Municipal Bonds: A Contrarian Play On The Fiscal Cliff

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Includes: BAB, HYD, MLN, MUB, MUNI, PZA, SHM, SMB, SUB, TFI
by: Skyler Greene

The income market looks pretty bleak right now. Short-term TIPS and Treasuries are selling at negative yields, and long-term ones aren't doing a whole lot better. The negative yields aren't just depressing -- they're risky.

In their overly hasty flight to Treasuries, American investors have been dropping municipal bonds like hotcakes. From Reuters:

For the fourth quarter in a row, households shed municipal bonds, dropping $195.1 billion of the debt in the first quarter of 2012 after jettisoning $135.5 billion bonds in the fourth quarter of 2011

While most investors are (somewhat blindly, in my opinion) seeking the perceived safety of US government bonds, I believe the muni bond market offers better opportunities at this juncture.

Implications of The Fiscal Cliff

The so-called "fiscal cliff" has seen an uptick in media coverage recently. For those who haven't heard or are fuzzy on the details, here's a primer from Smartmoney:

Right now, the maximum federal rate on long-term capital gains and dividends is only 15%. Starting next year, the maximum rate on long-term gains is scheduled to increase to 20% (or 18% on gains from assets acquired after Dec. 31, 2000, and held for over five years), and the maximum rate on dividends will skyrocket to a whopping 39.6%.

It's important to note that for most retail investors purchasing bond funds or ETFs, their primary income stream is through dividends distributed by the fund. So if the tax cuts aren't extended, investors could see a sharp increase in their effective tax rate.

Such a tax hike would make Treasuries and other near-ZIRP fixed income investments seem even less appealing than they already are. However, as municipal bonds are generally tax-free, their "effective" yield skyrockets under the tax conditions post-cliff. As noted by Mark Martiak, Senior Vice President of First Allied Securities:

If the Bush tax cuts sunset as we anticipate they might on December 31st, investors only have one asset class where they can get tax free returns.

This isn't a consideration to take lightly. For investors in the highest tax bracket, a tax-free AAA-rated 10-year muni (current yield ~2.3%) provides the same "effective" yield as a 3.8% taxable bond. A tax-free A-rated muni (yielding ~3.2%) is equivalent to a 5.3% yielding bond. This gives munis a significant advantage, because you get higher yield without sacrificing credit rating.

Additional Considerations: Yield Curve, Defaults, Rising Interest Rates

While municipal bonds are definitely an attractive position to hold as a hedge against the fiscal cliff, there are obviously other factors to consider. Jim Kochan, chief fixed-income strategist at Wells Fargo Advantage Funds, gives a good overview in an interview with Barrons:

The other area Kochan still likes is muni bonds, where spreads over Treasuries remain reasonably attractive, particularly for munis with slightly less than top-tier credit ratings. "You get paid to be in single-A and triple-B [rated bonds]" he says. But he cautions against buying longer-dated munis as a way to boost yield, given that they're typically more sensitive to interest rate movements. "I would be cautious with regard to duration risk in munis," he says.

The other issue to consider is the default rate. Even highly-rated municipal bonds are not immune to default. According to Moody's, the current municipal bond default rate is double the historical average. This is, however, only really relevant to individual bond buyers or those with significant concentration risk -- those investing in ETFs or mutual funds should be fine.

Conclusion: Municipal Bonds offer a unique opportunity

In light of the looming fiscal cliff and the pathetic yields on Treasuries, municipal bonds are one of the few fixed-income assets still yielding opportunities. While my money's still on U.S. stocks and high-yield bonds, I may look to put some cash into a muni bond ETF. SeekingAlpha contributor David Fry has a great list of muni ETFs that can serve as a good starting point. Listed below are the ETFs he named. (For more details, please refer to his article.)

Van Eck High Yield Municipal Bond ETF (HYD)

Invesco PowerShares Build America Bonds ETF (NYSEARCA:BAB)

Van Eck Market Vectors Long Municipal Bond ETF (NYSEARCA:MLN)

PIMCO Intermediate Municipal Bond ETF (NYSEARCA:MUNI)

SPDR Barclays Capital Municipal Bond ETF (NYSEARCA:TFI)

Invesco PowerShares Insured Municipal Bond ETF (NYSEARCA:PZA)

SPDR Short-term Muni ETF (NYSEARCA:SHM)

Van Eck Market Vectors Short Municipal Index ETF (NYSEARCA:SMB)

iShares S&P Short-Term National AMT-Free ETF (NYSEARCA:SUB)

iShares S&P National Municipal Bond ETF (NYSEARCA:MUB)

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SHM over the next 72 hours.