How Tax Reform Could Affect Muni ETFs

President Donald Trump is looking to make sweeping changes to the U.S. tax system and that effort could have consequences, both good and bad, for a variety of asset classes.

Some bond market analysts and participants are concerned about the impact a Trump presidency will have on municipal bonds.

Prior to the Fed raising interest rates for the only time last year in December, income investors widely embraced muni ETFs. However, the Fed is targeting three rate hikes for 2017, a scenario that could pressure fixed income assets.

The iShares S&P National AMT-Free Muni Bond ETF (NYSEArca: MUB), the largest municipal bond ETF, is a favorite destination for investors looking for income with the specter of high credit risk.

Since muni bond interest is exempt from federal taxes, muni ETFs are a good way for investors seeking tax-exempt income, especially those in higher tax brackets. Due to its tax-exempt status, the asset category is also best utilized in taxable accounts. The tax-exempt status also creates high demand for municipal bonds. Consequently, the perceived bond yields are typically lower than their taxable counterparts.

“The hard truth: Lower individual tax rates reduce the value of a municipal bond’s tax exemption. For example, a drop in the top tax rate from 43.4% to 33% means $4,340 in annual savings would be reduced to $3,300. And to the extent that lower tax-exempt benefit mutes the demand for municipal bonds, market valuations could suffer,” said BlackRock in a recent note.