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Muni Bond ETFs Wither on Tax Talk

Muni Bond ETFs Wither on Tax Talk

One of investors' favorite asset classes in 2012 got cold dose of fiscal cliff reality on Wednesday as municipal bond ETFs faltered on news both parties are willing to change the tax-exempt status of municipal-bond interest in an effort to dodge the fiscal cliff.

As was reported earlier this year, the idea of curbing the tax-exempt status of municipal-bond interest stems from a request by Sen. Max Baucus (D-Mont.) to the Congressional Committee on Taxation to conjure up revenue-generating ideas. One such idea was altering the tax-exempt status of municipal-bond interest.

With time running out for the White House and Congress to skirt the fiscal cliff, politicians from both parties are scrambling for ideas and ways to compromise. On the rare occasion that bipartisanship finds it way to Washington, D.C., in this case at least, investors could suffer.

Presiden Obama floated the idea of taxing municipal-bond interest last year and again in February, but now House Speak John Boehner (R-OH) is warming to the idea, according to the Wall Street Journal.

Those wondering why the iShares S&P National AMT-Free Municipal Bond Fund (NYSE: MUB), the largest muni bond ETF by assets, has lost almost 1.3 percent in the past five sessions need only look to Capitol Hill.

MUB is not the only muni bond ETF suffering. Just one day after the announcement that it had topped $1 billion in assets under management, the Market Vectors High-Yield Municipal Index ETF (NYSE: HYD) is off 1.2 percent in late trading on volume that is more than five times the daily average. To say the least, that type of intraday move is uncommon in the world of muni bond ETFs.

For essentially all of this year, investors have overlooked a rising number of municipal defaults and the precarious financial positions of some large states such as California and Illinois to send fresh cash flowing into ETFs such as HYD and MUB. One of the big reasons: The tax-exempt status of muni bonds. 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.

Consideration of altering the tax status of municipal bonds indicates something investors probably already knew about U.S. politicians: Both parties are out of touch with their constituents. A majority of U.S. muni bond issues are owned directly by U.S. households, meaning individual investors. Another significant chunk is held by mutual funds and ETFs such as HYD and MUB with the remaining percentage held by banks, insurance companies, and related entities.

Add to that the demographics of municipal-bond investors. Since this is generally not a volatile asset class, but one prized for stability and steady income, two 25 year olds discussing ETFs at the local dive bar probably will not talk about HYD, MUB and related fare. On the other hand, two 65 year olds at the 19th hole very well could be talking about MUB or HYD. That is to say altering the tax status of muni bonds does not just hurt investors and ETFs, it hurts older investors that own specific muni issues or ETFs like HYD and MUB.

Both parties ought to remember that seniors are, generally speaking, an active, informed voting block and they are unlikely to be happy about higher taxes on one of their primary sources of income.

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