For investors, the last few months have been dominated by two words: fiscal cliff. The combination of automatic expiring tax breaks and across-the-board government spending cuts scheduled to become effective on January 1, 2013, has sent a shiver down the spine of market participants. The pending line in the sand was drawn during the last debt ceiling debate, as members of Congress couldn't decide on how to cut spending/raise taxes enough. The resulting Budget Control Act plus the expiration of the Bush-era tax cuts was designed as motivation to get the Federal government to move and create a realistic solution to fixing the United States's budget woes.

The $600 billion in proposed cuts across defense, federal agencies and cabinet departments is certainly good motivation to get the job done.If the Feds don't act in time, analysts expect the economy to truly "fall over a cliff" and regress back into recession. The Tax Policy Center reports that middle-income families will pay an average of $2,000 more in taxes in 2013, while the Congressional Budget Office estimates that 3.4 million or more people will lose their jobs. This will push the unemployment rate back up over 9%. Meanwhile, taxes on dividends and capital gains will surge.

It's no wonder that investors are on the edge when it comes to the fiscal cliff.For those in certain exchanged-traded fund sectors, the cliff takes on a heightened sense of urgency as well. Many of the proposals to fix the looming deadline will dramatically alter many of the popular investments. Here are three that could see radically different futures after the cliff deadline .

1. Municipal Bonds

Municipal bonds have long been favored by investors for their tax-free yields. In recent years, as interest rates have sunk to historic lows, more and more investorsin all tax bracketshave been drawn to the asset class as a way to get additional yield. Add in the daily tradability of ETFs like the iShares S&P National AMT-Free Muni Bond (MUB) and SPDR Nuveen Barclays Capital Muni Bond (TFI), and it's easy to see why munis are now part of almost every investor's portfolio and have been one of the best performing bond sectors over the last few years .

Well, investors in the sector may not be cheering for long. Even munis' tax-free nature is on the chopping block when it comes to the cliff. While Congress isn't yet expected to try to change muni bonds' tax-free status completely, analysts estimate that lawmakers could limit how much income investors could deduct under the popular tax break based on income bracket; that break has been around since 1913.

By limiting the tax deduction, experts predict that muni bonds will be a less popular asset class and result in higher borrowing costs for state and local governmentsparticularly those in the weakest financial positions. This could impact the economy just as much as going over the cliff, as state governments are forced to slash budgets, raise taxes and cancel essential programs.

The potential proposals could affect the whole host of muni bond ETFs that have sprung up in recent years to take advantage of investors' appetites for the bonds. Those in the junk or high yield sectorlike the Market Vectors High-Yield Muni ETF (HYD)or those tracking weaker financial stateslike the iShares S&P CA AMT-Free Municipal (CMF)could be most affected.

2. Dividend Stocks

Like muni bonds, dividend investing is in style again as investors try to navigate the low interest rate environment, especially since they've enjoyed low tax rates on dividends and capital gains due to the Bush-era cuts. Funds like the Vanguard Dividend Appreciation ETF (VIG) have swelled in assets under managementin this case, to $14.5 billionas the low rates have made dividends a popular draw for investors.

With the fiscal cliff throwing dividend tax rates for a loop, these ETFs may also be less desirable in 2013. Back in 2003, the Bush tax cuts lowered the top income tax rate on qualified dividends by 15%. With the expiration of those tax rates and the introduction of taxes associated with Obamacare, the top tax rate on dividends is set to rise to as high as 43% for high-income earners. That higher tax rate certainly makes dividends less attractive to portfolios and companies hoping to draw investors to their stocks.

Already, investors have begun selling broad dividend-focused vehicles like the iShares Dow Jones Select Dividend ETF (DVY), and many income-oriented funds now sit closer to their lows than highs. Going over the cliff could exaggerate that fact further, with continued selling pressure into the new year.

Interestingly enough, a potential winner in all of this could be firms focused on share buy-backs. The PowerShares Buyback Achievers ETF (PKW) could see its star shine as investors flock to the fund as a way to profit from corporations' large cash holdings.

3. Treasury Bonds

While the original point of the fiscal cliff and Budget Control Act was designed to help improve Uncle Sam's finances and reduce its debt burden, the initial shock to the economy could actually do more harm than good.

As the cliff debates have raged, demand for the safe haven assets and ETFs like the iShares Barclays 7-10 Year Treasury (IEF) has been strong. However, going over the cliff could actually result in less tax revenues for the feds as the unemployment rate will skyrocket; it stands to reason that fewer jobs will result in less income taxes. That could potentially counteract any boost seen from raising the tax rates in the first place. Analysts also estimate that pending the outcome of the cliff, the United States could be facing another debt downgrade from the various ratings agencies. That downgradethe United States's secondcould finally be the straw that broke the camel's back and cause investors to demand more from U.S. bonds. That will raise the cost of borrowing for the United States, which again could counteract any revenue increases.

It's also worth nothing that bond interest income is taxed at ordinary income rates.

All in all, investors in funds like the SPDR Barclays Cap Intermediate Term Corp Bond (ITR) could see decreasing returns.

The Bottom Line

For all investors, going over the fiscal cliff could mean a world of hurt. For those with holdings in these popular ETF categories, a worsening U.S. economy could result in some investing heartache. Understanding the potential outcomes is key for portfolios.

Disclosure: Photo courtesy of Mike Murphy.No positions at time of writing.

Related Articles
  1. Investing Basics

    Top Tips for Diversifying with Exotic Currencies

    Is there an opportunity in exotic currencies right now, or are you safer sticking to the major ones?
  2. Mutual Funds & ETFs

    The 3 Biggest Mutual Fund Companies in the US

    Compare and contrast the rise of America's big three institutional asset managers: BlackRock Funds, The Vanguard Group and State Street Global Advisors.
  3. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  4. Professionals

    5 Top-Rated Funds for Your Retirement Portfolio

    Mutual funds are a good choice for emotional investors. Here are five popular funds to consider.
  5. Investing News

    Are Stocks Cheap Now? Nope. And Here's Why

    Are stocks cheap right now? Be wary of those who are telling you what you want to hear. Here's why.
  6. Investing News

    4 Value Stocks Worth Your Immediate Attention

    Here are four stocks that offer good value and will likely outperform the majority of stocks throughout the broader market over the next several years.
  7. Investing News

    These 3 High-Quality Stocks Are Dividend Royalty

    Here are three resilient, dividend-paying companies that may mitigate some worry in an uncertain investing environment.
  8. Stock Analysis

    An Auto Stock Alternative to Ford and GM

    If you're not sure where Ford and General Motors are going, you might want to look at this auto investment option instead.
  9. Stock Analysis

    The 6 Biggest Russian Energy Companies

    Learn about the top energy companies in Russia, a country that holds some of the largest reserves of oil, natural gas and coal in the world.
  10. Mutual Funds & ETFs

    The 4 Best Buy-and-Hold ETFs

    Explore detailed analyses of the top buy-and-hold exchange traded funds, and learn about their characteristics, statistics and suitability.
  1. Can mutual funds invest in IPOs?

    Mutual funds can invest in initial public offerings (IPOS). However, most mutual funds have bylaws that prevent them from ... Read Full Answer >>
  2. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!