MLPs, Munis and the fiscal cliff

The fiscal cliff is coming and the politicians are going to let us drive right over it. At least that’s the drumbeat you hear in the financial news media. And with 5 months to go until the end of 2012 the drumbeat is picking up its tempo. With that in mind I thought it would be useful to take a look at what impact the fiscal cliff would have on asset classes, the likely outcomes, and the implications for investors.

That’s the bad, scary news. The likely outcome of what I described above is very very small in my opinion. In fact, I think the most likely outcome is an extension of the status quo. It may be ugly and drawn out but that’s what I think will happen. Political sausage making is ugly to say the least. So, most likely there is no impact to investments. The second most probable outcome is some sort of compromise where the increases to income and investment taxes only happen to people making above a certain threshold, at least $250,000 for a couple but probably higher if there is to be any sort of compromise. The two least likely scenarios are do nothing and drive off the cliff with everyone on board, including the middle class, or some sort of complete reform of the entire tax system. I think the market is pricing in a scenario that varies between driving off the cliff completely and the compromise scenario.

So, what are some of the impacts in investment if some or all of the increases go through. First, I don’t think it’s as much as people think. Most investors in the market, in terms of dollars and volume, are tax exempt. The bulk of dollars and trades are done by institutions such as pension funds, hedge funds, mutual funds, investment banks, etc… Even with the massive increase on the dividend side I wouldn’t expect huge changes. The US has had way higher dividend taxes before. And turn it around the other way, we didn’t have a huge boom in dividend stock returns when the tax rate went down from the income tax rate to 15%. But at the margin there will be some impacts and investors will make changes to their asset allocations. Also, some assets classes may even benefit. Two of the assets classes that can benefit are munis and MLPs.

Munis are tax exempt at the federal level thus an increase in federal taxes make them look more attractive. Also, munis are exempt from the calculation to determine the Obamacare investment surcharge. For wealthy investors I suspect this presents a very attractive alternative. At a 43.4% marginal income tax rate on investment income a taxable investment would need to offer almost twice the yield of munis to be competitive. Thus I expect munis to have a nice tailwind in an increased tax environment. Similarly for MLPs. Most of the distributions from MLPs are tax deferred, since the large part of the distributions are a return of capital, so any investment tax increase makes MLPs more attractive. These are two asset classes to consider if you think some of the tax increases will go through. And even with the continuation of the status quo scenario there is good value in munis and MLPs to be had today.

In summary, I think the whole fiscal cliff thing is over blown. The most likely scenario is an extension of the status quo at least for a year. However, in the event that doesn’t happen munis and MLPs are a couple of assets classes that will have some nice tailwinds from any increases in investment taxes.