Why is This Topic Important to Wealth Managers? This blogticle discusses the municipal bond market. The discussion focuses on regulation regarding wealth managers who recommend the use of muni bonds to clients.

This past week served as the one year anniversary of when President Obama signed into law the Dodd-Frank Act. [1]

The Dodd-Frank Act was enacted, among other things, to promote the financial stability of the United States by improving accountability and transparency in the financial system.[2]

With Section 975 of Title IX of the Dodd-Frank Act, Congress amended Section 15B of the Exchange Act [3] to, among other things, make it unlawful for municipal advisors to provide certain advice to, or solicit, municipal entities or certain other persons without registering with the Commission.[4]

Since then the SEC has taken several actions regarding municipal securities. In December, it voted to propose a rule creating a new process by which municipal advisors must register with the SEC. [5] In May 2010, the Commission voted to approve rule changes improving the quality and timeliness of municipal securities disclosure. [6]

Both measures were intended to strengthen existing requirements for the scope of securities covered, the nature of the events that issuers must disclose, and the time period in which disclosure must be made.

Until the passage of the Dodd-Frank Act, the activities of municipal advisors were largely unregulated and municipal advisors were generally not required to register with the Commission or any other federal, state or self-regulatory entity with respect to their municipal advisory activities.

Some entities that are now subject to registration as municipal advisors pursuant to Section 15B of the Exchange Act, and rules or regulations promulgated thereunder, currently are subject to regulation by various federal and state regulators in other capacities.  These entities include brokers, dealers, municipal securities dealers, investment advisers, and banks.  Such regulations, however, generally do not apply to their activities as municipal advisors.

Municipal advisors engage in municipal advisory activities in a variety of contexts.  For example, municipal advisors participate in the majority of issuances of municipal securities.

According to the Municipal Securities Rulemaking Board (“MSRB” or “Board”), approximately $315 billion (70%) [7] of the municipal debt issued in 2008 was issued with the participation of municipal advisors commonly referred to as “financial advisors.”

A study that looked at historical involvement by “financial advisors” identified participation rates of approximately 50% in a nearly twenty-year period ending in 2002. [8]

The municipal securities market consists of over 51,000 issuers,[9] a diverse group that includes states, their political subdivisions such as cities, towns and counties, and their instrumentalities such as school districts or port authorities.  These public bodies are governed by state and local laws, including state constitutions, statutes, city charters, and municipal codes.

Municipal securities are issued by government entities to pay for a variety of public projects, for cash flow and other governmental needs, and to fund non-governmental private projects by acting as a conduit on behalf of private organizations that wish to obtain tax-exempt interest rates.

As of March 31, 2010, municipal issuers had an outstanding principal amount of securities in excess of $2.8 trillion. [10]

Tomorrow’s blogticle will continue discussion on regulation.

---

[1] The Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).

[2] See Pub. L. No. 111-203 Preamble.

[3] 15 U.S.C. 78o-4.  All references in this Release to the Exchange Act refer to the Exchange Act as amended by the Dodd-Frank Act.

[4] See Section 975(a)(1)(B) of the Dodd-Frank Act; 15 U.S.C. 78o-4(a)(1)(B)

[5] See 17 CFR Parts 240 and 249.

[6] See 17 CFR Parts 240 and 241.

[7] See Municipal Securities Rulemaking Board, “Unregulated Municipal Market Participants:

A Case for Reform” (Apr. 2009), available at http://www.msrb.org/News-and-Events/PressReleases/Press-Releases/~/media/Files/SpecialPublications/MSRBReportonUnregulatedMarketParticipants_April09.ashx (“MSRB

Study”).

[8] See Arthur Allen and Donna Dudney, May 2010, Does the Quality of Financial Advice

Affect Prices?  The Financial Review 45: 389 (“Allen and Dudney”) (analyzing data from

1984 to 2002).

[9] See Report on Transactions in Municipal Securities, Office of Economic Analysis and

Office of Municipal Securities, the Division of Trading and Markets, U.S. Securities and

Exchange Commission, (July 1, 2004).

[10] See Federal Reserve Board, Flow of Funds Accounts, Flows and Outstandings, First Quarter

Why is this Topic Important to Wealth Managers? This week we continue our series on “Wealth Management in Today’s Economic Environment”. The series is designed to address the specific question many wealth managers are currently asking: “what are the best investment, retirement and financial planning tools given the current global financial position?” We explore alternatives from “safe” to “risky” from “traditional” to “emerging” to discover and discuss the most relevant wealth management tools and techniques available today. We look forward to presenting this discussion and think you will find the information quite valuable. Please note that this series is presented in continuation starting with last week’s entries. That being said each blogticle resumes discussion from the previous day.

Interest received from bonds is generally taxed at ordinary income rates, this includes both government and corporate bonds unless otherwise excluded by the tax code. [1] Dividends though (as discussed earlier in this series) are taxed at capital gains rates, which for the meanwhile, can provide a significant tax advantage.

However, some state and local municipal bonds often called “muni” bonds, are tax—exempt under Internal Revenue Code § 103. The general obligation interest on state or local bonds fall into this category, [2] as distinguished from private activity bonds. [3]

A comparison between tax-exempt and taxable income bonds is illustrated with rates of return below:

“A 4% yield on a muni is the equivalent of a 5.6% payout on a taxable bond if you’re in the 28% tax bracket and 6% if you’re in the 33% bracket. And these yields are relatively safe. Muni defaults have been rare over the years.” [4] However, some state and local municipalities are currently facing financial difficulties. This may affect the traditional ability of the issuers to pay. See generally though Advisorfyi.com, Change in Muni Bond Market Could Help Producers.

The advantage of municipal bonds over corporate bonds is that income from the latter is not specifically excluded from gross income.  Another example adapted from Advanced Markets Advisor FX: [5]

Individual A can chose to purchase, a $1,000 Corporate Bond with an annual interest rate 7.5%, or a $1,000 State/Local Bond at 5.5%.  The first option will yield Interest Income of $750 with a tax of $210 (28% bracket), therefore a net return of $540. The State/Local bond will yield $550 and the income is specifically excluded from gross income.  Even though the corporate bond has a higher stated return the muni bond is most likely a better overall investment.  But why are the muni rates lower?

The “exclusion is intended to benefit state and local governmental units” because the cost of borrowing to these institutions becomes less and in turn “enabling them to market bond issues to investors at lower rates of interest than ordinary private sector bonds.”  Additionally, because “the interest on these bonds is tax-free, investors are generally willing to purchase them at prices that provide a lower rate of return than regular bonds.” [6]

Our series continues tomorrow to continue to explore financial planning in today’s economy.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

Series Author: Benjamin Terner

---

[1] 26 U.S.C. § 61(a)(4).

[2] 26 U.S.C. § 103 (a).

[3] Municipal Securities Rulemaking Board.  http://www.msrb.org/msrb1/glossary/view_def.asp?param=PRIVATEACTIVITYBOND.  2010.  Last Accessed 10/9/10; A detailed discussion of private activity bonds in comparison to general obligation bonds can be found at Tax Facts: Q 1123. Is interest on obligations issued by state and local governments taxable?

[4] “Tax-Free Bonds”.  Kiplinger’s Personal Finance Magazine.  March 2008.  Jeffrey R. Kosnett and David Landis.  http://www.kiplinger.com/magazine/archives/2008/03/maximize-returns-with-bonds.html#ixzz11tDv5mBV.  Last Accessed 10/9/10.

[5] AUS Main Libraries.  Section 19. Income Taxes.  Subheading 3-“Interest On State And Local (“Muni”) Bonds—I.R.C. §103.”  http://www.advisorfx.com/articles/f19_1_8_3240.aspx?action=13.  Last Accessed 10/9/10.

[6] Id.

Why is this Topic Important to Wealth Managers? Discusses opportunity presented by the looming muni bond market.  Offers an alternative investment to muni bonds that contains similar tax benefits.

The Wall Street Journal has recently noted that significant withdrawal of funds from municipal bonds throughout the country totaled over $4 billion in a one week period. [1] According to some estimates, the withdrawal accounts for only one tenth of one percent of the overall muni bond market.  [2] Yet, the numbers are record breaking.  The withdrawal is the largest from the muni bond market since last November, reports the Wall Street Journal.

However, the trouble seems to have started well before Meredith Whitney appeared on “60 Minutes”  in late December of last year when she call for the future “collapse” of the muni bond market.  In her opinion, the state and local governments will be forced to default on obligations made to bond holders because the governmental entities are quickly running out of liquidity.  Nevertheless, the muni bond numbers reflect the ”10th straight week of outflows, which total roughly $20.6 billion.” [3]

Whitney though may have created in the muni bond market what is now known as Gladwell’s “Tipping Point”.  It reasonably appears that she has influenced an overall decline in the faith and credibility of the muni bond market.  “The four-week moving average, a more meaningful number because of the longer time span it measures, was an outflow of $2.2 billion versus an outflow of $1.9 billion in the previous four-week period.” [4]

Many individuals are aware of the bad financial positions of more than a few states.  In California alone, the budget deficit is over $25 billion.  Some are even speculating about another “bail-out” for state and local governments who can’t meet their obligations.

How does all this affect wealth managers?

What exactly will happen is yet to be decided.  However, what is currently known is many individual investors recently liquidated tax favored investments.  Furthermore, it has created a perfect opportunity to promote other tax favorable investments such as life insurance and annuity products.  Because many investors in the muni bond market are accustomed to tax free interest on their investment, and further since life insurance and annuity products offer similar tax treatment, the switch is an appealing conversion.

In fact, lately some insurance companies have repositioned their annuity products to be presented in a light that provides a safe guaranteed source of income.  Many investors who were seeking the “safety” offered by instruments backed by state and local governments are likely to be more amenable now to funding investments offered by private institutions.  Annuities specifically fit the bill, and since most companies offer a line of annuity products from fixed rate to variable and indexed, there is certainly a product out there to fit most investor’s needs.

Next week’s blogs will be discussing more market opportunities for wealth managers.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

---

[1] Kelly Nolan.  Wall Street Journal. “UPDATE:Muni Mutual Funds See $4B Outflow In Latest Week—Lipper”. http://online.wsj.com/article/BT-CO-20110120-717343.html.  January 20,1011.  Last Accessed January 20, 2011.

[2] .  Nicole Bullock.  Financial Times. “Record amounts withdrawn from US muni funds.” http://www.ft.com/cms/s/0/0aae4f6a-24ff-11e0-895d-00144feab49a.html#axzz1BdnfaiYw. January 21, 2011.  Last Accessed January 20, 2010 (PST).

[3] Kelly Nolan.  Wall Street Journal “UPDATE:Muni Mutual Funds See $4B Outflow In Latest Week—Lipper”.

[4] Id.

Why is this Topic Important to Wealth Managers?   Discuses one alternative investment wealth managers are continuing to explore in consideration of uncertain tax law changes.  Provides general background as well as analysis and comparison to show the benefits available through the purchase of tax-exempt bonds.     

Interest received from bonds is generally taxed at ordinary income rates.  This includes both government and corporate bonds unless otherwise excluded by the tax code.[1]  Dividends though are taxed at capital gains rates, which for the meanwhile can provide significant tax benefits.  See our previous AdvisorFYI blogticle of September 13^th Bush Tax Cuts Set to Expire. 

However, some state and local municipal bonds often called “muni” bonds, produce tax—exempt interest income under Internal Revenue Code § 103. The general obligation interest on state or local bonds fall into this category[2] as distinguished from private activity bonds. [3] 

A detailed discussion of private activity bonds in comparison to general obligation bonds can be found at Tax Facts: Q 1123. Is interest on obligations issued by state and local governments taxable? This blogticle deals with general obligation bonds.  A comparison between tax-exempt and taxable income bonds is illustrated with rates of return below: 

“A 4% yield on a muni is the equivalent of a 5.6% payout on a taxable bond if you’re in the 28% tax bracket and 6% if you’re in the 33% bracket.” [4]  The advantage of municipal bonds over corporate bonds is that income from the latter is not specifically excluded from gross income.  Another example adapted from AdvisorFX: [5]

Individual A can chose to purchase, a $1,000 corporate bond with an annual interest rate 7.5%, or a $1,000 state/local bond at 5.5%.  The first option will yield interest income of $750 with a tax of $210 (28% bracket), therefore a net return of $540. The state/local bond will yield $550 and the income is specifically excluded from gross income.  Even though the corporate bond has a higher stated return the muni bond is most likely a better overall investment.  But why are the muni rates lower? 

This tax preferential return allows municipalities to raise money from the investment market at a cheaper interest rate cost.  The “exclusion is intended to benefit state and local governmental units” because the cost of borrowing to these institutions becomes less and in turn “enabling them to market bond issues to investors at lower rates of interest than ordinary private sector bonds.”  Additionally, because “the interest on these bonds is tax-free, investors are generally willing to purchase them at prices that provide a lower rate of return than regular bonds.” [6]

Let’s take a look at another example [7]:

Investor X has $10,000 to invest.  His first option is a triple-A-rated, ten-year muni, which yields 3.43%, and his second option is ten-year Treasury notes, which yields 3.83%.

In all tax brackets, the muni will yield $343.  In the 28% bracket, the after tax income from the T-bills is $276, in the 33% bracket it is $257, and in the 35% bracket it is $249.  Thus, the higher the bracket the more efficient tax-exempt bonds become to an investor in relation to other taxable investments.  In this case the 28% bracket taxpayer saw an greater return on investment of $67, the 33% bracket saw the amount to be $86, and the 35% saw a $94 benefit over the Treasury notes, even though the interest rate yield was a higher stated amount.  In other words, the benefit of purchasing the tax-exempt bonds produced almost 1% (.94%) higher yield over the Treasury notes

Tomorrow’s blogticle will discuss the taxation of life settlement agreements. 

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

---

 

[1] 26 U.S.C. § 61(a)(4).  

[2] 26 U.S.C. § 103 (a).   

[3] Municipal Securities Rulemaking Board.  http://www.msrb.org/msrb1/glossary/view_def.asp?param=PRIVATEACTIVITYBOND.  2010.  Last Accessed 10/9/10.

[4] “Tax-Free Bonds”.  Kiplinger’s Personal Finance Magazine.  March 2008.  Jeffrey R. Kosnett and David Landis.  http://www.kiplinger.com/magazine/archives/2008/03/maximize-returns-with-bonds.html#ixzz11tDv5mBV.  Last Accessed 10/9/10. 

[5] AUS Main Libraries.  Section 19. Income Taxes.  Subheading 3-“Interest On State And Local (“Muni”) Bonds—I.R.C. §103.”  http://www.advisorfx.com/articles/f19_1_8_3240.aspx?action=13.  Last Accessed 10/9/10.  

[6] Id. 

[7] Adapted from Kiplinger’s Personal Finance, March 2008.