ETF Trends
ETF Trends

As regulators are set to approve a new rule to exclude municipal debt from a group of easily liquidated assets that banks can use in a credit crunch, muni bonds, along with related exchange traded funds, may find less support from large financial institutions.

The Federal Reserve, along with other regulators, could approve a final liquidity rule on September 3, barring debt issued by states and municipalities from being listed as high-quality assets to help sustain a bank through a 30-day squeeze, Bloomberg reports.

Consequently, the new regulation could diminish demand for munis and pressure municipal bond-related ETFs, like the iShares National AMT-Free Muni Bond ETF (NYSEArca: MUB), as banks are given less incentive to purchase the debt to cushion potential downturns. [Muni ETFs Supported by Lowest New Issuance Since 2001]

Fitch Ratings has stated that an exclusion could allow banks to begin cutting their holdings in the $3.7 trillion municipal bond market.

“Over time there would be less demand for municipal securities,” Michael Decker, a managing director who tracks municipal securities regulations for the Securities Industry and Financial Markets Association, said in the article. “The result would be higher borrowing costs for state and local governments.”

According to the Federal Reserve, U.S. chartered banks hold $425.2 billion in muni debt as of the end of the first quarter, up from $221.9 billion in 2008.

Additionally, the new ruling “will almost certainly decrease liquidity in asset markets disfavored by the rule,” American Bankers Association President Frank Keating said in a note.

Nevertheless, some banks will keep their exposure to munis above the minimum standard, regardless of regulatory changes. For instance, Citigroup (NYSE: C) has expressed interest in keeping above the minimum, with Howard Marsh, head of the munis division of a unit of Citigroup, pointing to the benefits of cash generation in times of a crisis.

The iShares Municipal Bond ETF tracks a group of investment-grade bonds issued by U.S. municipalities. The ETF has a 1.76% 30-day SEC yield or a 3.11% tax equivalent SEC yield for those in the highest income bracket.

iShares National AMT-Free Muni Bond ETF

For more information on the munis market, visit our municipal bonds category.

Max Chen contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.