Politics are in the air and for the first time in eight years, American investors are facing what's likely to be more than just a breeze of change. There is the complete certainty of a new presidential administration. And there is the near-certainty of a Democratic-controlled Congress. But it's uncertain what that means for the tax code. A large number of significant tax provisions enacted under the Bush administration are set to expire, unless made permanent by the new administration and Congress, not the least of which is the capital gains tax. I won't speculate on—if or when—the tax code might be changed. But there is one related tax-advantaged topic I can address: municipal bonds. This usually sleepy asset class could pack some serious punch over the next few years.

As an asset class, fixed income has been particularly erratic this year, reaching a level of volatility not seen in decades. After several years of narrowing spreads and declining interest rates, the subprime crisis in late 2007 literally shocked the system as investors demanded to be paid for the "sudden" realization of the risk involved in non-Treasury issues. This drove prices down and pushed yields up in the municipal market as the crisis played out early this year.

While the muni market began to normalize a bit toward the end of the first quarter of this year, prices remained at a stable, though narrower, premium to Treasuries. Three months later—at the end of second quarter 2008—that situation remained the same and some bond managers are now estimating that it will be another nine to 12 months before the nervousness overhanging the municipal market is removed.

Until that happens, municipal bonds might continue to trade at tight premiums over Treasuries, even close to par. It doesn't mean, however, that municipal bonds should be considered risk-free. Municipal offerings, while not exposed to the same types of credit risks as corporate bonds or mortgage-backed issues, are still exposed to some economic risk. Since most municipal bonds are backed by either the tax revenues of the state issuing the bonds or the direct revenues of the project the bonds finance, any projected drop in these revenues will normally be reflected in an increase in credit risk (the risk of not receiving timely coupon payments), which will decrease prices. We suggest this credit risk associated with bonds can be managed in much the same way as company-specific risk is managed with equities—through diversification and professional management.

A professionally managed bond portfolio can offer an investor a number of advantages, including a broad range of national issuers, in-depth research and due diligence, and more competitive pricing through large volume purchase transactions. But perhaps the most important tool municipal bond managers have at their disposal is the opportunity to see prices and credit qualities of bonds across the nation. They can see, for example, how high demand in one state may drive down yields and make them unattractive compared to bonds from another state. This is the primary reason that managers recommend a national portfolio for most clients. With a weakening economy and the increasing weakness of the "insurance" bought by many municipalities for their issues, there is also potential for a dramatic increase in defaults, which could ruin the return profile of any bond portfolio.

Spotlight Manager: Breckinridge Capital Advisors—Enhanced Tax-Free Income:

Breckinridge Capital Advisors is a prime example of the type of research-intensive firm that can protect investor capital and still maximize current income. The management team has the capability to customize a portfolio to a client's needs; including maturity and duration ranges, minimum and target credit quality ratings, and the percentage of bonds from the client's home state.

The firm runs one of the largest Web-based bond marketplaces, giving it access to a wide range of bonds from across the country. And the portfolio managers are some of the most experienced in the business. This wealth of experience has allowed the firm to keep its exemplary record intact, as no client has ever had a bond default in any portfolio. Breckinridge has consistently bested the Lehman Brothers 5-year Municipal Bond Index over the last decade, and on a risk-adjusted basis outperformed two-thirds of its peers over that same period.

Advisor Action and Implementation

The combination of the uncertainty surrounding potential changes in the tax code and an unusual dynamic in the municipal bond market has created an opportunity for advisors to add significant value for their taxable clients. The current yields in the municipal market offer the same or better returns than Treasuries even before their tax-exempt status is considered. At the same time, though, the current economic environment creates a slightly higher level of risk in this market. But it is one we think can easily be managed through the implementation of a professionally managed portfolio. Advisors with taxable clients, especially those seeking high levels of current income, should re-examine their clients' allocations to fixed income, and consider rebalancing portfolios or deploying cash to take advantage of the opportunities currently offered in this usually sleepy asset class.