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Last week might have been the calm before the storm.

Between the US Thanksgiving holiday and a recessed Congress, there was not much news to drive the markets. But investors should expect that to change this week. Not only will US policymakers be returning from a holiday break to resume fiscal cliff negotiations, but the European debt crisis could also be in the headlines as Greece and Spain face key events in addressing their fiscal issues.

This all means investors can expect higher market volatility.

In the United States, policymakers have proclaimed a desire to work together on the fiscal cliff, but marginal tax rates on upper-income Americans remains a big stumbling block. Republicans have agreed to higher revenue, but through fewer deductions rather than higher marginal tax rates. So far, the President and House Minority Leader Nancy Pelosi are insisting on the expiration of the Bush Tax cuts for more high earners. This is likely to remain a barrier to a deal until we see some willingness to compromise. In the absence of any softening of positions, expect the fiscal cliff negotiations to drag on, keeping markets on edge.

Outside of the United States there are several events to watch in Europe, specifically in Greece and Spain. In Greece, the last few weeks have been characterized by inertia and squabbling by the European Union and the IMF over how to reduce Greece’s debt burden. While negotiations remain stalled, Greece is still awaiting the release of another 31.5 billion euros in installment loans. German Chancellor Merkel has suggested an agreement could come this week, but if this remains unresolved expect some pressure on European markets.

Finally, following Sunday’s regional elections in Catalonia, investors will be watching to see whether the Spanish government requests a formal bailout, which would open the way for a potentially open-ended purchase of short-term Spanish bonds by the European Central Bank. Should Spain request a bailout, this would likely be viewed positively by investors, as it would suggest that Madrid is addressing its long-term financing issues.

With all these issues remaining, the potential for higher volatility into the end of the year exists. One way to position portfolios for this environment is with an overweight to municipal bonds.

Matt Tucker recently blogged about the flows we’ve seen into muni bond funds. I have favored an overweight to munis all year, and I would stick with this trade going into 2013, particularly if we go over the fiscal cliff. Under that scenario, munis would be even more valuable as the value of the tax-shield goes up.

In addition, not only do munis offer a significant tax advantage, but municipal bonds look cheap relative to other alternatives, particularly US Treasuries. Over the last 30 years, the 10-year Treasury note typically yielded about 60 basis points over an index of general obligation (GO) muni bonds of a similar maturity. Today, thanks to the Federal Reserve artificially suppressing yields, the Bond Buyer 11 - an index of GO munis yields - is yielding 170 basis points over Treasuries. Given the potential for more volatility, higher tax rates and favorable spreads, I would continue to advocate investors remain overweight to municipal bonds. One potential solution is through the iShares S&P National AMT-Free Municipal Bond Fund (MUB).

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Source: The Calm Before The Storm?