Our perspective on municipal bonds and the fiscal cliff

Investors have quickly moved beyond the uncertainty related to the outcome of the November elections, to focus almost entirely on the ambiguity surrounding the outcome of the so-called “fiscal cliff.” Like other investors, we are mindful of the negotiations taking place in Washington, D.C., over the coming weeks. However, understanding that we cannot predict their ultimate outcome, we continue to focus on what we do know and on what we can control.

What we know

If legislators in Washington cannot reach a deal before Dec. 31, 2012:

  • Tax rates across all tax brackets will rise. For those in the highest tax bracket, taxes would climb from 35.0% to 39.6%. High-income earners1 will also be subject to a new Medicare tax of 3.8% (enacted as part of the “Obamacare” legislation). (Data: Bloomberg.)
  • Across-the-board spending cuts will take place. As has been widely reported, these so-called sequestration measures would be felt particularly within the defense sector, and states that host significant defense industries may potentially feel the related effects.

What we’re watching

In our opinion, most investors seem to view the fiscal cliff as a zero-sum event — either we fall off the proverbial cliff or we don’t. With this in mind, many investors have adopted a “risk-off” stance since the election, shifting out of equities and other risk assets and moving toward lower-risk securities. Indeed, municipal bonds have, in our opinion, benefited from this shift since the election.

In our view, however, many investors, including municipal bond investors, have largely ignored the risks inherent in some of the potential deals being discussed to avert the cliff. We have noted, for example, that twice during negotiations between the White House and congressional Republicans, the idea of capping municipal bonds’ tax deduction at 28% has been raised. If enacted, a 28% cap on municipal bonds’ tax exemption could reduce their attractiveness to high income earners, a group that historically has invested in municipal bonds due to their unique tax benefits.

How we’re preparing

Even with the strong historical performance that the municipal bond market has enjoyed year-to-date, we believe there remains opportunity within the market and can see certain scenarios related to the fiscal cliff in which new value opportunities may emerge. We specifically look toward two possibilities as potential buying opportunities:

  • If a long-term deal on the fiscal cliff is struck in December, we could potentially see investors adopting a “risk-on” posture once again, buying equities and other risk assets at the expense of bonds (including municipal bonds).
  • In the event that a 28% cap on municipal bonds is enacted, we envision a scenario in which investors irrationally, in our opinion, punish municipal bonds.

In either of these cases, we look to relatively recent history — specifically, the three-month period ended January 2011 during which municipal bonds experienced a steep selloff — to support our belief that what investors may initially view as a negative event for the municipal bond market, could offer a significant opportunity for long-term investors such as ourselves to locate and purchase deeply discounted securities.

In our view, the municipal market overshot its true value to the downside in 2010 as investors turned away from the municipal market, fearing a massive wave of defaults that simply never occurred.

Within our portfolios, we were able to take advantage of what we believe were some extraordinary value opportunities that emerged at that time. Today, we continue to hold many of the fundamentally sound bonds that we purchased at that time at deep discounts, when many investors had fled the municipal market entirely.

It’s important to note, however, that while we continue to see opportunity for performance within the municipal market and look to benefit from any potential unrest in the coming months, we remain aware that a number of significant headwinds — aside from the fiscal cliff situation in the United States — have yet to be resolved. Accordingly, we currently maintain a cautious view within the portfolios we manage, focusing on credit-level analysis, studying one bond at a time, monitoring prevailing credit conditions, and maintaining diversified portfolios across both credit rating and yield curve considerations. This approach also generally leads us to favor revenue bonds over general obligation (GO) debt, and state issues over local debt, as we believe that state officials will have better tools to address the consequences of deficit-reduction policies that appear on the horizon, whether or not a deficit deal is struck between now and Dec. 31.

Access additional information, including fact sheets, commentaries, and other literature, on the Delaware Investments lineup of municipal fixed income funds.

1Applies to unearned income from interest dividends, capital gains, annuities, royalties, and rent. Income from municipal bond interest is exempt.


Carefully consider the Funds' investment objectives, risk factors, charges, and expenses before investing. This and other information can be found in the Funds' prospectuses and their summary prospectuses, which may be obtained by visiting the fund literature page or calling 800 523-1918. Investors should read the prospectus and the summary prospectus carefully before investing.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

These Funds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Funds to reinvest that money at a lower interest rate.

Funds that invest primarily in one state may be more susceptible to the economic, regulatory, and other factors of that state than funds that invest more broadly.

High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds.

Substantially all dividend income derived from tax-free funds is exempt from federal income tax. Some income may be subject to the federal alternative minimum tax (AMT) that applies to certain investors. Capital gains, if any, are taxable.

Diversification may not protect against market risk.

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