Bonds subject to the market discount rule might be the ugly ducklings of the municipal market right now, but a quick drop in interest rates could turn them into swans.
While that premise is technically true, finding many believers in the municipal ranks these days is extremely difficult, according to Christopher M. Dillon, a vice president and municipal market strategist at J.P. Morgan Securities Inc.
"At some point when people do decide that yields are going to decline again, the thing about these very cheap discounts is that they are going to be stellar performers," Dillon said.
Investors who are "the first to make that call and be fight are going to make a lot of money," Dillon said. "But at the moment, people don't seem to hold that view and there's no bid in the market."
Though the market discount rule was part of the 1993 federal budget act, traders first began to feel its impact last spring as yields rose and bonds began to trade at levels below where they had come to market, creating market discount liability.
"I think it's absolutely distorting the market," lamented one trader last April. "It's one of the reasons the market is so sloppy."
The provision means that in some but not all cases, the gains on the sale of such bonds will be treated as ordinary income rather than capital gains, subjecting them to a higher tax rate. Ordinary income tax rates can reach as high as 39.6%, compared with the 28% capital gains rate.
Dillon explained that if a bond is issued at par, the difference between where it is trading in the secondary market and par is the market discount. Next, the number of full years left to maturity is multiplied by 0.25 per year. For instance, Dillon said, the number nine would be used for a bond with 9.5 years left to maturity.
"And that gives you this band," he said. "If the bond price is below the issue price, which in this case is 100, but within the band, it's subject to capital gains tax. If it's outside of this band, then the whole market discount, the whole discount from 100, is subject to ordinary income tax."
The rule has caused some changes in the municipal market, Dillon said.
"It's really created a dichotomy where basically people in the new-issue market are looking for sort of insulation from potential market discount, and in the secondary market, there's just no bid for that type of paper," he said.
The secondary market's shunning of discounts is a departure from 1993, when investors would pay up for some discounts. With callable bonds, investors previously were willing to pay more for discounts because of the added call protection they afforded, Dillon said. If an issuer can call a bond from an investor at par, the investor would rather have a bond that is trading at 90, Dillon said.
"Now, not only are they not paying up for that, but it's trading cheap to where it even should be on an after-tax basis," he said. "Right now they are being after-taxed at 39.6%, [but] as they start to move back toward par, at some point they become after-taxed at 28%, once they move within that de minimis band," he said.
Earlier this year, it looked as if the market might get some relief regarding the rule from Washington when Rep. Benjamin Cardin, D-Md., introduced legislation to repeal the provision. The Public Securities Association's July 15 municipal securities newsletter quoted a statement Cardin made in introducing the legislation.
"Of critical importance to the success of the American system of public finance is the liquidity of the secondary market .... Investors are willing to accept lower rates of return on state and local government securities because of the tax exemption, but also because they know they can readily sell their bonds, if necessary, before maturity. It is this indispensable characteristic of the municipal bond market that was handicapped last year by the Budget Act."
However, Christopher Lynch, legislative director for Cardin's office, said on Wednesday that Republican victories at the polls have created a need to rethink strategies. That means Cardin's office will be effectively starting from "ground zero," he said.
"With the turnover of the Congress and the Republican majority, we are going to be stepping back and taking a look at all the different pieces of legislation we've been working on and try and reassess what might be the best strategy for seeing those bills enacted into law," Lynch said. "I think our interest in past legislation that we have introduced remains."
Micah Green, executive vice president of the PSA, said the group warned of the effects of the rule at the tune of the 1993 budget act, but at that point it was the furthest thing from most people's minds.
"We believe it has added complexity and cost to the marketplace that should not be," Green said Wednesday. While efforts to get the bill passed as part of a tax simplification plan this year foundered, Green said he believes Cardin is committed to reintroducing the bill next year.
"The bill enjoyed pretty widespread bipartisan support," Green said. "It's not a partisan issue; there were numerous Republican co-sponsors of Congressman Cardin's bill."
Meanwhile, in Wednesday trading, municipal bond prices overall were up 3/4 point. Yields on high-grade issues fell by five basis points through the intermediate range and by 10 basis points on the long end. Dollar bonds were up a point and activity was light to moderate.
"Muni cash was up pretty much in line with the Treasury market," one trader said. The government market was up 22/32 to yield 7.94%. In debt futures, the December municipal contract settled up 1 21/32 to 83 16/32. The contract had been up roughly 2 1/2 points from the previous day's close earlier in the session. Wednesday's December MOB spread was negative 489, compared with negative 490 on Tuesday.
The 30-day visible supply of municipal bonds Wednesday totaled $3.145 billion, down $148.8 million from Tuesday. That comprised $1.495 billion of competitive bonds, down $380 million from Tuesday, and $1.650 billion of negotiated bonds, up $231.4 million from Tuesday.
Standard & Poor's Corp.'s Blue List of municipal bonds was down $38.1 million Wednesday to $1.86 billion.
