briefing on behalf of 13 fund companies.

"One of the points that Kentucky has taken is that Congress knows about this whole system and as (the system) developed, Congress took no action," says Smith. "Kentucky says the court ought to defer to Congress, which shouldn't have the court upsetting the whole system."

The questioning by the court's justices last week gives the industry a lot of hope. We have said "if it's kind of a close question, leave it for Congress. Because, after all, the Commerce clause talks about Congress' power," said Chief Justice John Roberts in a transcript of the oral arguments on the Supreme Court Web site. "This is an area where Congress can regulate if it wants to, and it has never shown the slightest interest in interfering with states tax exemptions for their own bonds."

In addressing the Davises' lawyers, Justice Stevens said, "The victims under your approach, as I understand it, are the 49 other states, and all of them seem to support your opponent in the briefs that were filed with the case."

Chief Justice Roberts put it succinctly when he said, "Your clients are not out-of-state issuers ... Why aren't

the Davises arguments limited to discrimination against them rather than discrimination against out-of-state issuers."

In fact, even though only 42 states have similar tax structures, all 50 states have filed friend-of-the-court briefs supporting the current system.