Archive for Friday, June 20, 2003

Cut in dividend taxes forces new thinking on municipal bonds

Higher interest rates may have to be offered to attract investors, city manager says

June 20, 2003


Future city construction projects -- such as a proposed wastewater treatment plant on the Wakarusa River -- could cost Lawrence taxpayers more because of the federal government's latest tax cut.

That's because Lawrence and other cities may have to pay higher interest rates when they issue bonds to remain competitive now that investors will pay lower taxes on stock dividends.

"You have to pay somebody more to take our bonds, the theory being," City Manager Mike Wildgen said. "It's a possibility."

The good news: Financial analysts say low interest rates mean cities and taxpayers might not feel the financial pain for a few years.

But when the economy finally recovers, "I think you'll start seeing higher rates for municipal bonds," said David Kelly, an economic adviser at Putnam Investments in Boston.

Lawrence and other cities don't collect enough money from taxpayers in a year to pay for major construction projects all at once without a major tax increase. So they issue bonds -- essentially, a way of taking out a loan from investors. And just like a bank loan, cities must repay the principal with interest.

Municipal bonds are attractive to investors because a return on the investment is virtually guaranteed, whereas stocks can be relatively volatile. And municipal bonds are tax free for investors, where stock dividends have come with a tax rate of as much as 25 percent.

But the 10-year, $350 billion federal tax cut that became law last month reduces the tax rate on stock dividends to 15 percent. And some analysts say that will make bonds less attractive to investors -- unless they pay a higher interest rate.

"That preference in law for stocks relative to bonds is important," Kelly said. "I think it hurts municipal bonds."

Not everyone agrees.

Lee Swinson, branch manager for US Bancorp Piper Jaffray in Lawrence, said bond buyers and stock buyers usually are different people. Bond buyers seek financial security; stock buyers yearn for the financial home run.

"When you compare to common stocks, yes (the tax cut) makes the stocks look more attractive," Swinson said. "But it doesn't make the bonds less attractive."

Ed Mullins, the city's finance director, said he didn't think the city would suffer greatly.

"The original Bush proposal would have eliminated the tax on dividends -- that did not happen, so I think the impact on municipal bonds will be relatively light," he said. "I think the security and total tax-exempt nature of municipal debt will still make it attractive."

But any increase could have a noticeable effect on city finances. The city is paying $10.1 million on bond and interest in the 2003 budget, just less than 10 percent of the total budget.

The possibility of rate increases, however, has escaped the notice of most cities.

"They're not screaming about it," said Kim Gulley, a spokeswoman for the Kansas League of Municipalities.

But Wildgen is preparing for an increase.

"There is -- from what I've read -- there's some feeling we'll be in a less competitive position compared to other taxable bond options investors have," he said. "I think there's still a lot of people hashing out what it means."

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