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This Buy Won Big in the Election

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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.

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