A couple of months ago, Governing.com ran an interesting story about a proposed change to the municipal bond market. This is a story about the impact of restructuring the municipal bonds market.

Facts About Municipal Bonds

Interest payments on municipal bonds are largely exempt from Federal income taxes. If you live in a high-tax, large state like California, there are bond funds that only buy California municipal bonds. Interest payments from those funds are also exempt from California income taxes. With California’s top tax bracket north of 13%, this is a huge incentive to store some of your wealth in such a fund.

The Proposed Change

The proposed new structure would remove the tax-exempt feature of these bonds. States would be compensated with direct payments from the Federal government. Here’s the description from Governing.com:

Although many state and local officials are fixated foremost on the infrastructure bill, the House budget reconciliation bill has three provisions that are a big deal in the world of municipal bond finance; on the Senate side, these provisions are now in peril. One of them gives issuers of tax-exempt debt an option to sell their bonds on a taxable basis, pay a higher interest rate and receive a federal cash subsidy. Economists call it a “taxable bond option” (TBO), though it’s better known in the industry as Build America Bonds (BABs) from the Obama era when they were allowed temporarily during the Great Recession.

The idea is that because of the hefty income tax breaks that rich investors enjoy when they buy muni bonds, it ultimately costs Uncle Sam less to just let the issuers sell the bonds taxably and pay them a cash subsidy instead. Allowing a TBO/BAB is arguably more efficient because it opens the muni market to pension funds and foreign investors that have no need for federally tax-exempt income.

The only feature of the provision now pending in congressional committees that some might challenge is the rate of subsidy. The pending language would allow 35 percent, which is debatable. The interest-rate difference on taxable versus tax-exempt muni bond yields in the marketplace is not necessarily the same fraction as the top income tax rate for fat cats. Lots of lower-bracket investors buy muni bonds through mutual funds, and the TBO option would add demand from non-taxable investors, so an economist can prove mathematically that the subsidy rate should be somewhat lower unless the IRS’s highest individual income tax rate exceeds 40 percent (including the Obamacare Net Investment Income Tax).

The intent of this change is to remove the tax incentive for people to buy municipal bonds. Doing this opens a whole new can of worms. In short, municipal bonds will have to compete with corporate and government securities. After a summary followed by a quick example, I’ll review the implications.

Summary

The root cause of potential problems is accounting and financial reporting standards. Corporations must follow Generally Accepted Accounting Principles (GAAP) in their financial reporting. The four fundamental principles of GAAP are cost, revenue, matching, and disclosure. When an accounting firm audits and verifies the firm’s financial statements, they follow GAAP. Negative reports about a business’s finances are rare because such statements increase the firm’s cost of borrowing. In extreme cases, the firm’s debt may be relegated to the junk bond market.

While there have been attempts to create accounting standards for government, there are no enforcement mechanisms. In fact, there are no auditors for government financial sta

tements. And no wonder. Corporations are often accused of creative accounting. But compared to governments, corporations are the gold standard of compliance and transparency.

That means pushing muni bonds into the corporate bond market would drive up borrowing costs in the muni bond sector. Government securities are relatively riskier (because of greater uncertainty about the veracity of their financial statements). The government will end up spending a lot more on subsidies to the muni bond issuers than they are losing in tax revenue today.^[1]

An Example

We have a chunk of money in a California-only muni bond fund. I could calculate how much this has saved us in taxes. But changing Federal tax brackets and laws means doing this would take more time than I want to devote to this article.

Since interest on these bonds is tax-exempt, the yield on them is considerably lower than corresponding corporate bond yields. For example, Vanguard mutual funds offers a long-term California muni bond fund. The ten-year average yield is 4.74%/

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Vanguard offers a variety of long-term corporate bond funds. Here’s an example that approximates a Baa corporate bond.^[2] The ten-year average yield is 6.69%.

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The difference is 6.69% ⎯ 4.74% = 1.95%.

That interest rate differential reflects three factors.

1. The municipal bonds are exempt from both Federal and California taxes.
2. The risk of the two asset classes is different because corporations are not government entities.
3. California is not the same as the entire country. The corporate bond fund is for U.S. corporations. The muni fund is California only. The risk differential for this factor could move the difference between the two yields in either direction.

What would happen to the muni bond market if this proposal was implemented? Let’s start with some basics.

Bond Market Fundamentals

All assets are substitutes for each other in that they are various ways of holding wealth. They must compete for funds by offering an appropriate yield to maturity for their level of risk. There are other factors as well – tax treatment of interest (or dividend) payments is one. The real question is the degree to which they are substitutes.

First a reminder: the price of a bond and its yield to maturity move in opposite directions. When the price of a bond increases, its yield must decrease. Therefore, when I’m talking about the price of a bond I’ll refer to 1/yield so that both price and 1/yield move in the same direction.

The definition of substitutes starts with two products, A and B. If an increase in the price (1/yield) of A causes the price (1/yield) of B to increase, A and B are substitutes. The logic here is clear. An increase in the price (1/yield) of A causes quantity demanded of A to decrease. Some former buyers of A will switch to B. Demand for B increases and the price (1/yield) of B also rises. Here’s a short video that illustrates what happens in the two markets. Note that the demand for municipal bonds increases in response to the increased price of corporate bonds. The corporate bond market sees a decrease in quantity demanded while the muni market sees an increase in demand.

But the real question is how much? If the yield on corporate bonds rises by 10 basis points,^[3] by how much does the yield on municipal bonds rise? To answer that we need to know the elasticity of substitution between the two assets.

For that, we turn to a 2014 article by Richard J. Cebula.^[4] He estimated the relationship between the real rate of return on municipal bonds and the yield to maturity on Baa corporate bonds as well as a number of other variables. He estimated two versions of his model. For simplicity, I’ll use his first which does a regression on levels of each variable.^[5] His estimate for the coefficient of RBaa (Baa rated corporate bond yield) is +0.561 with a t-value of 3.06. Cebula’s data is annual from 1960 to 2011. With 52 data points, that t has a p-value of 0.0038. Pretty reliable. But what does it mean?

First, the coefficient is positive. That means the yields on the two assets move in the same direction at the same time. Which means they are substitutes. That’s a good thing. In fact, the coefficients on all the statistically significant variables are positive. That means we are dealing with a group of assets that are substitutes for each other.^[6]

In short, a 100 basis point (1 percentage point) increase in RBaa causes the yield on municipal bonds to rise by 56.1 basis points (slightly more than ½ percentage point). The elasticity of substitution at the means of the two variables is 1.40.^[7]

In other words, muni bonds and corporate Baa bonds are substitutes but not perfect substitutes. And no wonder. Muni bonds are tax exempt. The yield on muni bonds rises less than the yield on corporate bonds because part of the muni bond rate increase is consumed as tax benefits to the buyer.

Conclusion

I had planned to include an elaborate series of calculations here. But this article has been sitting in my “to-do” list for three months. Anyone who wants my data can click here to download my Excel workbook.

1. I’m just going to assert this. Doing the calculations would take too much of my time and energy. ↑
2. Patience. The reason I chose this will be clear later. ↑
3. One basis point is 0.01 percentage point. An interest rate that rises from 2.41% to 2.47% has risen by 6 basis points. ↑
4. Cebula, Richard J. (2014). “An exploratory analysis of the impact of budget deficits and other factors on the ex post real interest rate yield on tax-free municipal bonds in the United States.” Applied Financial Economics, 24:19 1297-1302. Available at http://dx.doi.org/10.1080/09603107.2014.925057. ↑
5. Cebula’s second estimation uses the percentage changes in the S&P 500 index and the change in real GDP per capita. While I would have liked to see the percent change in the S&P 500 in his first estimation, he used the level instead. ↑
6. One of the independent variables is not an asset. Cebula’s real interest is the relationship between the U.S. government budget deficit and the real yield on municipal bonds. His measure of the budget deficit is the nominal annual deficit as a percentage of nominal GDP each year. For those who are interested, the coefficient of the budget deficit variable is 0.271 with a t-value of 2.36 (p = 0.0227). ↑
7. Using Cebula’s second estimation, the coefficient is 0.511. The implied elasticity is 1.27. ↑