As part of a well-rounded fixed-income portfolio, municipal bond exchange-traded funds have helped diversify bond allocations. However, this time around, the focus has been on the tax-exempt status found in munis and its safe-haven status ahead of the “fiscal cliff” tax hikes.

Municipal bonds are debt securities issued by a county, municipality or state as a way to finance local capital expenditures, such as the construction of bridges, highways and schools, among others. Muni bonds are particularly popular because the securities are exempt from federal taxes and most state and local taxes if the investor lives in the state in which the bond is issued.

The Internal Revenue Service calculates that about 51 percent of all muni-bond-interest income was claimed by investors with less than $200,000 in earnings, so the tax break helps a wide range of investors. The tax-exempt status has been a hot topic as investors and advisors try to position themselves ahead of the end to the Bush-era tax perks.

The fiscal cliff deadline has put a spotlight on dividend- and yield-earning assets as the 15 percent preferential tax rate will end on Jan. 1, raising capital gains to 20 percent and dividend tax rates to income rates, which may be as high as 43 percent for high-income earners when including a 0.9 percent Medicare payroll tax and another 3.8 percent Obamacare tax.

However, there are some considerations. For instance, President Barack Obama and some members of Congress have proposed eliminating the federal income tax exemption on muni bond interest or limiting it to fewer investors as a way to ease the ballooning government deficit. This idea has cropped up over the years, but the proposal has usually been shelved as many expected a removal of the tax-exempt status would do more harm than good – fewer investors would be inclined to invest, which would ultimately force state and local governments to increase costs and burden taxpayers.

Moreover, SEC chair Mary Schapiro recently stepped down and will be replaced with SEC Commissioner Elisse Walter, who has been more critical of the munis market. Walter has been a proponent of municipal-bond reforms, such as creating a detailed federal-disclosure system for the industry.

No matter how you cut it, we are ultimately facing a higher tax rate environment. In the next few months, the Bush-era taxes will be phased out and we will be hit with a higher tax bill. Consequently, advisors will have to look for ways to be more efficient in their overall asset allocation strategies. Advisors who are looking to gain exposure to munis could consider municipal bond ETFs as an attractive alternative to other low-yielding areas of the fixed-income market.

Municipal ETF Options As The Fiscal Cliff Looms
The largest broad municipal bond ETF is the iShares S&P National AMT-Free Municipal Bond Fund (MUB), which has almost $3.5 billion in assets. The ETF comes with a 1.50 percent 30-day SEC yield and a 0.25 percent expense ratio. State by state, the fund’s top allocations include California 22.0 percent, New York 18.4 percent, Texas 7.8 percent, New Jersey 5.3 percent and Puerto Rico 5.0 percent. While we have recently heard of troubled muni debt from California, overall default rates remain low and local governments are capable of raising taxes as a way to support loans. Nevertheless, MUB is stocked with investment-grade quality securities, which include AAA 17.7 percent, AA+ 14.9 percent, AA 16.2 percent, AA- 17.7 percent, A+ 10.1 percent, A 5.0 percent, A0 11.3 percent, BBB+ 1.9 percent, BBB 2.1 percent and BBB- 0.7 percent -- everything above BBB- or Baa3 is considered investment grade quality.

Another option is the SPDR Barclays Capital Municipal Bond (TFI), which has a 1.51 percent 30-day SEC yield and a 0.23 percent expense ratio. TFI’s credit quality break down includes Aaa 20.0 percent, Aa 79.3 percent and A 0.7percent. This fund has a heavier allocation toward New York at 19.7 percent, followed by California 11.2 percent, Texas 9.1 percent, Florida 5.3 percent and Washington 5.1 percent.

For those who are more comfortable handling a little more risk, high-yield municipal bond ETFs are also an interesting alternative. The Market Vectors High Yield Municipal Index (HYD) has a 4.26 percent 30-day SEC yield and a 0.35 percent expense ratio. Since the fund is exposed to high-yield issues, it holds speculative, non-investment grade, or “junk” bonds, with credit ratings broken down to BAA 25.0 percent, BA 17.8 percent, B 29.7 percent and CAA1/C 3.0 percent. Again, California is a major component at 22.0 percent, followed by New York 10.0 percent, Puerto Rico 8.4 percent, Ohio 8.0 percent, New Jersey 8.0 percent and Texas 4.6 percent.

Additionally, the SPDR Nuveen S&P High Yield Municipal Bond (HYMB) is the other high-yield municipal bond ETF available, with a 4.12 percent 30-day SEC yield and 0.45 percent expense ratio. The SPDR high yield muni bond ETF has a small allocation in investment-grade quality bonds, but the majority falls under speculative grade status, including Aa 1.2 percent, A 10.6 percent, Baa 31.7 percent and under Baa 36.7 percent. State by state, allocations include California 18.2 percent, Florida 8.2 percent, Ohio 6.7 percent, New Jersey 6.2 percent and Texas 6.2 percent.

Don’t sit idly by and let the tax changes weigh down your fixed-income portfolio. Municipal bond ETFs would make a valuable addition going forward.