Court ruling could spur more muni investments

NEW YORK (Reuters) - More money is expected to start flowing into state-specific mutual funds after the U.S. Supreme Court preserved crucial tax breaks for investors who buy U.S. municipal bonds.

The top court on Monday overturned a Kentucky appeals court decision that it was unconstitutional for the state to exempt interest on its own bonds while taxing securities sold by other states. For details, see <ID:nN19533964>.

The ruling was an important victory for the $373 billion U.S. municipal bond fund industry, which sells funds to investors in specific states to take advantage of the tax breaks.

Mutual fund companies had 451 state-specific funds with $155.8 billion of assets at the end of 2007, according to the Investment Company Institute, an investment industry group.

If the Kentucky decision had been upheld, they would have had to find new investments, disband or reorganize these funds.

Now, mutual fund companies “don’t have to worry about their single-state bond funds going out of business any time soon,” said Scott Berry, a mutual fund analyst at research company Morningstar in Chicago.

That’s because the Supreme Court’s decision removed the risk that bonds sold by high-tax states such as New York, California or Massachusetts would lose value if tax breaks were eliminated, dragging down returns of state-specific mutual funds.

“The municipal industry is the winner,” said Thomas Doe, president of Municipal Market Advisors, a research company in Concord, Massachusetts.

Currently, 42 states offer exemptions for their municipal bonds, while taxing out-of-state bonds. Investors who buy bonds sold by states they live in don’t pay state income taxes on the interest they earn.

This incentive increases demand for home-state bonds and lowers borrowing costs for states that raise money for various public projects from new classrooms to bridges in the $2.5 trillion U.S. municipal bond market.

The Kentucky court in 2006 ruled this practice was unconstitutional, raising concerns that bond prices in some states would plummet because states would either have to exempt all or tax all municipal bonds if the Supreme Court backed the decision.

John Miller, chief investment officer for municipal bonds at Nuveen Investments, a mutual fund company in Chicago, said some investors have been taking their money out of state-specific funds because of the Kentucky court decision. Nuveen has 26 state-specific funds with $19.6 billion in assets.

“I am certain that there were individuals who liquidated state-specific portfolios,” Miller said. “On balance, this will improve flows into state funds because this was a considerable risk and uncertainty that has been lifted from the market.”

Individuals who took money out of state-specific funds could have put them into tax-free money market funds, which were not as vulnerable to individual state taxes, Miller said.

The number of state-specific mutual funds has been declining since the mid-1990s even as assets swelled, though at a slower pace than assets in national municipal bond funds.

Last year, state fund assets rose 1 percent, while national fund assets increased 4 percent to $218 billion, according to the Investment Company Institute.

Analysts said it was hard to disentangle the effect of uncertainty created by the Kentucky court decision from other factors such as the credit crisis and a flight to quality, which translated into low returns on municipal bonds last year.

Last year, national long-term funds returned only 1.27 percent on average, compared with 1.5 percent for New York state funds and 0.71 percent for California funds, according to Morningstar Data. Five-year average national fund returns stood at 3.22 percent at the end of April, Morningstar’s Berry said.

But with the risk of potential non-market-related losses eliminated, state-specific funds may regain their allure.

“There may well be a pickup of fund flows into state-specific mutual funds,” said James Colby, senior municipal bond strategist with Van Eck Global, a money management company in New York.

Reporting by Anastasija Johnson; Editing by Jonathan Oatis