SALT Making Muni Bond ETF Investing Sweeter

Municipal bonds enjoyed their best start to a year this time since 2006. Muni bond funds, in fact, had their best quarter of inflows since 2009. According to Morningstar data, tax-free muni bonds garnered more than $8.8 billion in net flows in the first quarter, surpassing U.S. equity funds ($6.2 billion) and international equity funds ($1.3 billion).

Actively managed muni funds were more in demand than passively managed funds, including ETFs. Active funds fetched $7.5 billion, more than five and a half times more than passive muni funds, which raked in only $1.3 billion in net flows, according to Morningstar. These funds are said to fetch more cash during the first four months of 2019 than they usually do in an entire year.

Investors should note that municipal bonds are excellent choices for investors seeking a steady stream of tax-free income. Usually, the interest income from munis is exempt from federal tax and may not even be taxable per state laws, making these especially attractive to investors in the high tax bracket, looking to reduce their tax liability. So, demand for munis go up in the tax season.

How SALT IS Benefiting Muni ETFs

But this year, the segment has held up well even after Tax Day was passed in April. The tax reform (or cuts) put muni bonds under pressure in the initial days of Trump administration. But the evaporation of the State and Local Tax (SALT) made investors flock to muni ETF investing.

There is now limitation on the deductibility of state and local taxes (the SALT deduction) from federal taxes for taxpayers in some states. They can no longer deduct more than $10,000 in state and local taxes from their federal income taxes.

The etf.com article went on to mention that “even with the reduction in the maximum federal individual income tax rate from 39.6% to 37%, the cap on the SALT deduction means the combined state and federal maximum effective income tax rates went up in seven states.” These states include California, Connecticut, Minnesota, New Jersey, New York, South Carolina and Wisconsin.

Limited Supplies

According to an article published on Forbes, the supply of municipal debt has been limited thanks to the elimination of a category known as “advanced refunding issues.” Advance refunding refers to when one bond issuance (issued at lower rate) is used to pay off another outstanding bond. Municipalities typically resort to advance refunding to lower borrowing costs and to take advantage of lower interest rates. Previously, advance refunding made up about a fifth of muni bond issuances annually.

Dovish Fed

Apart from the said causes, the Fed also came up with dovish comments. Still-subdued inflation led the central bank to consider a “patient” approach to future rate hikes.

Munis Are Hot

All these perked up demand for muni bonds, which are safer than corporate bonds and yield higher than treasuries. Investors should note that muni bond ETF iShares National Muni Bond ETF MUB returned more than long-term treasury bond ETF iShares 20+ Year Treasury Bond (NASDAQ:TLT) ETF (NZ:TLT) and investment-grade corporate bond ETF iShares iBoxx $ Investment Grade Corporate Bond ETF LQD since the start of tax reform in January 2018 (see all Municipal Bond ETFs here).

Below are the muni bond ETF winners in the past one-year.

Xtrackers Municipal Infrastructure Revenue Bond Fund RVNU – Up 7.8%

VanEck Vectors AMT-Free Long Municipal Index ETF (NZ:MLN) – Up 7.3%

VanEck Vectors AMT-Free Intermediate Municipal Index ETF (LON:ITM) – Up 7.3%

First Trust Municipal High-Income ETF FMHI – Up 7.1%

Franklin Liberty Municipal Bond ETF FLMB – Up 7.0%

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