Massive budget deficits brought on by years of reckless spending and low taxes have put many cash-strapped nations such as Greece and Spain in impossible positions. These countries now find themselves searching for ways to cut fat from their bloated budgets and get their fiscal houses in order and avoid the financial devastation that comes along with a sovereign debt default. While austerity measures have been held out as a vital component of the solution to these fiscal woes, many debt-laden European countries have found it difficult to cut social spending for political reasons. As such, tax hikes are popping up throughout the world, as governments desperate to reel in deficits have begun pulling out all the stops.
With a budget deficit quickly approaching 11%, the United States appears to be heading towards some difficult decisions. As demonstrated by many state governments as of late, a number of spending programs are untouchable because of the potential political fallout, and taxes are therefore considered the lesser of two evils. Tax increases have been proposed or implemented in cities and states around the country including New Jersey, Kansas, and Arizona. And the clock is ticking down to a hike of federal taxes across the board.
“On or about Jan. 1, 2011, federal, state and local tax rates are scheduled to rise quite sharply,” writes renowned economist Art Laffer in a Wall Street Journal piece. “President George W. Bush’s tax cuts expire on that date, meaning that the highest federal personal income tax rate will go 39.6% from 35%, the highest federal dividend tax rate pops up to 39.6% from 15%, the capital gains tax rate to 20% from 15%, and the estate tax rate to 55% from zero. Lots and lots of other changes will also occur as a result of the sunset provision in the Bush tax cuts.”
Muni Bond: The Tax Antidote?
For investors in high tax brackets looking to minimize their liability to the government, municipal bonds have long been a popular portfolio holding. Municipal bonds are issued by state or local governments in order to finance various projects such as the construction of bridges, highways, or subway systems. These bonds are generally free from federal taxes, which allows investors in high income tax brackets to decrease their tax liabilities substantially while still maintaining high-yielding securities in their portfolio. For example, if the top marginal tax rate goes up to 40% a muni yielding 5% would provide investors the same after-tax yield as investing in a taxable bond delivering a yield of 8.3%.
Due to the default risk associated with municipal debt, these bonds tend to carry a much higher interest rate than comparable Treasury bonds of a similar maturity. Municipal bond exposure through ETFs has become popular in recent years, as the immediate diversification provided adds immediate value and the lower cost relative to muni bond mutual funds enhances bottom line returns. Luckily for investors, there are several municipal bond ETFs available. Below we profile three popular of the most popular funds which may be able to help high net worth investors to cut down on their swelling tax liabilities (see Why ETF Really Stands For “Efficient Tax Features”).
iShares S&P National Municipal Bond Fund (MUB)
For investors seeking exposure to municipal bonds from across the country, MUB offers a compelling choice. The fund tracks the S&P National AMT-Free Municipal Bond Index, which measures the performance of the investment grade segment of the U.S. muni bond market. The fund contains just under 700 holdings and has just 8.7% of its assets in its top ten holdings. When compared to the other funds on this list MUB has a much greater focus on the short-term; close to 15% of its assets will mature in less than five years (also see PowerShares To Launch Build America Bond ETF).
iShares S&P Cali Muni Bond Fund (CMF)
For investors partial to the California municipal bond market, CMF tracks the S&P California AMT-Free Municipal Bond Index, a benchmark that measures the performance of investment grade municipal bonds in the Golden State. The fund has been relatively stable as of late posting a year-to-date return of just 2.7% and a beta of 0.05. In terms of time until maturity, 8.3% of the fund matures in less than five years while close to 46% of the fund’s holdings has more than 20 years until maturity (see California Muni ETFs: Value Play Or Sucker’s Bet?)
iShares S&P NY Muni Fund (NYF)
NYF tracks the S&P New York AMT-Free Municipal Bond Index, which measures the performance of the investment grade segment of the New York municipal bond market. Almost 70% of its securities pay coupons between 4% and 5%, while another quarter of holdings deliver between 5% and 6%. The fund has a definite tilt towards medium and long term securities; less than 6% of underlying securities mature within five years while more than 42% of its assets have more than 20 years until retirement (read Muni Bond ETFs: New York vs. California).
For more ETF ideas make sure to sign up for our free ETF newsletter.
Disclosure: No positions at time of writing.