While the Republican victories in the midterm elections make an extension of the tax cuts implemented by George W. Bush more likely, it’s hardly a done deal. Tax planning is imperative as uncertainty looms, and municipal bonds remain an excellent tool for reducing your obligation to the tax man.–The Editors

Home Sweet Home

Once viewed as a bastion of security, municipal (muni) bonds have lost much of their allure since the downgrade of Ambac Financial (NYSE: ABK) in early 2008 triggered a run on monoline insurers. In the aftermath only two major players remained, and the fiscal health of states and municipalities remains uncertain.

States and localities primarily rely on three revenue streams: income tax, sales tax and property tax.

Income tax receipts have plunged because of high unemployment. Joblessness has hurt consumer spending and affected sales tax collections. And the take from property taxes has sunk to all-time lows as real estate values have fallen by a third in many areas of the country; some of the hardest hit areas have seen such revenue cut in half. Even the collections from consumption-based sales taxes declined by 7 percent last year.

This perfect storm, combined with poorly structured bond deals floated at the height of the bubble, has left many state governments scrambling to meet their constitutional requirements to balance budgets. A few even face potential default.

Although a large proportion of municipalities face spending cuts, most are positioned to make do with weaker tax revenues. And if you’re holding shares in a well-diversified exchange-traded fund (ETF) that focuses on munis, there’s little downside risk, aside from the initial market jolt of an unexpected default.

For income investors, munis are still attractive. Despite the fiscal worries, municipal funds remain fairly valued and the market is already beginning to price in higher tax rates.

One of the best municipal ETFs on the market is iShares S&P Short-Term National AMT-Free Municipal Bond (NYSE: SUB). It offers a short, 2.1-year duration and a weighted average maturity of 2.3 years. That means it has a relatively low sensitivity to interest rate changes and invests in issues whose coupon payments aren’t subject to the alternative minimum tax (AMT).

Currently yielding 1.25 percent–which amounts to a 2 percent tax-equivalent yield for those in the top tax brackets–and with only moderate exposure to problematic states relative to its peers, iShares S&P Short-Term National AMT-Free Municipal Bond is an attractive tool for both limiting overall tax liability while potentially dodging the AMT.

For those of you who want to enjoy the tax advantages offered by municipal bonds but still want to limit your risk, Van Eck offers Market Vectors Pre-Refunded Municipal Index ETF (NYSE: PRB).

Municipal bonds become pre-refunded when they’re essentially refinanced; just as you sometimes refinance your home, issuers will refinance debt to take advantage of lower interest rates. When that occurs refunding bonds are sold at the new, lower interest rates and the proceeds of that sale are used to buy securities such as Treasury bonds. These new securities are placed in escrow to be put towards paying off the principal and interest on the original bond issue, essentially eliminating the credit risk.

Composed entirely of pre-refunded and escrowed-to-maturity municipal bonds, all of the ETF’s holdings are secured by escrow accounts or trusts that contain US government bonds.

Offering a tax-equivalent yield of 2.3 percent for those in the highest tax brackets, Market Vectors Pre-Refunded Municipal Index ETF is a one of the least risky ways to reduce your tax obligation. –Benjamin Shepherd

WHY TO BUY
ISHARES S&P SHORT-TERM NATIONAL AMT-FREE MUNICIPAL BOND (NYSE: SUB, $105.78)
MARKET VESTORS PRE-REFUNDED MUNICIPAL INDEX ETF (NYSE: PRB, $25.32)

*Low risk tools for reducing tax liability for most investors

*Attractive taxable-equivalent yields