Possible changes to the tax code may prompt private wealth managers to shift assets to high-quality, taxable bonds from municipal holdings in anticipation of tax reform that could make previously taxable income tax free.
The potential shift comes on the heels of a Bush administration advisory panel on tax reform examining the impact of taxes on investment at its most recent meeting in March. While the form of a change in the tax code has not yet been decided upon, some market participants believe an investment credit, for example, making the first $10,000 of investments tax free, would drive investors from tax-free municipal bonds to taxable securities. "There would be less incentive to be in munis," according to Dominic Konstam, head of interest-rate strategy at Credit Suisse First Boston. He added: "The government's ultimate goal would be to move away from an income tax, meaning all forms of savings would be tax free."
At least one investor has made a contingency plan should tax reform impact the muni market. Mellon Financial's private wealth management group may shift up to $120 million out of tax-free munis into taxable agencies, according to John Flahive, director of fixed income. He believes muni bond prices will suffer if the investment credit concept gains steam. The change would increase Mellon's holdings of agencies from zero to 10% of the $12 billion currently invested in nontaxable securities.
To be sure, tax reform is not on most portfolio managers' immediate horizon, with Social Security reform having taken center stage. But the market getting wind of a large investment credit could prove to be negative for munis—and a boon for high-quality surrogates in the taxable market. "If the panel decided for taxpayers who earn less than $50,000 the first $5,000 is exempt, that's not going to hurt the market. It depends on the nature of the language and how much political gundpowder is pushing to make it a reality," Flahive said. Konstam said while the initial amount of a tax credit may be small, the administration could raise that amount gradually.
The panel is made up of a mix of former congressmen, academics and representatives from major asset managers. Its mandate is to develop options for reforming the tax code for submission to the Treasury secretary. The panel's recommendations will carry weight because the panel was convened by the President and its findings will shape the debate on tax reform going forward.
