Recs

4

This Buy Won Big in the Election

Don't let it get away!

Keep track of the stocks that matter to you.

Help yourself with the Fool's FREE and easy new watchlist service today.

Even as stocks teeter in the wake of the results of the election earlier this week, the bond market continues to perform as well as ever. With new concerns about a global economic slowdown, unrest in Europe, and the impact of Hurricane Sandy in the northeastern U.S., investors have taken flight to their traditional safe haven, even with interest rates already at rock-bottom levels.

But one particular corner of the bond market that has gone largely unnoticed is now prone to get a lot more interest. With the fiscal cliff and higher tax rates looming, the once-sleepy municipal bond market will draw plenty of attention from investors seeking to shelter income from a big rise in tax rates.

Where the action has been
In recent years, bond investors have tended to focus on more exciting parts of the credit markets in order to search for potential investment opportunities. Despite the mortgage meltdown and concerns about toxic assets, bonds backed by mortgages with the implicit federal guarantee of government-sponsored enterprises Fannie Mae and Freddie Mac have attracted huge amounts of attention, with mortgage REITs Annaly Capital (NYSE: NLY  ) and American Capital Agency (Nasdaq: AGNC  ) using them to profit handsomely from cheap leverage and spreads between financing expense and asset-backed security income. For those seeking high yields from direct bond investments, investing in debt from Sprint (NYSE: S  ) , CIT Group (NYSE: CIT  ) , and other junk bond issuers has offered much better interest rates than Treasuries, albeit with greater default and business risk.

All the while, municipal bonds have languished outside the limelight. Their yields have been almost as high as Treasury yields for much of the past year, despite the fact that muni bond interest is free of federal tax. By allowing you to avoid as much as 35% of your interest going to Uncle Sam, muni bonds have offered attractive after-tax rates.

Muni bonds have faced a couple of problems, though. First, concerns about the ability of municipalities to repay bonds have made muni investors a lot more nervous about investing in them, especially after high-profile bankruptcies with several communities around the nation. Second, with calls from both parties for tax reform, some investors have feared that Congress would lobby to remove or water down the tax-exempt status of municipal bond interest, taking away a key component of their attraction for investors and potentially causing big drops in their value.

Big fight coming?
With a four-year track record of difficult relations on fiscal matters, a divided Congress may well have too many more important matters on its plate to worry about minor changes to municipal bond taxation. Although both Mitt Romney and Barack Obama proposed cutting the maximum tax break on municipal bond interest from 35% to 28%, Romney would have gotten there due to a reduction in the maximum overall tax rate, and so that apparent agreement far from guarantees bipartisan support now that the elections are over. The interest exemption arguably has more value as a bargaining chip, but with no guarantee of a bargain actually getting done, the chances of tax-free interest surviving into 2013 and beyond are higher.

As a result, prices of municipal bonds rose yesterday, as investors continued a buying spree that has 2012 on track to be one of the most popular ever for muni bond demand. The broad-based iShares S&P Nat'l AMT-Free Muni ETF (NYSEMKT: MUB  ) gained just a quarter percent, but many closed-end muni funds specializing in bonds from particular states performed much better. Combined with a relative lack of new supply of municipal bonds as state and local governments rein in spending and cut back on major capital projects, munis have posted substantial gains in recent months.

Munis will only get more valuable if tax rates increase. With the new top rate slated to rise to 39.6%, not including a 3.7% surtax on investment income for high-bracket taxpayers, interest that's exempt from tax will give people an even bigger tax break.

Should you buy munis?
Municipal bonds are worth looking at, especially if you're at the upper end of the income scale. Although they have their fair share of risk, their after-tax returns compare well with record-low rates on other types of bonds. If you already plan to have fixed-income exposure in your taxable account, munis may be the best way to maximize your interest income, taking what you pay Uncle Sam into account.

Dividend-seeking investors may prefer the big yields that mortgage REIT Annaly Capital gets from its mortgage-backed bond portfolio. But there are some crucial issues investors have to understand about Annaly's business model before deciding whether Annaly's a buy. In our popular premium research report on the company, our analyst runs through these absolute must-know topics, as well as the future opportunities and pitfalls of their strategy. Click here now to claim your copy.


Read/Post Comments (0) | Recommend This Article (4)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2101673, ~/Articles/ArticleHandler.aspx, 9/17/2014 11:37:52 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

Today's Market

updated Moments ago Sponsored by:
DOW 17,152.81 20.84 0.12%
S&P 500 2,000.80 1.82 0.09%
NASD 4,560.10 7.34 0.16%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/17/2014 11:21 AM
AGNC $22.65 Up +0.04 +0.18%
American Capital A… CAPS Rating: ****
CIT $47.89 Up +0.10 +0.21%
CIT Group, Inc. CAPS Rating: ***
MUB $109.11 Up +0.06 +0.06%
iShares S&P Nation… CAPS Rating: *
NLY $11.45 Up +0.02 +0.17%
Annaly Capital Man… CAPS Rating: ****
S $6.74 Down -0.03 -0.44%
Sprint CAPS Rating: **

Advertisement