Municipal yields improve to close out week; tax law changes seen as 'threat,' analyst says

By Sheri Kasprzak

New York, Dec. 21 - Municipal yields were somewhat improved on Friday as Treasuries improved and the dwindling supply helped alleviate some pressure on yields, said traders.

"The tone is firmer, and there's a lighter feeling to the market," said a trader reached midday.

"Bids are out there, but I also think that supply is so low going into next week that we're seeing less pressure."

Meanwhile, the market is still going to be impacted by potential changes to tax law, said Tom Kozlik municipal credit analyst with Janney Montgomery Scott LLC.

Tax-exempt status threatened

"Municipal analysts have been warning municipal investors that there is the greatest threat to the tax-exemption since the 1986 tax act for months now," Kozlik said Friday.

"And if Republicans and Democrats currently agree on anything, it is that a portion of municipal bond interest should be taxed, likely retroactively. This idea has been proposed several times by president [Barack] Obama in the past, in the form of a 28% cap that would limit the value of the tax-exemption.

"The possibility for a change is a limited reason why from Dec. 7 to Dec. 18 municipal benchmark yields increased by 34 basis points and flows to municipal mutual funds fell sharply to only $211 million for the week ending Dec. 12 after five straight weeks of positive flows over $1 billion, not a leading reason."

Fiscal cliff also troublesome

The municipal market also has to worry about the fiscal cliff and how it will impact tax-exemption, said Kozlik.

"On the one hand, it is our understanding that the tax-exemption is in fact on the table as part of the fiscal cliff negotiations," Kozlik said.

"On the other hand, we expect, as we have for some time, that any potential immediate fiscal cliff and debt limit talks are finalized. We do think that the threat for change remains elevated, but we are also aware of several efforts where groups, mostly issuers, are trying to educate D.C. lawmakers on the importance of the tax-exemption to their financing needs.

"It is also possible as a result of these issuer-led efforts that political actors dial back their support of potential changes to the municipal bond tax-exemption.

"Therefore, we still think that it is too early to have a clear read on what might become of the tax-exemption and we do not recommend specific changes to investor strategies. We advise investors to continue to monitor the situation and we will provide updates as new facts present themselves."

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