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Can muni bonds help you deal with fiscal cliff?

Published: Nov 19, 2012 1:38 p.m. ET


Tax bracket, residency and risk tolerance all factor in



SAN FRANCISCO (MarketWatch) — Municipal bonds continue to gain as stocks sway to and fro with every utterance from Washington on the likelihood of a deal to avert the so-called fiscal cliff, the set of tax hikes and spending cuts scheduled to start in January.

Many municipal-bond investors are taking a longer-term view: One way or another it’s pretty likely that tax rates will go up, especially for those in the higher income brackets. That will make it better to have more investments for assets where the interest income is exempt from federal income taxes.

Still, how to take advantage of that isn’t clear-cut. For one thing, the appeal of muni bonds depends on an investor’s federal tax bracket. The exemption is usually considered to be worth more if you’re in one of the higher brackets.

Their popularity this year has pushed municipal-bond yields to their lowest in decades. Read: Muni yields fall to lowest in decades as Pimco piles in.

Like all bonds, yields go in the opposite direction of prices, so that means muni-bond funds and exchange-traded funds have continued to do well this year.

The iShares S&P National AMT-Free Municipal Bond Fund MUB, +0.01%  and SPDR Nuveen Barclays Municipal Bond ETF TFI, +0.04%  have gained 4.5% this year, more than the two biggest taxable bond ETFs or high-yield ETFs.

On the other hand, the tax-exempt status of muni bonds is not guaranteed. There have again been rumblings about this as part of a potential rewriting of the U.S. tax code, and it’s probably up for discussion once the fiscal cliff gets dealt with. Read: Muni tax-exemption at risk in fiscal debate.

Location, rating matter

Muni bonds also hold more appeal if you live somewhere with high state or local taxes, because the bulk of muni-bond interest is exempt from those as well. Some municipal bonds are taxable, depending on what the funds will be used for.

Investment falls off 'fiscal cliff'

U.S. companies are scaling back investment plans at the fastest pace since the recession, signaling more trouble for the recovery. (Photo: AP)

So for example, California and New York muni bonds are worth more to residents of those states. In states with no income tax, the appeal goes down.

The iShares S&P California AMT-Free Municipal Bond Fund CMF, +0.04%  is up 6.3% this year.

Finally, if you’re still interested in buying muni bonds, it’s worth noting the credit rating on such investments. The majority of debt backed by the full faith and credit of states, cities and other local municipalities, or backed by revenue streams from necessities like water, sewer and power systems, tend to be rated fairly high and rarely default. But as with all investing, it’s best to know what you’re buying. Unrated bonds are where you see the bulk of municipal defaults. High-yield muni bonds and funds also carry higher risks.

In short, muni bonds not for everyone. Some advisers are telling clients to do the same thing with bond assets that have done well this year as many are doing with stocks: Sell them before capital-gains taxes go up. Read: Yield-hungry investors start their rotation.

Stock References

  • MUB
    +0.01 +0.01%
  • TFI
    +0.01 +0.04%
  • CMF
    +0.05 +0.04%

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