Fiscal Cliff Could Chase Investors to Muni ETFs

Prized for decent yields and tax advantages, municipal bonds and the ETFs that track them could become prime destinations for income investors if the fiscal cliff becomes a reality. Fears of the fiscal cliff, the GDP-draining scenario under which old tax reductions expire and become new tax increases, have already pounded an array of sectors and ETFs.

Dividend funds, telecommunications and utilities names, just to name a few, have suffered at the hands of the fiscal cliff. As one example, the Utilities Select SPDR (NYSE:XLU) has plunged almost 5.9 percent in the past month. Conversely, the $3.4 billion iShares S&P National AMT-Free Municipal Bond Fund (NYSE:MUB) has jumped 1.3 percent.

Even with the recent bullishness, municipal bonds and the corresponding ETFs are not richly valued.

"Not only do munis offer a significant tax advantage, but municipal bonds look cheap relative to other alternatives, particularly US Treasuries," said iShares Global Chief Investment Strategist Russ Koesterich in a note. "Over the last 30 years, the 10-year Treasury note typically yielded about 60 basis points over an index of general obligation (GO) muni bonds of a similar maturity. Today, thanks to the Federal Reserve artificially suppressing yields, the Bond Buyer 11 an index of GO munis yields is yielding 170 basis points over Treasuries. Given the potential for more volatility, higher tax rates, and favorable spreads, I would continue advocate investors remain overweight to municipal bonds."

ETFs such as MUB, which has a 30-day SEC yield of 1.56 percent, and the $1.2 billion SPDR Nuveen Barclays Municipal Bond ETF (NYSE:TFI) could see increased inflows if the fiscal cliff comes to pass. Should that happen, the dividend tax rate will rise, at the very least on those earning more than $250,000 per year. TFI's 30-day SEC yield is 1.55 percent.

That would likely increase the allure of the tax advantages offered by municipal bond funds. Municipal bonds are attractive because these bonds are usually exempt from federal taxes and many are not subject to state and local taxes, either.

Investors have already been pouring a bit more cash into muni bond ETFs in the days since Election Day. The iShares S&P California AMT-Free Municipal Bond Fund (NYSE:CMF) and MUB both saw inflows from November 7-13 while investors took almost $400 million out of the iShares iBoxx $ High Yield Corporate Bond Fund (NYSE:HYG), according to iShares.

CMF, which has nearly $275 million in assets under management, also has a 30-day SEC yield of 1.56 percent. Although the ETF focuses on muni issues from financially challenged California, nearly all of the ETF's 377 holdings are rated investment-grade.

Despite concerns about municipal defaults, a scant percentage of muni bond issues actually default. That has assuaged investors and helped bolster inflows to these ETFs this year.

With that in mind, investors looking for more yield while gaining the fiscal cliff protection offered by municipal bond ETFs can consider higher-yielding fare such as the Market Vectors High-Yield Municipal Index ETF (NYSE:HYD). HYD, which has over $994 million in AUM, has a 30-day SEC yield of 4.3 percent and pays a monthly dividend. The fund allocates nearly 22 percent of its weight to California bonds.

Another alternative is the $182.4 million SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSE:HYMB). HYMB, which has a 30-day SEC yield of 4.18 percent, features an 18 allocation to California bonds.

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