Barrons: Health-Care Winner

Barrons posted last week how municipal bonds could be the surprising winner of the new health-care bill.  Excerpts below with my highlights:

....{A} less-obvious beneficiary of Obamacare may be tax-free municipal bonds. Upper-income individuals face significantly higher tax rates in the coming years, including new levies on "unearned" income from interest, dividends and capital gains to help pay for health-care reform. Beginning in 2013, individuals earning more than $200,000 and couples earning more than $250,000 will pay the 3.8% Medicare tax on investment income, which is projected to raise $87 billion over the next 10 years, according to ISI Group's Washington research team.

That would be on top of the rate increases slated to take effect next year with the phase-out of the Bush tax cuts. The top bracket on ordinary income (which includes interest income) will rise to 39.6% from 35% presently. Dividends, which have enjoyed a top tax rate of just 15%, would revert to being taxed as ordinary income.

The capital-gains tax rate, also 15% currently, would rise back to 20%. The Obama budget proposals for next year call for taxing both capital gains and dividends at a relatively investor-friendly 20% for singles earning $200,000 and couples earning $250,000, but that would require Congressional action, which hardly is a sure thing......

......Be that as it may, for singles earnings over $200,000 and couples making over $250,000, between the 39.6% top tax bracket and the 3.8% Medicare tax, investors will be paying a top rate on interest income of 43.4%, or nearly one-fourth more than the current 35% rate, according to a research note by Costas Kalaitzidis, an analyst and portfolio manager with Asset Preservation Advisors in Atlanta.  Those upper-income investors would face a 23.8% tax rate on dividends and capital gains starting 2013, versus 15% currently. That will result in a 59% tax hike on these forms of investment income for those in the top brackets.

All else being equal, those higher levies on investment income may persuade individuals and families they might just as well clip coupons on tax-free municipal bonds as bear the risk of taxable bonds or stocks.

For an investor taxed at the top rate of 43.4% slated to take effect in 2013, a 5% long-term, tax-free muni would equivalent to earning 8.8% on a taxable debt security. That is what corporate junk bonds are fetching these days.

For those same top-bracket investors in equities, they would have to earn a total return from dividends and capital gains of 6.6% just to match the return of a 5% tax-free bond. Of course, higher-risk stocks ought to return significantly more than munis.

Even at today's tax rates, long-term munis compare favorably with taxable investments, especially Treasury securities. For 30-year maturities, triple-A-rated general obligation bonds yield 4.44%, nearly as much as the 4.60% on the Treasury long bond....

{However shorter maturing municipals},  are overpriced, says Philip G. Condon, head of municipal bond portfolio management at DWS Investments, Deutsche Bank's U.S. retail asset-management unit. Investors fleeing money-market funds paying a pittance like 0.1% are sticking to ultra-safe, high-quality, short-intermediate munis....

....The problem is that states and municipalities tend to issue long-term bonds to finance capital projects while individual investors prefer shorter maturies, Condon explains. Ashton P. Goodfield, head of muni-bond trading for DWS, further points out taxable Build America Bonds have exacerbated the supply tightness by reducing the volume of traditional tax-free bonds coming to market. Indeed, given the effect of BABs, calls and maturities, the total of tax-free bonds outstanding may shrink outright this year, she adds.

The result is an extremely positively sloped yield curve, which means longer maturities provide significantly higher yields. Condon sees the migration of investors seeking higher yields from longer maturities resulting in higher prices at the long end, and thus, in a flatter yield curve....

....While most of the bill for health-care reform doesn't come due right away, the economy is certain to face higher taxes in 2011 with the sunset of the Bush tax cut, at least for upper-income earners. Meanwhile, the Federal Reserve is widely expected to begin raising interest rates in 2011, if not earlier. Given all that, could somebody explain the market's bullishness?

Link:  Barrons: Surprising Health-care Winner!