The income tax has made more liars out of the American people than golf has. - Will Rogers
The wages of sin are death, but by the time taxes are taken out, it's just sort of a tired feeling. - Paula Poundstone
To put it mildly, tax talk is hot these days and of course with it comes uncertainty as to the value of the income exemption on municipal bonds. The administration has floated the so-called "Buffet Rule" which would enforce a minimum effective tax rate for wealthy individuals along with the draft Debt Reduction Act of 2011 that would involve automatic spending cuts, including ones on tax preferences on interest. Needless to say, many muni market participants are not fans of the additional uncertainty of the value of tax-exemption.
But really how new is this? The chart below shows historical top Federal marginal tax rates from the inception of the income tax in 1913 to today.
Source: National Taxpayer's Union
A few interesting things to note. First the highest federal marginal tax rate was often well north of 50% from 1932 through 1986. For most of that period this rate kicked in for those earning more than $200k to $400k, though during the late 30s and early 40s it was reserveded for those Rockefellers of the day taking down more than $5 million. Next, note the creation of tax-exempt VRDBs coincided fairly closely with a big drop in the top Federal Marginal Tax Rate (FMTR) with the Tax Reform Act of 1986.
How has this changed the value of tax-exempt bonds? This is at best difficult to say as the municipal market has changed so dramatically (along with other financial markets) during the period after the Tax Reform Act of 1986. Since then, the top Federal Marginal Tax Rate (FMTR) in relative terms simply hasn't changed much.
Once you remove the effect of rate levels themselves we find that the very approximate relationship between tax rates and tax-exempt / taxable ratios in the variable rate market are
Tax-Exempt / Taxable Ratio = (1 - TopFMTR) + 2%
Depending on the data set you use and how you control for rates you can get that 2% to move around quite a bit but we find this a reasonable rule of thumb when rates are in a normal range. Of course they haven't been anywhere near normal for many years since Fed Funds has been effectively zero.
Today the true tax risk could go in either direction. The threat of higher marginal tax rates on high earners would bode well for the value of tax-exemption, but proposals pushing a lower FMTR with fewer loopholes would likely hurt.
Tax risk is certainly real, now how much SIFMA/LIBOR swap do you need to hedge it?
"Those who trust to chance must abide by the results of chance."
- Calvin Coolidge
One of the early lessons of modern finance that I was taught, like many others, in portfolio management class is that correlation is risk in a large diversified portfolio. This lesson for many has morphed into myth in light of the financial crisis. Based upon fairly low correlation calculations in normal market environments, investors thought they held diversified positions in say domestic equities, real estate, or even credit default swaps. However in mathematical terms correlations are time inhomogeneous – that is, they aren’t stable over time. And worse, recent experience showed us that for many of the aforementioned markets in times of stress, when you need diversification most, correlations move to 1; now your subtly engineered, diversified portfolio is one big boulder heading south.
What does this have to do with municipal issuers? Municipal and
tax-exempt borrowers often focus their energy predominantly on cash flow and cost of capital when looking at debt management. That’s not to say mark to market changes are ignored, particularly in the case of liability based hedges which can lead to collateral calls and liquidity pressure, but this is usually secondary to understanding the impact on debt service and budgets.
From a cash flow perspective, the two primary types of cash flow risk factors in which munis dabble are interest rate (say LIBOR) and tax-exempt/taxable ratio (SIFMA/LIBOR) risks. Looking at these two factors, through up and down market cycles including the crisis, we find that the correlation is negative and has stayed negative. Ratio risk performs poorly when rates are low but very well when rates are higher. Market microstructure reasons abound to explain the phenomenon which should give financial managers comfort.
Interesting thing about tax-exempt variable rate demand bonds (VRDBs) is they contain both risks within the structure (no, LIBOR swaps do not
add tax risk – it exists in the VRDBs whether hedged or not!). With many issuers struggling against tight budgets and looking for ways to lower debt service, at least in the near term, how do you determine the optimal amount of each factor? That depends upon your expected view of rates, tax-exempt/taxable ratios, the volatility of each, and the correlation between the two. A good tax-exempt risk structuring tool can get you there.
As people soak in the joy (or tragedy depending on your perspective) of the latest apparent tax deal extending current marginal tax rates for a few more years, thought we'd check in and see what the money markets have to say about future tax rates. Many people may not know that swap markets provide a way to assess the almighty market's view of future marginal tax rates. Indeed they do and currently show a near zero value to future tax-exemption.
The vanilla SIFMA swap curve indicates what fixed rate a counterparty is willing to receive over a certain term in exchange for the SIFMA municipal swap index. It starts getting more interesting when you look at the SIFMA/LIBOR basis swap, which is the commitment to exchange SIFMA rates for 3M LIBOR on a quarterly basis for a specified term. You can calculate this by dividing vanilla fixed SIFMA swap rates by vanilla LIBOR swap rates. This currently ranges from about 90% at one year out to 88.5% at the thirty year point.
If we look at this ratio on a forward basis (3M forwards out thirty
years), we see that 3M forwards for SIFMA and LIBOR converge and almost sit on top of each other at the long end of the curve. See right vertical axis and red line in chart for forward SIFMA/LIBOR. But if SIFMA is effectively the tax-exempt equivalent of LIBOR, one minus this ratio provides us with the future implied marginal tax rate (left vertical axis green line). As you can see, implied forward tax rates steadily drop towards zero based upon current 3M SIFMA and LIBOR forward rates.
Why is this? Well there's an awful lot going on in the news these days that could be impacting this. Is the swap market pricing in the risk that the interest exemption on municipal bonds is repealed, thus eliminating the expected tax advantage for the SIFMA index? Or is it the likelihood that marginal tax rates simply decrease, along the lines of the deficit commission's recent report (pg 29)? Or is it that there's a lot of muni cash supply in the pipeline, BABs may not be renewed, investors are withdrawing cash from muni funds, the press is beating up state and local finances every other day comparing them to sub-prime, and this is just a mirrored reflection of the cash (bond) market showing up in the SIFMA swap market. Maybe it's a combination. Academics may debate the "pure expectations" rate hypothesis implicit in this whole discussion; though even critics should agree that given we're dealing with one forward rate divided by another, some bias should come out in the proverbial wash.
Of course it's impossible to say, but relative to assuming pure interest and liquidity risks in this environment which some are doing by renewing VRDB facilities, it's an interesting relationship to consider. What do you