Tax Proposal Puts Muni Bond ETFs At Risk

 |  Includes: HYD
by: Tom Lydon

Muni bond exchange traded funds may be at the mercy of a potential change to the tax code with consequences dire enough to steer investors away. If the interest deduction proposal is repealed, municipal bond investments could suffer.

Muni bond ETFs have appealed to investors for yield and as a safe haven. Tax benefits are another attraction of these investments, but they will soon be a thing of the past if the latest proposal passes, taking away the interest deduction benefit.

"Repealing the interest exclusion of municipal bonds will lead to higher financing costs for governments and, consequently, local taxpayers," says Jim Colby, senior portfolio manager at Van Eck Global.

Since the Sixteenth Amendment of the Constitution was adopted almost 100 years ago, the government has opted not to tax interest on tax-exempt muni issues. Should the proposal to tax interest earned on muni bonds become a reality, some analysts see problems for municipalities and taxpayers alike, reports Benzinga.

The Market Vectors High-Yield Muni ETF (NYSEARCA:HYD) touts $908 million in assets under management. HYD has a yield of around 5%. About 70% of municipal bonds are owned by individual investors, according to Morgan Stanley data. This also applies to muni bond ETFs.

"In my opinion, the practical aspect of this debate rests on the reality that state and local governments must have access to capital if they are truly to recover and rebound from the recession," Colby wrote in a blog post. "Municipals generally have long been an effective vehicle for that access, and with rates remaining near historically low levels, I see no better financing alternative."

Once the taxation starts at the Federal level, it is a matter of time before states begin to do the same. This would lead to double taxation of the interest earned with a muni bond investment. Issues from states with no tax such as Florida and Texas would not be taxed at the state level, but would fall under the Federal tax law.

So far, neither Presidential candidate has spoken out for or against the idea of taxing interest for revenue generation.

Market Vectors High-Yield Muni ETFClick to enlarge

Tisha Guerrero contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.