3 ETF Sectors Facing Tax Uncertainty

by on December 21, 2012 | ETFs Mentioned:

For investors, the last few months have been dominated by two words: fiscal cliff. The combination of automatic expiring tax breaks and across-the-board government spending cuts scheduled to become effective on January 1, 2013, has sent a shiver down the spine of market participants. 

The pending line in the sand was drawn during the last debt ceiling debate, as members of Congress couldn’t decide on how to cut spending/raise taxes enough. The resulting Budget Control Act plus the expiration of the Bush-era tax cuts was designed as motivation to get the Federal government to move and create a realistic solution to fixing the United States’s budget woes.

The $600 billion in proposed cuts across defense, federal agencies and cabinet departments is certainly good motivation to get the job done. If the Feds don’t act in time, analysts expect the economy to truly “fall over a cliff” and regress back into recession. The Tax Policy Center reports that middle-income families will pay an average of $2,000 more in taxes in 2013, while the Congressional Budget Office estimates that 3.4 million or more people will lose their jobs. This will push the unemployment rate back up over 9%. Meanwhile, taxes on dividends and capital gains will surge.

It’s no wonder that investors are on the edge when it comes to the fiscal cliff. For those in certain exchanged-traded fund sectors, the cliff takes on a heightened sense of urgency as well. Many of the proposals to fix the looming deadline will dramatically alter many of the popular investments. Here are three that could see radically different futures after the cliff deadline [for more ETF news and analysis subscribe to our free newsletter].

1. Municipal Bonds

Municipal bonds have long been favored by investors for their tax-free yields. In recent years, as interest rates have sunk to historic lows, more and more investors–in all tax brackets–have been drawn to the asset class as a way to get additional yield. Add in the daily tradability of ETFs like the iShares S&P National AMT-Free Muni Bond (MUB) and SPDR Nuveen Barclays Capital Muni Bond (TFI), and it’s easy to see why munis are now part of almost every investor’s portfolio and have been one of the best performing bond sectors over the last few years [see also How To Pick The Right ETF Every Time].

Well, investors in the sector may not be cheering for long. Even munis’ tax-free nature is on the chopping block when it comes to the cliff. While Congress isn’t yet expected to try to change muni bonds’ tax-free status completely, analysts estimate that lawmakers could limit how much income investors could deduct under the popular tax break based on income bracket; that break has been around since 1913.

By limiting the tax deduction, experts predict that muni bonds will be a less popular asset class and result in higher borrowing costs for state and local governments–particularly those in the weakest financial positions. This could impact the economy just as much as going over the cliff, as state governments are forced to slash budgets, raise taxes and cancel essential programs.

The potential proposals could affect the whole host of muni bond ETFs that have sprung up in recent years to take advantage of investors’ appetites for the bonds. Those in the junk or high yield sector–like the Market Vectors High-Yield Muni ETF (HYD)–or those tracking weaker financial states–like the iShares S&P CA AMT-Free Municipal (CMF)–could be most affected.

2. Dividend Stocks

Like muni bonds, dividend investing is in style again as investors try to navigate the low interest rate environment, especially since they’ve enjoyed low tax rates on dividends and capital gains due to the Bush-era cuts. Funds like the Vanguard Dividend Appreciation ETF (VIG) have swelled in assets under management–in this case, to $14.5 billion–as the low rates have made dividends a popular draw for investors.

With the fiscal cliff throwing dividend tax rates for a loop, these ETFs may also be less desirable in 2013. Back in 2003, the Bush tax cuts lowered the top income tax rate on qualified dividends by 15%. With the expiration of those tax rates and the introduction of taxes associated with Obamacare, the top tax rate on dividends is set to rise to as high as 43% for high-income earners. That higher tax rate certainly makes dividends less attractive to portfolios and companies hoping to draw investors to their stocks.

Already, investors have begun selling broad dividend-focused vehicles like the iShares Dow Jones Select Dividend ETF (DVY), and many income-oriented funds now sit closer to their lows than highs. Going over the cliff could exaggerate that fact further, with continued selling pressure into the new year.

Interestingly enough, a potential winner in all of this could be firms focused on share buy-backs. The PowerShares Buyback Achievers ETF (PKW) could see its star shine as investors flock to the fund as a way to profit from corporations’ large cash holdings.

3. Treasury Bonds

While the original point of the fiscal cliff and Budget Control Act was designed to help improve Uncle Sam’s finances and reduce its debt burden, the initial shock to the economy could actually do more harm than good.

As the cliff debates have raged, demand for the safe haven assets and ETFs like the iShares Barclays 7-10 Year Treasury (IEF) has been strong. However, going over the cliff could actually result in less tax revenues for the feds as the unemployment rate will skyrocket; it stands to reason that fewer jobs will result in less income taxes. That could potentially counteract any boost seen from raising the tax rates in the first place. Analysts also estimate that pending the outcome of the cliff, the United States could be facing another debt downgrade from the various ratings agencies. That downgrade–the United States’s second–could finally be the straw that broke the camel’s back and cause investors to demand more from U.S. bonds. That will raise the cost of borrowing for the United States, which again could counteract any revenue increases.

It’s also worth nothing that bond interest income is taxed at ordinary income rates.

All in all, investors in funds like the SPDR Barclays Cap Intermediate Term Corp Bond (ITR) could see decreasing returns.

The Bottom Line

For all investors, going over the fiscal cliff could mean a world of hurt. For those with holdings in these popular ETF categories, a worsening U.S. economy could result in some investing heartache. Understanding the potential outcomes is key for portfolios.

[For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro]

Disclosure: Photo courtesy of Mike Murphy. No positions at time of writing.