Tax Proposal has Potential Tax Consequences for Muni Bond ETFs

Per a request by Sen. Max Baucus (D-Mont.), the Congressional Committee on Taxation released a report including revenue-generating ideas earlier tin October. In that report was a proposal that gained some attention earlier in 2012. That proposal is the repeal of the interest deduction for municipal bonds, a move that if it comes to pass could prove punitive for municipal bond ETFs.

Despite a rising number of municipal defaults this year, investors have continued embracing muni bond ETFs as one income-generating avenue. However, decent yields and monthly dividends paid by ETFs such as the Market Vectors High-Yield Muni ETF (NYSE:HYD) and the iShares S&P National AMT-Free Muni Bond ETF (NYSE:MUB) are only part of the allure of this asset class.

Another large part of the equation is the tax benefits. 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.

"Rrepealing the interest exclusion of municipal bonds will lead to higher financing costs for governments and, consequently, local taxpayers," Jim Colby, senior portfolio manager at Market Vectors.

The proposal led to the creation of Municipal Bonds for America, a group that is advocating for the proposal's repeal. If the issue were getting more airtime, more investors would know about Municipal Bonds for America. Perhaps the mainstream media should do investors a favor and bring the group and its cause to light more.

Approximately 70 percent of municipal bonds are owned by individual investors, according to Morgan Stanley. That popularity is evident at the ETF level, too. The iShares S&P National AMT-Free Municipal Bond Fund has almost $3.2 billion in assets under management. The Market Vectors High-Yield Muni ETF has over $908 million in AUM and the Market Vectors Long Municipal Index ETF (NYSE:MLN) has $106.2 million in assets.

Colby helps oversee nearly $1.9 billion in municipal bond ETFs, including HYD, MLN and the Short Municipal Bond Index (NYSE Arca: SMB).

"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."

The precarious financial positions of some states, California among them, means the proposal to repeal the tax exemption for muni bond interest payments has the potential to be a hot-button issue. As Colby noted, neither President Obama nor Republican challenger Mitt Romney want to be seen as favoring the idea.

In theory, if President Obama spook out in favor of the proposal, the Romney camp could assail him for attacking a source of income for retirees, a demographic that is among the largest owners of municipal debt. If Romney advocated the proposal, the President's team could frame it as another Romney flip-flop because, to this point, the Republican has been opposed to tax increases.

Another possible issue to consider is that if Uncle Sams starts tax muni bond interest, some states could follow suit. That could increase the allure of issues from states with no income tax, but muni bond ETFs are not heavy on issues from non-income tax states.

For example, Texas, Florida, Arizona and Nevada account for barely more than 10 percent of HYD's weight, though Texas and Florida combine for 11 percent of MUB's weight.

For more on muni bond ETFs, click here.