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Phew, Supreme Court upholds current muni market structure

Posted by: Aaron Pressman on May 19, 2008

The U.S. Supreme Court issued a 7-2 decision this morning declining to throw the entire multi-trillion-dollar municipal bond market into chaos. Phew. Nothing to see here, move along.

The longer version: A couple in Kentucky sued the state for taxing the interest they collected from out-of-state municipal bonds they owned. That’s been the practice in the muni market since forever. States only agree to forgo income tax on muni bonds issued in their state, whether by the state itself or by its cities and towns. That creates built-in demand for the bonds and lowers the interest rates the issuers have to pay. If the Supreme Court had agreed with the Davis’s, states might have had to pay billions in tax refunds and the true value of the majority of muni bonds would have been in question.

A lower court had agreed with the couple’s argument that this practice was unfair, because Kentucky was seemingly discriminating against bonds from states and thus violating the Constitution’s interstate commerce clause. In an opinion written by Justice David Souter, the Supreme Court said the pratice was allowable because it furthered important public goals. Souter writes:

Kentucky’s tax exemption favors a traditional government function without any differential treatment favoring local entities oversubstantially similar out-of-state interests. This type of law does “not ‘discriminate against interstate commerce’ for purposes of the dormant Commerce Clause.”

The case is Department of Revenue of Kentucky v Davis and you can find a PDF of today’s opinion (along with a dissent by Justices Kennedy and Alito) on the court’s web site here.

The decision isn’t having any kind of immediate impact on muni bond prices, though it lifts one several clouds of uncertainty hanging over the market. Not only are the big national ETFs like the iShares S&P National Municipal Bond Fund (Symbol: MUB) and the SPDR Lehman Municipal ETF (TFI) virtually unchanged but even the few state-specific exchange-traded funds are doing nothing. iShares California (CMF) and New York (NYF) funds, for example, are practically unchanged.

The muni market has suffered much more from the financial woes of bond insurers and fallout from the demise of auction-rate securities. Returns on national muni bond mutual funds have dramatically lagged gains on taxable bonds funds. The average national muni fund posted a total return of 1.1% over the past year versus 10.1% for long-term Treasury bond funds, according to Morningstar. Getting great news from Justice Souter is one thing. Getting great news from bond insurers Ambac (ABK) and MBIA (MBI) would be far better.

Reader Comments

Alan Viard

May 19, 2008 5:28 PM

This post provides a good summary of the Davis decision on But, the one thing it doesn't mention is the Court's refusal to uphold (for now, at least) the selective tax exemption as it pertains to private-activity bonds. In footnote 2, the Court states:

"An argument raised by one of the Davises’ amici focuses on so-called “private-activity,” “industrial-revenue,” or “conduit” bonds, a subset of municipal bonds used to finance projects by private entities. These bonds are often (but not always) exempt under the Kentucky scheme. Amici contend that Kentucky’s exemption of these bonds, at the very least, plainly violates the Commerce Clause. See Brief for Alan D. Viard et al. as Amici Curiae 25–26. This argument, however, was not considered below, was never pressed by the Davises themselves, and is barely developed by amici. Moreover, we cannot tell with certainty what the consequences would be of holding that Kentucky violates the Commerce Clause by exempting such bonds; we must assume that it could disrupt important projects that the States have deemed to have public purposes. Accordingly, it is best to set this argument aside and leave for another day any claim that differential treatment of interest on private-activity bonds should be evaluated differently from the treatment of municipal bond interest generally."

It may well be that the Court will uphold the exemption for these bonds when it confronts the question - the sentence about "important projects" and "public purposes" may suggest that.

Nevertheless, the Court leaves the validity of the exemption for these bonds "for another day." This is an important segment of the market, maybe a quarter of the total. So, I think it's worth noting that the Court has not yet resolved this question. Of course, I'm also gratified that the Court relied on my brief (filed for me and my fellow scholars by Richards Kibbe & Orbe) in drawing this potential distinction.


Alan D. Viard, Resident Scholar
American Enterprise Institute
202-419-5202 phone
202-862-7177 fax

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