By Neena Mishra
Just a year after the debt debacle, it appears as though the markets are heading toward another key do-or-die situation resulting from more Washington inaction.
Fiscal cliff refers to expiration of Bush-era tax cuts, combined with drastic spending cuts on the defense and domestic budgets. Last week, we had a very interesting discussion on the topic, where most comments indicated that the market has not yet priced-in the fiscal cliff.
According to the Congressional Budget Office (CBO), the U.S. will slip into deep recession with the real GDP declining by 0.5% between the fourth quarters of 2012 and 2013 and the unemployment rate rising to about 9% by the second half of 2013, if the fiscal cliff actually happens. There are many other estimates with more dire consequences for the economy.
It is possible that the Congress will act to avoid the crisis but investors should not forget that it is impossible to predict what politicians will do. As such they need to prepare for any possible situation.
Below we have analyzed the possible market scenario as we approach the fiscal cliff and how investors could position their portfolios using ETFs to benefit at the edge of the cliff.
Market Volatility will Rise- Use Low-Volatility ETFs for Hedging
The current volatility levels do not reflect the possibility of the fiscal cliff. Thus it is almost certain that uncertainty will increase as we approach the year-end, resulting in high market volatility. We recommend investing in low-volatility ETFs that are designed for investors who want to avoid volatility and limit the downside in their portfolios while staying invested in equities. Low-volatility products in general have proven their ability to deliver superior risk adjusted returns historically.
PowerShares S&P 500 Low Volatility (SPLV)
SPLV tracks the S&P 500 Low Volatility Index, which consists of 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months.
The ETF currently has a 30-day SEC yield of 2.99%, while it charges an expense ratio of 0.25% per year.
The fund was launched in May last year and has proved to be extremely popular with investors as it has already garnered $2.3 billion in assets. The ETF holds 98 securities currently, concentrated mostly in the Utilities (31.2%) and Consumer Staples (28.7%) sectors.
Prepare For A Dividend Tax Increase- Municipal Bonds Look Attractive
Currently qualified dividends are taxed at 15% top rate, same as the long-term capital gains rate. If the tax cuts are not extended, the long-term capital gains tax will revert to 20% but the dividends will be taxed as income, at rates up to 39.6%. Additionally, there may be a 3.8% surcharge on investment income for investors with higher incomes.
While we do not recommend that investors should sell their dividend stocks or ETFs in anticipation, as the dividend-paying stocks and ETFs (typically with a value focus) have outperformed the broader markets over the longer term, they should also look at some of the other more tax-efficient income alternatives.
Municipal bonds will then look very attractive in terms of yield (tax-free at federal level) when compared with effective (after-tax) yield of other assets with similar level of risk.
Further despite several reports about the possibilities of default, the actual defaults in this space so far have remained in line with the historical averages.
iShares S&P National Municipal Bond ETF (MUB)
We prefer diversified national municipal bond ETFs since diversification reduces the risk of default. MUB is the largest and most popular fund in the municipal bond space, with assets of about $3.1 billion and average trading volume (3 months) of over 185,000 shares.
The ETF charges a low expense ratio of 25 bps and currently pays a 30-day SEC yield of 1.82% (tax-equivalent distribution yield of 4.39%). It uses sampling strategy, by holding about 2,000 securities out of the index's more than 9,000 holdings. The weighted average maturity of the holdings is 6.0 years while the effective duration is 6.5 years.
Safe-Haven Trade Will be Back-Treasuries Will Rally Further
As the fear will return in the markets, the safe-haven appeal of U.S. treasuries will get a boost. As a result, the treasuries will rally further and the riskier assets will sell off. Also if the government fails to reach an agreement, the resulting fiscal contraction will be good for bonds. Further, in the event of further monetary stimulus by the Federal Reserve, the longer-end of the treasury curve will benefit more.
We continue to believe that U.S. treasuries are not suitable for long-term investors at current levels, as they yield negligible or negative real returns. However, the long-term treasuries may be great short-term plays to take advantage of safe-haven trades. On the other hand, the high-yield segment of the bond market may sell off so the investors may also consider tactical trades of shorting junk bonds/ETFs and buying long-term treasuries.
iShares Barclays 20+ Year Treasury Bond ETF (TLT)
TLT tracks the Barclays U.S. 20+ Year Treasury Bond Index, which is a market capitalization weighted index of U.S. Treasury securities having maturity greater than 20 years.
Launched in February 2008, the fund has amassed more than $3.6 billion in assets so far. It holds 20 securities, with a weighted average maturity of 28 years and an effective duration of 17.3 years. The fund pays a 30-day SEC yield of 2.56% currently.
The expense ratio for the fund is 15 basis points, which is among the lowest charges in this space.