Three ETFs To Shield From Expiring ‘Bush Tax Cuts’

by on July 28, 2010 | ETFs Mentioned:

In the past two weeks, many large U.S. corporations have posted solid earnings which has sparked optimism over an economic recovery. However, recent testimony from Fed Chair Ben Bernanke has weighed on the markets and has kept many investors fearful about the near future. In his testimony, Bernanke called the American economic outlook ‘unusually uncertain’ and said that several tools were being discussed in order to help boost the economy. This gloomy proposition left many certain that a double dip was around the corner which has placed an extremely heavy burden on the federal government in order to quickly revive the economy before the November elections while simultaneously keeping the ever-increasing budget deficits in check. As a way to cut back on this deficit while keeping the vast majority of the electorate satisfied, legislators are discussing the possibility of allowing the now infamous ‘Bush tax cuts’ to expire for taxpayers that have an income of $250,000 or more. If the cuts are allowed to expire, the top individual tax rate would raise from 35% to 39.4% next year and many investors could see increased rates on capital gains and dividends as well [see Three ETFs To Protect Against Rising Taxes].

While president Barack Obama supports the plan to increase the taxes on these wealthy individuals back to 39.4%, he faces stiff opposition from Republicans, small businesses, and even some fellow Democrats. Democratic consensus has been eroding as the economy has remained sluggish, with some in the majority party openly expressing their concerns over raising taxes while facing a grim economic portrait wrought with high levels of unemployment.  “As a general rule, you don’t want to be cutting spending or raising taxes in the midst of a meltdown,” says Senator Kent Conrad, Democrat of North Dakota,”We know that very soon we’ve got to pivot and focus on the deficit.  But it probably is too soon to cut spending or raise taxes.”  However, Republicans also find themselves conflicted, many are unsure of which should take greater priority; the extension of the tax cuts to help boost the economy, or allowing the cuts to expire in order to narrow the budget deficit, which is becoming an increasingly large issue for fiscal conservatives. This is especially true given the immense cost of continuing the tax breaks for high-income individuals; some estimates put the cost to the Federal Government at $115 billion, a figure which could greatly help in reducing the country’s immense debt load. Due to these high costs and the struggling economy, it is uncertain whether the ‘Bush tax cuts’ will be allowed to expire for those in the highest tax brackets, however, investors can begin to prepare themselves for increased rates by taking a closer look at the municipal bond market [see Top Ten Bond ETFs of 2009].

Municipal bonds are issued by state and local governments to either develop or finance projects such as sewer systems or highways. Since state and local governments cannot print money like the federal government, most investors agree that municipal bonds have a higher default risk than Treasury Bills so they typically provide a higher return to investors as well.For high tax bracket individuals, these securities can also provide an excellent avenue to minimize tax liabilities on the Federal level.  Often called “tax-free” bonds, munis are exempt from federal taxes so a municipal bond yielding 4% for an investor at a marginal tax rate of 35% would be receiving the equivalent return of a taxable bond yielding 6.15%. However, an investor at a lower tax bracket would fail to see the majority of this tax benefit making these securities more appropriate for high net worth individuals. Below, we highlight three municipal bond funds which can provide high net worth individuals a haven for protecting their funds should tax rates creep higher at the end of the year [also see Advanced Bond ETF Investing: Five Funds Worth A Closer Look].

Municipal Bond ETFs In Focus

  • iShares S&P National Municipal Bond Fund (MUB): MUB seeks to replicate the performance of the S&P National AMT-Free Municipal Bond Index which measure the performance of investment grade U.S. municipal bonds.  MUB’s top holdings include the California State General Obligation Bond (1.09%), Massachusetts State School Building Authority Bond (0.88%), and the North Carolina State General Obligation Bond (0.86%).  In total, 60.8% of MUB’s holdings have coupons of between 4%-5% while 32.4% of MUB has a slightly higher coupon of 5%-6%. The fund also has a heavy focus on high-quality bonds with 31% rating ‘AAA’ and 37.1% achieving a ‘AA’ rating. Possibly due to these high credit ratings and relatively good yields, MUB finds itself as one of the most popular municipal bond funds with assets of $2 billion and an average trading volume of just under 100,000 shares a day.  The fund has a year-to-date return of 2.12% and pays a 30-Day SEC Yield of 3.1% while charging a modest expense ratio of 25 basis points. [see more fundamentals of MUB here].

  • PowerShares Build America Bond Fund (BAB): The ETF tracks the performance of the BofA Merrill Lynch Build America Bond Index consisting of Build America Bonds which are publicly traded and U.S. dollar-denominated and are issued by state and local governments across the country. Top holdings of BAB includes the New York General Obligation Bond (2.78%), the California State General Obligation Bond (2.65%), and the Cowlitz County Washington Public Utilities District Bond (2.05%) [see the complete listing of the fund's top holdings here]. The fund has a heavy focus on securities paying interest of between 6%-8%; these bonds make up roughly 71% of the fund’s total assets while AA rated bonds are the most popular credit quality level, making up 57.6% of the fund. Thus far in 2010, BAB has dominated the Municipal Bond ETFdb Category, posting a year-to-date return of 6.73% while charging an expense ratio of 0.35%. However, the fund has been losing momentum in recent weeks as BAB supply has flooded the market and left the security trading rangebound since mid-May [also see All American ETF Options].

  • iShares S&P Cali Municipal Bond Fund (CMF): This ETF tracks the performance of the S&P California AMT-Free Municipal Bond Index which invests in investment grade California municipal bonds.  The fund’s major holdings include the California State General Obligation Bond (3.66%), the San Diego California Unified School District Bond (2.55%), and the California Statewide Communities Development Authority Bond (2.49%). Virtually all of the bonds pay out interest between 4%-6% with just 0.8% of the fund’s holdings falling outside of that yield range. In terms of years until maturity, the fund has a heavy focus on longer-term securities with 20-30 year bonds making up 45.6% of the fund’s total assets. CMF is one of the more popular California-focused muni bond funds, controlling assets of $227 million while maintaining an average trading volume of 7,594. This iShares fund, which charges an expense ratio of 0.25%, has a year-to-date return 2.41% and a 52 week return of 6.5% which is strong considering California’s well-documented budget issues.  [also see Muni Bond ETFs: New York vs. California].

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Disclosure: No positions at time of writing.