While no one yet has a handle on the fiscal cliff’s outcome regarding taxes on capital gains and dividends — among many other concerns — investors would be wise to start looking at municipal bonds. They’re likely to remain an income-producing haven for dollars once plowed directly into blue-chip dividend stocks like Exxon Mobil (NYSE:XOM), Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG) or their corporate bond offerings.
The reasons are fairly straightforward: safety and yield.
Let’s talk safety first. Municipal bonds have gotten a bad rap recently as high-profile municipalities like Harrisburg, Pa., and Sacramento, Calif., teeter on the edge of bankruptcy. Trust me, they won’t be the only entities facing fiscal cliffs of their own down the road.
But the reality is that very few municipal bonds default. How few? Consider this Moody’s (NYSE:MCO) data provided by learnbonds.com, which compares default rates across similarly rated municipal and corporate bonds from 1970-2011:
|Rating||Municipal Bond Default RATE||Corporate Bond Default Rate|
To boost the evidence even further, Moody’s also says:
- No AAA-rated muni bond has ever defaulted
- Under 1 in 2,000 A-rated munis have defaulted
- A-rated munis have less than 1/10th the defaults of AAA-rated corporate bonds
It’s important to remember the U.S. currently has only four AAA-rated corporate bond issuers: JNJ, XOM, Microsoft (NASDAQ:MSFT) and ADP (NYSE:ADP). So, the corporate market is thin, while 16 of the 50 states have AAA credit ratings, and over 90% of municipal debt is A-rated. The takeaway? You have lots of muni bond offerings to choose from, virtually all of which will carry little risk.
The other critical component to the equation is yield, and for the time being, municipal bond yields are doing very well. I say for the time being because rumors on the Street say Congress may place a cap on the deductibility of muni bond interest as part of any fiscal cliff deal. That possibility is probably clouding investor sentiment.
It’s possible but, as I pointed out recently, not likely that anyone in Congress has the stomach to simply eliminate the tax benefits because states, cities and towns of all sizes depend on the money to fund projects big and small. And Congress works for those people.
All of which means muni investors will continue to see tax-equivalent yields at higher rates than most corporate bonds and equity dividend yields. For example, a 3% muni bond at a taxpayer’s 30% tax rate garners a 4.28% (.03/.70) yield. Investors will have to look for junk bonds or companies whose stocks offer similar dividend yields — which often means they’re in some trouble, like Hewlett-Packard (NYSE:HPQ) with its 4.04% yield.
However, investors might be scared off by the cost of entry for some muni bonds as prices have risen over the past few years. That leads Profitable Investing editor Richard Band to suggest that investors wait to see how the fiscal cliff negotiations play out. Does it mean the smart money is already in, and it’s too late to play?
Not really. If dividend rates wind up either unchanged or only mildly raised, it’s possible investors will abandon the muni market and head back to dividend stocks. Call that a buying opportunity in munis!
I’m with Band on this one: Municipal bonds can be an important part of any diversified portfolio, and once the entry prices turn right, their yields and safety can boost a portfolio’s overall performance.
Keep an eye on this asset class, and add it to your portfolio when the time is right.
Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing he is long MSFT, XOM and JNJ.