Here's Why Bonds Matter on Election Day

NEW YORK ( TheStreet) -- Shortly after Americans select a president for the next four years, Congress will reconvene to solve the so-called fiscal cliff, and bond investors would be wise to keep an eye on discussions.

Treasury bond yields hit historic lows over the summer as speculation about whether Federal Reserve would embark on another round of quantitative easing kept investors on edge. The Fed eventually announced the extension of its Operation Twist maturity extension program through the end of the year as well as an open-ended, mortgage-backed securities purchasing program in mid-September.

While the yield on the 10-year Treasury has bounced back over the past few months, it still remains solidly below 2%, and that's pushed many investors into lower credit quality corporate bonds, according to Jeffrey Sica, chief investment officer of SICA Wealth Management.

"First of all, people have become extremely hungry for yields, so they've moved to lower credit quality bonds in order to get yields," said Sica. "So they've put themselves in the position of taking on more risks just to achieve yield."

Many bond analysts have said it's difficult to draw any conclusions about what will happen to bonds after the election, as any prediction has to be multi-pronged: Forecasting not only who will win the presidential election but also how the make-up of Congress shapes up and what deals will get done in order to address the fiscal cliff.

Here are a few scenarios that could play out:

In the event of a Barack Obama victory, investors should be able to trust that the Fed will be little changed. Fed Chairman Ben Bernanke's second term runs through Jan. 31, 2014. Unlike Mitt Romney, Obama has not expressed any intention to remove Bernanke before that date.

Pertaining to central bank policy, Bernanke and the Fed have committed to continue open-ended quantitative easing until the economy and the labor market not only improve significantly and also show an ability to maintain that momentum for an extended period of time. The bank has not been more specific about how long.

This means the Fed's efforts will continue to keep a lid on Treasury yields for the foreseeable future and likely push more investors toward other investments, such as stocks and corporate bonds.

A Mitt Romney victory, on the other hand, would leave investors with a lot of questions.

Romney has said he would remove Bernanke as Fed chairman if he wins the presidency. The former Massachusetts governor has also expressed a lack of enthusiasm for monetary stimulus, so the fate of quantitative easing would be left in doubt.

In addition, Romney has promised to rein in spending, and his policies have seemed to favor less central banking activity and less bond buying, which could begin to boost the yield in treasuries and eventually lead investors back into higher quality credit treasury bonds. Analysts aren't sure how long, though, a massive move like this would take.

Municipal bonds are another beast for investors to consider.

Right now, the ultra-appealing, tax-exempt munis are a safe haven for many investors, but negotiations about the fiscal cliff could bring about broad-based tax reform.

If Congress decides that it wants to eliminate the tax exemption on munis, investors would have far less incentive to invest in these bonds.

If Congress doesn't lift the tax exemption, or, say, politicians decide to allow for some exemptions to remain in place it could become an even more appealing investment if income taxes increase -- a case that one analyst said could happen under Obama.

"If Obama gets reelected and the Bush tax cuts expire for the top wage earners then you're going to have top tax rates go higher, so higher income taxes are obviously a positive for the tax exempt market," said Susan Courtney, head of the Prudential fixed income's municipal bond team.

She also added that, if Congress decides to eliminate tax exemption on munis, another big question would be would some bonds would be grandfathered in for the exemption.

If so, lawmakers would have to determine a date for which bonds would be tax exempt and which bonds would not. In that case, the tax-exempt munis would become much more valuable to investors.

-- Written by Joe Deaux in New York.

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