The 2012 election results are now finalized Florida ultimately went to the president but the exercise in democracy did little to clear up the outlook for the next several months. With the fiscal cliff continuing to loom large, the next few months are all but certain to be dominated by political sparring, back room negotiations, and plenty of finger pointing on both sides. As the stakes increase, Washington (and apparently the country as a whole) remain divided over the most appropriate path to restore solid fiscal footing.
Without action from Congress either in the form of a "grand bargain" or a mini-compromise nearly 83% of U.S. households will see tax increases averaging about $3,700 next year according to the Tax Policy Center, a nonpartisan research group. More than 98% of households earning at least $50,000 a year would see taxes increase. Those substantial increases should increase interest in tax-exempt revenue streams, such as municipal bonds.
However, the future for the $3.7 trillion municipal bond market is one of the several fiscal matters that will be decided in the months to come. And while the ultimate outcome is anyone's guess, there are a few leading theories on what could transpire between now and January.
Outcome #1: Municipal Bond Exemption Drops to 28%
The Obama re-election makes it more likely that the tax break associated with municipal bonds will be reduced from 35% down to 28% at some point in the near future, partially diminishing the appeal of these securities to high earners. That plan has reportedly received initial bi-partisan support in the Senate, though the specifics of any legislation are far from concrete at this point.
It's worth noting that a reduction in the top bracket benefit likely wouldn't be implemented before 2014. An increase in the tax rates for those in the highest brackets, however, is likely coming at the beginning of 2013. In other words, any decrease in the value of the municipal bond tax exemption would come long after effective tax rates jump (thereby making tax exempt income more valuable).
Outcome #2: Limits on Municipal Bond Issuers
It's also possible that legislators will elect to reduce the number of entities eligible to sell tax-exempt municipal debt, based on metrics such as the size of the debt issuance. Under one plan being floated, debt issuances of $250 million or more could be subject to normal tax rates, which would increase federal revenue. Such an initiative would, of course, increase the cost of borrowing for already cash-strapped municipalities and other issuers.
Such an initiative would go against efforts to simplify the U.S. tax code. Given the complexities associated with this plan, a cap on the number of municipal bond issuers seems like a long shot in the current environment.
Outcome #3: Continued Gridlock = Status Quo
Though Obama scored a convincing Electoral College victory, he will likely continue to face resistance from a divided Washington as the fiscal cliff approaches (and throughout the entirety of his second term). The average U.S. voter cast his or her ballot for a Democratic president, Republican representative, Democratic senator, and Republican governor. In other words, the stage has been set perfectly for continued gridlock and wrangling over fiscal issues.
A divided Washington (and specifically, a divided Congress) is perhaps suggestive that the status quo will simply continue. There's a strong likelihood that a compromise on the treatment of municipal bonds is politically impossible, and legislators elect to tackle the fiscal issues on other fronts.
Gross Remains Bullish
For what it's worth, one of the world's most successful and well-respected bond fund managers continues to maintain a meaningfully overweight positions in municipal bonds. "Muni bonds, which are tax-free, would be a valuable type of asset going forward," said Gross recently on Bloomberg TV. Gross's $280 billion Total Return Fund holds the most municipal debt it has in the past six years, indicating the the Bond King remains bullish on this asset class.
More On Municipal Bonds and the Election
Bill Gross on Obama's Re-Election (Bloomberg TV)