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By Carla Fried

Auspicious will not be tip of the tongue to describe January stock performance. Using some leading ETFs as proxies, the chart below gives a clear look at how stocks all over the globe landed in negative territory in January, led of course by the near 8% decline for the iShares Core MSCI Emerging Markets ETF (NYSEARCA:IEMG). The Vanguard FTSE Developed Markets ETF (NYSEARCA:VEA) bled a little less. The SPDR S&P 500 (NYSEARCA:SPY) was a veritable bastion of strength by comparison. Bonds were a different story.

SPY Total Return Price Chart

SPY Total Return Price data by YCharts

While the major bond categories all registered positive performance, it’s not exactly following the script that was laid out in 2014 allocation outlooks. Both junk bonds and bank loan funds (also junk), the darlings of nearly every fixed income strategist, lagged the gain for the iShares Core Total U.S. Bond ETF (NYSEARCA:AGG). Granted, that might flip in the coming months if the Fed turns the tap another notch or two tighter on its bond purchases. Any rate rise will impact high-grade bonds more than the high yield segments. But it’s the performance of municipal bonds that is the real story here, as shown in the performance of the iShares S&P National AMT-Free ETF (NYSEARCA:MUB).

Municipal bonds, even the high-grade segment, tend not to be as sensitive to rising rates as Treasuries or high quality corporate bonds. That could be especially important this year if we do get more Fed tightening. Meanwhile, after a 2013 of headline muni bond body blows -- Detroit’s bankruptcy and the bubbling up of Puerto Rico’s fiscal woes -- order has been restored in the muni market, which has rallied more than the taxable market since early fall:

MUB Total Return Price Chart

MUB Total Return Price data by YCharts

While the next round of headlines will no doubt trigger more volatility, the fact is, the overall municipal bond market is quite healthy. Defaults last year were less than 0.50%. And most state and local revenue hauls are on the upswing given improving economic performance.

While the institutional money running muni portfolios will tell you no one “inside” was surprised by the Detroit and Puerto Rico issues, the muni market is highly dependent on retail investors, who tend to be thrown by scary headlines and falling NAVs. No getting ‘round that dynamic.

But if you’re focused on fundamentals and willing to ride out the intermittent volatility, high grade municipal bonds offer a pretty compelling opportunity. The trailing 12-month yield on the iShares S&P National AMT-Free Muni ETF is around 2.7% today. For someone in just the 28% federal tax bracket, that’s the equivalent of a 3.75% taxable yield. At the 35% tax bracket, that gives you the equivalent of a 4%+ yield. If you’re in the top 39.6% federal income tax bracket, it pushes your taxable equivalent yield up to 4.5%. That’s from a high grade portfolio.

While a general rate rise will put some pressure on bonds, there’s also a potential tailwind lurking for municipal bonds between now and mid April when 2013 federal tax returns will be filed. Not only was the top income tax bracket raised from 35% to 39.6% last year, 2013 was also the first year the new 3.8% investment income tax was in play. Couples filing joint returns with income of at least $250,000 and individuals with income above $200,000 are targets of the new tax, which is levied on the lesser of how much income exceeds those thresholds, or the amount of net investment income you booked in the year.

Long story somewhat shorter: Every CPA and financial advisor out there knows full well that for clients whose investment income is triggering the 3.8% tax, municipal bonds can be a way to reduce the pain. Muni bond interest is not considered “investment income” for purposes of levying the new 3.8% Medicare tax. That fact might come up in more conversations this spring as folks sign their 2013 tax returns and see a bigger bill than anticipated.

While the iShares S&P National AMT Free Muni ETF is the big whale in tax-exempt ETFs, a seven-year duration means a bit more price volatility when those intermittent swoons occur. The SPDR Nuveen Barclays Short-Term ETF (NYSEARCA:SHM) has a duration of less than three years.

If you want even more control over duration risk, iShares has a series of target-maturity muni bonds funds. Each portfolio in the series holds bonds that mature in the same year. You can build a laddered portfolio with the iShares 2015 S&P National AMT-Free ETF (MUAD), the iShares 2016 S&P National AMT-Fee ETF (MUAE), the 2017 portfolio (MUAF) and 2018 portfolio (MUAG). Just be aware that with just $100 million or so in each series, liquidity is not yet at peak, making them more ideal for buy-and-hold.

Disclosure: None

Source: 2014's Bad Start: Muni Bonds A Bright Exception