Not long after surviving its latest challenge, talk of eliminating the exemption on interest from municipal bonds is back in yet another attempt to bail out a sea of federal debt and deficits with a thimble.

Unfortunately, there have been many efforts to repeal the exemption, including last year, when it emerged as a serious possibility during the federal tax and spending debate (“13 Words That Could end the Muni Exemption”).

The idea then, as now, makes little sense. For investors, however, the renewed debate comes at a notable moment: Tax-exempt yields are reaching levels not seen in years.

Tempting target

As the national debt pushes past $40 trillion, ideas for reining it in are percolating.

Repealing the exemption was among dozens of changes the Tax Foundation recently proposed to the tax code. Its analysis estimates that eliminating the exemption prospectively – for newly issued bonds – would reduce the primary federal deficit by $155.2 billion from 2027 through 2036.

While significant on its own, $155.2 billion over a decade would make only a tiny dent in the enormous fiscal challenges, though it helps explain why the exemption remains a tempting target.

Recurring threat

“With the deficit increasing, and with the national debt clearing the $40 trillion threshold in recent weeks, we fully expect the topic of addressing the runaway debt to remain front and center for Congress going forward,” Brett Bolton, of the Bond Market Association, told The Bond Buyer.

During last year’s tax and spending debate, eliminating the exemption was estimated to generate roughly $250 billion over 10 years. Congress ultimately preserved the exemption.

Still, the issue is unlikely to disappear. “The magnitude of the threat of attack on the exemption is only going to increase as the debt rises,” a municipal strategist told The Bond Buyer.

What the exemption makes possible

There are compelling reasons the exemption has survived repeated challenges. Beyond their attraction to bondholders, tax-exempt bonds are an essential financing tool that helps state and local governments borrow at lower rates to finance public infrastructure. They have financed roads and transportation systems, schools, hospitals, water and sewer systems and other public infrastructure for generations. They’re the primary source of funding for the traditional capital needs of state and local governments.

Eliminating the exemption would not only make it more expensive for state and local governments to borrow – a consequence the Tax Foundation itself acknowledges – but for smaller communities, the consequences could extend beyond higher rates to reduced access to the public debt markets.

Attractive yields

For investors, the more immediate consideration is the opportunity in today’s market.

A September bond-market selloff recently pushed 30-year municipal yields to their highest level since February 2011, according to Nuveen, creating a compelling opportunity for investors amid fresh talk of changing the exemption.

No one knows what Congress will or won’t do, but analysts in the past – and the Tax Foundation now – have assumed that if the exemption were eliminated, the change would apply only to newly issued bonds.

For now, investors can still lock in historically attractive levels of tax-exempt income while financing projects that municipal bonds have helped communities build for generations.