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What investors may buy because of higher taxes

What investors may buy because of higher taxes

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If you think municipal bonds are having a tough 2014 given Puerto Rico and Detroit, guess again. And, investors facing higher taxes this year may soon flock to munis because of their favorable, if not exempt, tax status.

The iShares National AMT-Free Muni Bond ETF (the MUB), which tracks municipal bonds, is up about 3% so far this year. It's now trading roughly where it was in in June 2013.

What's causing the run up in muni bonds?

"Part of what's going on here is what you would call the 'January Effect' in the municipal bond market," says Priscilla Hancock, Fixed Income Strategist at JP Morgan Asset Management. "Every January, you have a lot of maturing bonds and you have a lot of coupons that are paid to investors. They have to reinvest them. This year, we had some tax-loss selling at the end of last year, so there are more proceeds that need to be reinvested. And, you have that coupled with the fact that there is very limited new-issue supply."

(Read: Bonds pare most price losses; upbeat data weighs)

According to Hancock, there have been about $10 billion in new municipal bonds versus almost $40 billion last year. "We have a lack of supply [and] we have a lot of cash that has to get to work," says Hancock. "So, it's a typical January Effect a little bit on steroids."

January isn't the only time municipal bonds generally see a spike, notes Hancock. "We have the same bit of effect in July," she says. On the other side, more bonds may hit the market soon. "You have a period in March and April when the issuers wake up from their winter snooze and they start issuing bonds.... That could be a great buying opportunity."

Nonetheless, while more bonds may come to market, there are two reasons Hancock believes issues will be lower than last year. "With rates higher this year, we don't have as much refunding," says Hancock. "And, we are still seeing some fiscal austerity this year as we go in; it's an election year."

(Read: Puerto Rico bonds do the unexpected: Rally)

As April 15 draws closer, Hancock believes investors will see the benefit of owning muni bonds.

"I'm not sure that everybody is really cognizant of how much their federal tax bill went up – we went from 36% to 39.6% to 43.4%," says Hancock of the top tax bracket. "You add in higher estate taxes in places like California and New York and you might have an effective marginal tax rate of 55%. That makes municipal bonds fairly attractive and, in some cases, the yields can rival historic equity returns."

To see the full discussion with Hancock on municipal bonds, watch the video above. 

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