Finally, following Sunday’s regional elections in Catalonia, investors will be watching to see whether the Spanish government requests a formal bailout, which would open the way for a potentially open-ended purchase of short-term Spanish bonds by the European Central Bank. Should Spain request a bailout, this would likely be viewed positively by investors, as it would suggest that Madrid is addressing its long-term financing issues.
With all these issues remaining, the potential for higher volatility into the end of the year exists. One way to position portfolios for this environment is with an overweight to municipal bonds.
Matt Tucker recently blogged about the flows we’ve seen into muni bond funds. I have favored an overweight to munis all year, and I would stick with this trade going into 2013, particularly if we go over the fiscal cliff. Under that scenario, munis would be even more valuable as the value of the tax-shield goes up.
In addition, not only do munis offer a significant tax advantage, but municipal bonds look cheap relative to other alternatives, particularly US Treasuries. 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. One potential solution is through the iShares S&P National AMT-Free Municipal Bond Fund (NYSEArca: MUB).
Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock.