INSIGHTS

On January 03, 2013

Political Small Ball And Its Impact On Municipal Bonds

In baseball, the term “small ball” is used to describe a method of scoring runs by doing a combination of little things successfully. Runners are moved along one base at a time by having their teammates hit singles, walk, bunt, steal bases, and make sacrifice flies. You could say small ball is the opposite of the “big inning” where home runs dominate.

In politics, making a grand bargain might be compared to the big inning where big things are accomplished in a big way. Given the serious issues we currently face regarding government spending, deficits, and the need for entitlement and tax code reform, it is not surprising many investors and the public generally have been feeling the need for a big inning or grand bargain from our political players.

But has the possibility of a grand bargain been a grand illusion all along?  The popular vote in the past four presidential elections has been fairly close by historical standards and recent studies and polls have highlighted the increasing polarization of our politics. Nate Silver, political analyst, recently noted the sharp decrease in Congressional districts that could be considered swing districts. These reasonably contested districts, where votes for Republican and Democratic candidates are fairly tight, have declined by two-thirds over the past 20 years (from 105 districts to just 35 currently). Incentives for compromise dwindle when a growing number of Congressional representatives are unlikely to face close election contests from an opposing party. In the past 18 months, we have had three failed attempts by our executive and legislative branches of government to arrive at a true grand bargain: the debt ceiling negotiations of July 2011, the supercommittee deliberations of fall 2011, and the November/December 2012 battle to avoid the fiscal cliff. In light of the political realities of the past few election cycles, it is no wonder a true grand bargain has been so elusive.

Given the agreement recently forged over the New Year, has enough uncertainty been removed to allow all economic players to get on with their economic lives?  That may be one of the key questions for 2013 and it remains to be seen how that will play out. We do have, for now, some clarity on tax rates for income, capital gains, dividends and estates. This is helpful, but a number of important issues remain unresolved including the prospect of sizable automatic cuts in defense and discretionary spending (the sequester) and the debt ceiling extension. Real progress on deficit reduction, likely to include the thorny issues of spending cuts, entitlements, and broader tax code reform, has also been put off for another day. Given the continued polarization of the electorate and our elected officials, it might be wise for investors to prepare themselves for a future 2013 calendar of rancorous debate under the threat of ongoing self-imposed deadlines. The next deadline appears to be late February/early March when the sequester, debt ceiling, and continuing resolution for Federal government operations converge.

What could the recent agreement on tax rates and the prospect for political small ball mean for the municipal bond market?  Higher tax rates will continue to fuel strong demand for municipal bonds. Political small ball, if it persists, is likely to mean a much more difficult road to a big agreement on broad tax reform. This may make changing or eliminating the municipal bond exemption less likely. It may not be that simple, however. One of the few large ways left to raise revenue for the federal government is to change/eliminate deductions and exemptions to the tax code. Democrats, who will be asked to cut spending and reform entitlements, are likely to insist on reducing or eliminating deductions and exemptions in exchange. The municipal bond exemption may be seen as low hanging fruit to some, i.e. something easy to change/eliminate without too much fuss. On the other hand, governors and mayors across the nation will insist that the revenue “lost” to the federal government due to the exemption is not very large and that the increased cost of issuing debt will be felt by every community that needs to finance long term projects. Depending on your point of view, fiddling with the municipal bond exemption separately may be easy to do because it’s small or not worth it to do because it’s small.

Even in the worst case scenario of the municipal bond exemption going away completely with no grandfather provisions, we estimate that municipal bond values in maturities of 10 years and under could decline by a range to 2% to 8% given the level of current muni bond yields and their relationship to taxable bond yields. Actual adjustments cannot be known, of course, since future supply/demand factors for munis may change due to new taxation rules.

Whether it comes in the form of “small ball” or “big innings”, political noise will continue to be part of the landscape investors will have to deal with in 2013. The potential crosscurrents affecting municipal bonds are varied with possible scenarios that may play out in a contradictory fashion. We continue to believe that an investment grade/intermediate maturity approach in the municipal space can meet investor objectives and reasonably weather potential volatility ahead.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.