Income tax volatility may hurt states: report

WASHINGTON/NEW YORK Wed Jun 8, 2011 4:13pm EDT

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WASHINGTON/NEW YORK (Reuters) - Income tax volatility could threaten the recent turnaround in state and local revenues, according to a report released on Wednesday, just as analyst Meredith Whitney again forecast doom for the U.S. municipal bond market.

eBooleant Consulting, LLC pointed out that even with the U.S. unemployment rate remaining high, revenues are still heavily reliant on the personal income tax.

"This will continue the destabilization of tax revenue over time," the fixed-income consultancy group said.

Revenues were almost three times as volatile in 2010 as they were in the early 1990s, eBooleant found, mostly because personal income tax receipts grew more volatile.

The 2007-2009 economic recession created budget gaps in almost every state. As they head into the next fiscal year, many states must again wipe out shortfalls, which has been made harder by the end of the Federal economic stimulus program and by years of slashing spending and drawing down "rainy day funds."

Many states hope a revenue turnaround will bring their budgets into balance, but some investors in the $2.9 trillion municipal bond market worry the rebound will not be adequate.

Wall Street analyst Whitney remains skeptical, and on Wednesday reiterated her call that hundreds of billions of dollars of municipal bonds will default.

Last year, Whitney said there could be 50 to 100 defaults by local governments. She pointed to precarious government budgets, saying unfunded liabilities threaten their finances.

There were 84 such defaults totaling $3 billion in 2010, according to ISA, an investment advisory and research firm based in Florida.

Whitney's bond default forecast has been challenged by many top fund managers.

Richard Bernstein, chief executive of Richard Bernstein Advisors LLC, discounted Whitney's alarms at the Reuters 2011 Investment Outlook Summit on Wednesday in New York.

He did say, however, the handsome yields munis currently pay make them the "junk bonds of this cycle." Actual corporate high-yield bonds, he noted, are trading at narrow spreads.

Bernstein, a former strategist at Merrill Lynch, said he is adding to the $150 million of asset allocations he manages by purchasing muni exchange traded funds.

And DWS Investments, in a report released on Wednesday, said Whitney's forecasts are overblown. It projected 39 defaults for all of 2011; through May 11 there have been 14.

"The muni market has defaults every year, even during boom years, particularly in bonds rated below investment grade and those that come from small issuers," DWS, part of the Deutsche Bank Group, said.

Meanwhile, this week's new-issue supply calendar of $5.9 billion makes it the largest week of the year for bond volume.

In the muni primary market on Wednesday, Bank of America Merrill Lynch priced $429 million Houston, Texas, combined utility system revenue bonds for retail investors, according to a market source. The bonds were priced with a top yield of 4.60 percent in 2035. Institutional pricing is set for Thursday.

Muni bond prices ended unchanged to slightly higher on Wednesday. Yields on top-rated 10-year bonds fell 1 basis point to 2.61 percent, while 30-year yields lost 1 basis point to 4.25 percent on Municipal Market Data's benchmark triple-A scale. MMD is a part of Thomson Reuters.

(Reporting by Lisa Lambert in Washington and Chip Barnett in New York; additional reporting by Jed Horowitz; Editing by Andrew Hay)

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