Bond Funds With $155 Billion Imperiled If U.S. Court Voids Law
By Greg Stohr and Jeremy R. Cooke

Oct. 29 (Bloomberg) -- Municipal-bond investors may be owed billions of dollars, and bond funds holding $155 billion rendered obsolete, as the result of a U.S. Supreme Court fight over state tax powers.

And that might be just the beginning of upheavals in the $2.5 trillion market in debt issued by state and local governments to pay for schools, roads, sewers and other civic works.

The justices hear arguments Nov. 5 on whether Kentucky violates the Constitution by taxing income earned on out-of- state bonds while exempting interest on ones issued by its own cities, school districts and other debt-issuing authorities. Barring such preferential treatment would force 42 states, including New York and California, to either tax their own bonds or give identical breaks to out-of-state bonds.

``It would result in a substantial reconfiguration of the municipal-bond market,'' says Gerard J. Lian, executive director of the Morgan Stanley/Van Kampen tax-exempt mutual fund group, which manages $15.8 billion. In a career spanning more than two decades in the business, ``it would rank up there as the biggest event that I can remember,'' he says.

A ruling against Kentucky would let holders of out-of-state bonds demand billions of dollars in tax refunds, according to a brief filed by the other 49 states. New York alone would face $200 million in claims. The court will rule by July.

The securities industry and the states are fighting to preserve the current system, making the potential repercussions a central part of their argument.

Instability and Uncertainty

Nuveen Investments Inc., the largest U.S. closed-end fund company, says banning in-state preferences might cause ``serious dislocation'' in both markets and government activities. The Securities Industry and Financial Markets Association, which represents the industry in Washington, says such a ruling would usher in a period of ``instability and price uncertainty.''

Eric Brunstad, who will argue on behalf of two Kentucky taxpayers, says those predictions are exaggerated and that any changes in the marketplace would benefit investors. A victory for his side, he says, would undermine the attraction of the 481 single-state bond funds, which held $155 billion as of 2006; investors, no longer influenced by the state tax advantages, would then gravitate toward more cost-efficient and diverse national funds.

``It's just not a good idea to have all of your bond investments in a single state like California,'' says Brunstad, a partner at Bingham McCutcheon in Hartford, Connecticut.

The Kentucky taxpayers have the support of a group of economists that includes R. Glenn Hubbard, formerly President George W. Bush's top economic adviser and now dean of Columbia University's graduate business school in New York.

`Utterly Anachronistic'

The current system is ``completely and utterly anachronistic,'' says another member of that group, Alan D. Viard, a scholar at the American Enterprise Institute in Washington. ``We live in an era when Treasury-bond money and corporate-bond money flows freely across national boundaries, but we have municipal-bond money trapped inside state lines.''

The disputed practice dates back to 1919, when New York's first income tax law exempted in-state municipal bonds. Today, all 42 states that tax municipal-bond interest give at least some preferential treatment to their own securities.

The system has given small issuers a ready market. Almost half the 2002 new long-term issues were for less than $1 million, according to the Internal Revenue Service. Single-state funds, eager to diversify, have snapped up local offerings.

``If you lost your single-state funds, that would reduce market access for small issues,'' Lian says.

Dormant Commerce

The Supreme Court case affects only state tax laws, not the federal exemption on municipal bonds. The legal question involves the so-called dormant commerce clause, a judge-created rule that bars states from discriminating against out-of-state business without authorization from Congress. The Kentucky Court of Appeals concluded last year that the state was violating that principle.

In April the Supreme Court limited the scope of the dormant commerce clause in a 6-3 decision that let two New York counties direct trash to designated, publicly owned facilities.

Writing for the majority in that case, United Haulers Association v. Oneida-Herkimer, Chief Justice John Roberts said the court should be deferential when states act to help out government entities, as opposed to private business.

`Legitimate Goals'

``It does not make sense to regard laws favoring local government and laws favoring private industry with equal skepticism,'' Roberts wrote. Laws that help local government ``may be directed toward any number of legitimate goals unrelated to protectionism.''

Some legal experts say that reasoning may foreshadow a victory for Kentucky and the current bond-taxing system.

``Until United Haulers, there was no serious argument that Kentucky's scheme was constitutional,'' says Walter Hellerstein, a tax law expert who teaches at the University of Georgia Law School in Athens and opposes the in-state preference. He says the court may uphold Kentucky's system to avoid unsettling financial markets.

The tax exemptions let issuers in high-tax states, including California and New York, sell bonds with relatively low borrowing costs. Twenty-year California general obligation bonds, on average, yield 11 basis points less than generic general purpose bonds rated A+, the same ranking as the state, according to data compiled by Bloomberg.

New York and Illinois

Bonds sold by New York's state and local governments yield 8 basis points less than those for Illinois, where most municipal debt is subject to state tax, according to Lehman Brothers Holdings Inc. indexes. A 10 basis-point difference equals about $1,000 a year on a $1 million investment.

Those spreads are ``not enormous, but they're significant,'' says Chris Mier, managing director and municipal strategist at Loop Capital Markets LLC in Chicago. ``That's real money on a large issue.''

Were bonds in high-tax states to lose their state exemptions, their collective value might plummet -- by almost $6 billion in California, New York and New Jersey alone, according to an estimate by the Pittsburgh-based National Federation of Municipal Analysts. Bonds in low-tax states might rise because they would become relatively more attractive.

Market Impact

The market impact would depend on how states reacted to a Supreme Court ruling. Many are legally barred from taxing in- state bonds and might instead exempt all municipal bonds. The reaction also would depend on Congress, which could effectively overturn the court and authorize in-state exemptions.

So far, the market has done little to prepare for the possibility that the court might bar in-state preferences. Municipal bonds already are having their worst year since 1999, according to a Merrill Lynch & Co. benchmark index.

``It's a difficult-to-hedge situation,'' Mier says.

Something of a test case has already occurred in Florida, when the state's highest court cast doubt on the validity of more than $13 billion in bonds that weren't approved by voters.

``The market went haywire,'' says Erik Kimball, a former bond analyst who is now a public-finance lawyer at Akerman Senterfitt in Orlando, Florida. ``Pricing was a problem. For a couple of weeks, my phone rang off the hook. Certainly, there was less trading during that period of time.''

Should the Supreme Court outlaw in-state tax preferences, Kimball says, ``I think we'll see that on a much larger scale.''