Impacts of Proposed SALT Cap Hike on Bond & Stock ETF Investments

The Republican-controlled U.S. House passed President Trump's tax and spending bill by a razor-thin margin of 215-214 votes, adding $3.8 trillion to the national debt. The bill is now headed for the Senate approval. The bill raised the SALT (State and Local Tax) deduction cap to $40,000 (from the current $10,000 limit).

The concession on SALT came after a group of blue-state Republicans, who described themselves as the "SALTY five," hoped for more generous provisions. The new deduction cap applies to those earning under $500,000.

However, the bill is facing fierce opposition from fiscal conservatives, especially around provisions on Medicaid reforms and green energy credits. Analysts warn the expanded bill can add more than $3 trillion to the deficit, which has rattled bond markets and contributed to a U.S. credit rating downgrade by Moody’s (read: ETF Strategies to Follow on Moody's Downgrade of U.S. Debt).

What Does it Mean for ETF Investing?

Municipal Bond ETFs: A Double-Edged Sword?

Wealthy individuals in high-tax states like New York and California will be able to deduct more of their state/local taxes amid the raised SALT deduction cap. Their federal tax burden would decrease, making the tax advantage of municipal bonds (which are exempt from federal taxes) less appealing.

If the demand for munis drops, prices of muni bonds can fall, causing yields to rise.That can hurt existing holders of muni bond ETFs but improve attractiveness for new buyers. iShares National Muni Bond ETF MUB should be closely tracked amid this circumstance. The MUB ETF yields 3.16% annually.

U.S. Treasury & Government Bond ETFs: Long-Term Gains, Short-Term Loses

A $3.3-trillion estimated increase in the primary deficit of more than 10 years adds pressure to U.S. Treasury yields, increasing supply and inflation fears. This can hurt long-duration government bond ETFs like TLT.

However, in times of uncertainty, treasuries often act as safe-haven assets. Therefore, short-term Treasuries like SHV and BIL may still be attractive. These carry lower default and interest rate risks. Moreover, SHV and BIL yield 4.70% and 4.68% annually, respectively.

Corporate Bond ETFs: Credit Spread Risks

Investors may now shift more of their fixed-income allocations into taxable bonds, which tend to offer higher yields than munis, now that investors are paying less tax overall in a raised SALT deduction environment.

Although high yields are negative for the overall bond investing market, investors still can settle for investment-grade corporate bond ETFs like LQD. However, one should try to avoid overexposure to junk bonds, which are more vulnerable to economic shocks. The ETF LQD yields 4.54% annually.

U.S. Stock Market: Deficit Vs Growth

Fiscal stimulus like lower tax policies may boost GDP and corporate profits in the short term, especially in infrastructure, defense and energy sectors. However, persistent deficit concerns can raise bond yields, and weigh on tech and growth stocks (that underperform in a rising rate environment). Therefore, SPDR Portfolio S&P 500 Growth ETF SPYG should be closely watched.

Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report

This article originally published on Zacks Investment Research (zacks.com).

Zacks Investment Research