Muni bonds to lose tax advantage?

State and local governments rely on municipal bonds to finance projects like highway construction. But those funds are under fire as Congress considers eliminating tax exemptions on muni bonds.

NEW YORK (CNNMoney) -- As lawmakers are busy trying to reach a compromise to get the nation's fiscal house in order, bond market experts are keeping a close eye on how tax reform will play out as part of the plan to reduce the federal deficit.

That's because one idea policymakers are considering is eliminating the tax exemption on new municipal bonds -- the major draw for investors of state and local debt.

According to estimates from the Joint Committee on Taxation, the federal government will forgo more than $200 billion in revenue thanks to municipal bond tax exemptions during the five years from 2010 and 2014.

The thought of tinkering with municipal bond tax policy has crossed politicians' minds in budget debates over the years, but this time, experts say it's more than just a random musing.

In April, senators Ron Wyden, a Democrat from Oregon, and Dan Coats, a Republican from Indiana, proposed a bill that replaces the tax exemption on municipal bonds with a tax credit for investors equal to 25% of the interest earned.

"Washington's influential and powerful want to overhaul the tax code, so there is more seriousness to the proposal to halt or diminish the traditional tax exemption for municipal bonds than ever before," said Howard Cure, director of municipal research at Evercore Wealth Management.

President Obama's budget request for next year gets rid of the tax exemption on municipal bonds and permanently restores the Build America Bond program, an expired Recovery Act initiative that allowed state and local governments to issue taxable bonds and receive payments from the federal government equaling 35% of their interest costs, albeit at a lower 28% subsidy rate.

At an even lower 15% subsidy rate, the Congressional Budget Office estimates the federal government would save $143 billion over the next decade -- just a drop in the bucket when you consider the president's $4 trillion reduction target.

Bonds: It's a seller's market

Still, market participants are taking the proposal seriously, as it could dramatically change the dynamic of the $3 trillion municipal bond market for issuers and investors.

"Current investors would walk away okay, since any changes will likely be accompanied with a grandfather clause -- all existing municipal bond holders would still be exempt for paying taxes on their returns," said Alex Grant, portfolio manager of RS Investments' High Yield Municipal Bond Fund (RSHMX) and the RS Tax-Exempt Fund (GUTEX). "But as those bonds mature, you'll see the asset class start to shrink."

Almost 75% of municipal bond buyers are retail investors primarily because of the tax advantages, Grant said. So any changes to the exemption will ultimately weigh on investor demand for municipal bonds, which state and local governments heavily rely on to fund infrastructure projects.

State and local government bond issuers may have to pay higher interest rates to investors, as they compete with other types of credit, particularly high-yield corporate bonds.

"Municipal bond issuers are dealing with their own budget problems, so they can't really afford to increase their borrowing expenses," Grant said, adding that the challenge of attracting investors in a taxable municipal market would be especially difficult for smaller issuers.

That's because while a taxable municipal bond market will bring new buyers like foreign investors and pension funds, like the Build America Bonds program did, those new investors will likely stick to issuers they're familiar with, such as big states including California and Texas.

"Issuers like local school districts or small water districts would have to attach such a big premium to their bonds that the federal subsidy would not be enough to counter their higher expenses," said Steven Harvey, senior portfolio manager at Standish Mellon Asset Management.

Foreigners still buying U.S. bonds

State and local government officials have been lobbying to retain the current tax exemption on their bonds.

"Municipal bonds are a critical tool to investing in infrastructure," said David Parkhurst, director and legislative counsel at the National Governors Association, "If state and local governments aren't able to go to market with their bonds and can't expect additional revenue from the federal government, this would hamstring expansion and infrastructure."

Because of its severe implications, experts are hoping lawmakers will thoughtfully consider the tax policies on municipal bonds.

"I wouldn't expect any debt ceiling compromise would impact the tax exemption for municipal bonds because it's too significant of a topic to consider behind closed doors," said Derek Dorn, a partner at Davis & Harman, and former senior financial counsel to Democratic Senator Jeff Bingaman, D-N.M.

"But when Congress gets through this initial debate and shifts focus to a broad tax reform, they'll scrutinize everything under the hood of tax expenditures," he added.