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Municipal bonds have been on a bit of a tear this Summer. For instance, the SPDR Barclays Capital Management Municipal Bond ETF (ticker TFI) is up 4% since July of this year, compared to a 2% rise in the Vanguard Total Bond Market ETF (ticker BND) or iShares Barclays Aggregate Bond Fund (ticker AGG) over the same time period. What accounts for the nearly 100% difference in the level of gains experienced by some municipal bond funds verses broader bond market funds?

One possibility would be that municipalities have simply become more creditworthy relative to other issuers over the last two months. That explanation seems unlikely, as most local and state governments continue to struggle with deteriorating finances. A second, more likely, possibility is that taxable investors are growing concerned about expiring tax cuts enacted under the Bush administration, and the possibility of rising Federal income tax rates going forward. Municipal bonds typically offer tax-exempt interest, which makes them relatively more attractive as tax rates climb. Perhaps what we are starting to see in the municipal bond market is a signal that investors expect tax rates to rise in the very near term, which for taxable investors makes the interest payments on a municipal bond fund relatively more attractive to interest payments on a taxable bond.

Will municipal bonds continue to outperform the broader bond market? Without the aid of a crystal ball, nobody can say for sure, but assuming the market is correct that tax rates are destined to rise substantially in the near term, the answer could very well be "yes". In terms of cash flow, the pre-tax yield on BND stands at 3.544%, whereas the after-tax yield on TFI stands at 3.58%, giving TFI an advantage over the broader bond market for taxable investors. And on an after-tax basis, that advantage would only increase if tax rates were set to rise in 2011 and beyond. By the same token, if Congress were to act this year to extend some of the Bush era income tax breaks, perhaps municipal bonds might loose some of their recent luster.

Whatever the reason for the recent gains in the municipal bond markets, few investors would be well counseled to speculate on how, or indeed, whether, Congress will act over the near term when it comes to changes in the U.S. tax code. But even as opaque as the future status of U.S. tax law may be, whatever happens, or does not happen, will have very significant impact on investment returns for taxable investors. At first blush, taxable investors seem to face a enormous risk that cannot be hedged.

One possible solution investors could consider would be to take a somewhat Salomonic approach to income investing: (1) hold municipal bonds and municipal bond funds, which may flourish under a higher tax regime and suffer somewhat under a lower tax regime, and (2) hold higher yielding assets that produce income taxable at ordinary rates (such as high yield bond funds including SPRD Barclays Capital High Yield Bond ETF (ticker JNK)), which would suffer comparatively under a higher tax regime, but possibly outperform in the event Congress acts to lower tax rates in 2011. The strategic thesis for such an approach would be that if Congress acts to reduce income tax rates, or even to extend the rates in effect this year, issues such as JNK and other high yield assets could stand to benefit, while issues such as TFI potentially come under pressure as investors find less reason to own tax-free income producing assets.

By the same token, if Congress fails to act this year, or raises taxes affirmatively, then issues such as JNK may come under some pressure, while municipal bond funds may enjoy an continued boost relative to the overall bond market.

Disclosure: Author holds long positions in AGG, BND, JNK and FTABX

Source: Hedging Tax Risk With Bond ETFs