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Forget Trump Fear: Tap Muni Bond ETFs Ahead of Tax Day

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As Tax Day is nearing, Americans are looking for ways to lower their tax burden. They need to file their income tax returns with the Internal Revenue Service by April 18. Some smart investors having some tricks up their sleeves to end up with smaller holes in their pockets.

There are various tax-exempt investment schemes including municipal bonds and certain money market funds, which one can invest in to reduce their tax burden. Specifically, municipal bonds are excellent choices for investors seeking a steady stream of tax free income.

Inside the Appeal of Muni Bonds

Usually, the interest income from munis is exempt from federal tax and may also not be taxable per state laws, making these especially attractive for investors in the high tax bracket looking to reduce their tax liability.

This is totally different from interest on Treasury and corporate bonds that are taxed as regular income. Apart from investors’ desire for a tax-shelter, improving fiscal health of many municipal bond issuers make a rewarding combination (read: 5 ETFs for Portfolio Safety, Stability and Diversification).

Investors should also note that the yield on the 10-year Treasury note has slid 26 bps to 2.36% as on April 4, 2017 from this year’s high of 2.62% hit in mid-March. The Fed’s dovish guidance on policy tightening in the March meeting was responsible for this trend.

This should perk up demand for muni bonds which are safer bets than corporate bonds and yield better than treasuries. According to Moody's Investors Service, the 1970 through 2015 average cumulative 10-year default rate for all rated munis was only 0.15%.

Why Was Muni Investment Hit by Trump?

With President Trump pledging for lower personal income tax rates, investors’ desire for a tax shelter in munis was quelled initially. Plus, Trump had proposed to increase infrastructure spending. If this happens, munis will be forced to issue more bonds offering higher yields amid diminishing demand (read: Top ETF Stories of November: Spotlight on Election & OPEC).

Is Trump Fear Overstated?

In the first place, Trump trade seems to have lost some steam lately on the President’s inability to pull off the Health Care bill. This has raised questions on the materialization of his other promises like higher infrastructure spending, deregulation and tax cuts. In fact, it is too early to factor in tax cut prospects in muni ETF investing (read: Will Muni Bond ETFs Bleed Under Trump or be Contrarian Bets?).

Also, even if the tax cut rule is implemented, solid yield offered by many muni bonds would likely provide a cushion in the segment. Most recently, Goldman Sachs commented that “after adjusting the current highest tax bracket from 43.4% to a hypothetical 33%, municipal bonds remain attractive compared to other investment grade fixed income.”

This is because “muni yields on a tax-equivalent basis, are roughly 5% — far more attractive than investment grade corporates (3%), agency mortgage-backed securities (2%), or Treasuries at 1.5%.”

Historically Munis Less Sensitive to Tax Changes

Citigroup also believes that historically (since 1980) retail demand of munis displayed lesser sensitivity on changes in the marginal tax rate. Though we may see a reduction in the marginal federal tax rate from 39.6% to 33%, the average tax bracket of 25% for all individual holders of municipal bonds are less likely to change much, as per the source.

ETF Picks

Yes, some may argue that muni bonds come with lower yields compared to taxable bonds. However, if we take into account after-tax returns, municipal bonds fetch better returns for investors in high tax brackets.

Below we offer some ETF choices:

VanEck Vectors CEF Municipal Income ETF (XMPT - Free Report)

The 71-holding fund looks to track the overall performance of the U.S.-listed closed-end funds that invest in U.S. dollar denominated tax-exempt market. Its 30-Day SEC yield is 5.09% and net expense ratio is 1.56% (see all muni bond ETFs here).  

Investors should note that a taxable bond investment would have to offer 6.79% (considering a 25% tax bracket) and 8.43% (considering a 39.6% tax bracket) yield, after the deduction of federal income taxes, to match the XMPT’s 30-Day SEC yield (as of April 4, 2017).

VanEck Vectors AMT-Free Long Municipal Index ETF (MLN - Free Report)

It tracks the overall performance of the U.S. dollar denominated long-term tax-exempt bond market with an upper medium credit quality. 30-Day SEC Yield stands at 3.24% which would have to be matched by offering 5.37% yield (to 39.6% tax payers) by equivalent taxable investments. It charges 24 bps.

PowerShares National AMT-Free Municipal Bond (PZA - Free Report)

This product is composed of U.S. dollar-denominated, investment grade, tax-exempt debt publicly issued by U.S. states and territories. It charges 28 bps in annual fees. With 357 securities in its basket, the fund has an effective duration of 8.16 years. The 30-Day SEC yield is 2.66% (as of April 4, 2017).

PowerShares California AMT-Free Municipal Bond Portfolio (PWZ - Free Report)

The 108-holding fund has a tilt toward long-term investment grade, tax-exempt debt publicly issued by California or any U.S. territory, or their political subdivisions. Its 30-Day SEC yield is 2.55% and charges 28 bps in fees.

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