Saturday, January 27, 2007

Municipal Bonds: Kentucky Court Case

As many of my blog readers invest in municipal bonds, I am providing information on a court case that would have important implications to municipal bond valuations. The case is Kentucky vs. Davis.

The basic issue of the case is whether a state has the authority to tax the interest on out of state municipal bonds held by residents of the particular state. The case was brought by George and Catherine Davis of Louisville, Kentucky. The issue is whether the state of Kentucky has the right to tax the interest on bonds issued by other states. The Davises' maintain Kentucky's policy of taxing out of state municipal bonds, but not income from Kentucky bonds, violates the Commerce Clause and the Equal Protection Clause of the U.S. Constitution. A Kentucky appeals court ruled in Davises' favor. The case has been appealed to the U.S. Supreme Court which is weighing whether to hear the case. On January 19th, the U.S. Supreme Court did not include this case on its argument calendar. The next opportunity to hear from the Supreme Court would be around February 20th.

One issue is the yield on bonds from high tax states tend to be lower. If the U.S. Supreme Court sides with the Davises, the value of bonds from the high tax states could decline by 1% to 4%. The states that could be impacted the most are:
  • California
  • Missouri
  • New York
  • Rhode Island, and others with big in -state tax advantages.
Conversely, states that do not have in state tax advantages historically have offered higher yields to attract investors. A few of those states are:
  • Illinois
  • Texas
  • Washington, and others.
Investors that purchase individual bonds and hold them to maturity likely will not be impacted to a large extent since they will receive the principal on the bonds at maturity. This is the case so long as states do not decide to tax their own munis in the event the Davises ultimately prevail in their case.

Kentucky Bond Fight Confronts U.S. Supreme Court
By: Joe Mysak
January 24, 2007

A Bomb In The Muni Market
Fortune Magazine
By: Jon Birger
February 5, 2007

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