Investors in the huge California municipal bond market have a lot riding on proposed tax changes in President Obama's budget.
The administration's call to restore higher tax brackets for the nation's top income-earners could fuel more investor demand for tax-free bonds. That would be good for current bond owners, and for muni issuers, if the result is to push down interest rates on new bonds.
But Obama also proposes to reduce the federal subsidy for a new breed of taxable munis, so-called Build America Bonds, that some state and local borrowers began to issue a year ago in place of tax-free securities.
That lower subsidy could give borrowers, including California, less incentive to issue the taxable bonds. If they shift their borrowing back to the tax-free market, that would mean a bigger supply of standard munis, which could put upward pressure on market interest rates and devalue outstanding bonds.
For the highest-income earners -- singles earning more than $200,000 and couples earning more than $250,000 -- the White House proposes to restore the top two marginal tax brackets of 36% and 39.6%, up from the current 33% and 35%. That almost certainly should boost the appeal of tax-free munis: They're the last legal tax dodge for many people.
In the 35% tax bracket, a tax-free yield of 4.5% is worth the same as a 6.9% yield on a taxable investment. In the 39.6% bracket, that 4.5% tax-free yield would be worth the same as a 7.4% taxable yield.
Meanwhile, the administration's proposed changes to the Build America Bonds program could have a significant effect on the California muni market: The state and its municipalities have been big beneficiaries of that year-old program.
Build America Bonds allow muni issuers to sell long-term taxable bonds to finance infrastructure projects and have Uncle Sam pick up 35% of the gross interest cost. The idea was to make it cheaper for many issuers to finance projects with taxable bonds than with tax-free bonds.
California issuers have sold $16.3 billion of Build America Bonds over the last year, 23% of the $71.5 billion issued nationwide, according to data firm Municipal Market Advisors. More telling is that California issuers account for 29% of the total federal subsidy under the program, in part because the state's fiscal mess has forced it to pay above-average interest rates to borrow.
Obama proposes to make the program permanent and to allow more muni issuers to make use of the financing. But he also wants to reduce the federal interest subsidy on the bonds to 28% from 35%. Depending on market interest rates for tax-free bonds, that could tilt some muni issuers away from the taxable bonds and back toward tax-free financing for their projects.
Matt Fabian, senior analyst at Municipal Market Advisors, described the subsidy cut as minor and said that for many muni issuers "there will still be a compelling argument" for issuing Build America Bonds.
Tom Dresslar, a spokesman for California Treasurer Bill Lockyer, said the program "has produced great benefits to California, so we're pleased that the administration wants to make it permanent." But he said the state was performing its own analysis to determine whether the lower subsidy would make the program less appealing.
Given the large backlog of voter-approved bonds that Lockyer has to sell, if the state sells fewer Build America Bonds it would have to issue more conventional tax-free bonds.