The municipal bond market, having weathered the year-end fiscal cliff deal with its tax-exempt status unchanged, is poised to hit another pocket of volatility leading up to the debate in Washington over the debt ceiling and spending cuts.
Among the forces at play is the fact that tax-free muni bonds are increasingly popular with high-income taxpayers facing higher marginal rates and increased taxes on their investment income.
But taxpayers planning to employ munis have to deal with new fears that tax-exempt income could be eliminated or trimmed in the next round of budget talks.
“The threat [to the tax exemption] is real, and it's a clear and present danger because everything is on the table right now,” said Ronald Bernardi, president of Bernardi Securities Inc.
Fund flow data aren't yet available for December, but net flows into muni bond funds from July to November averaged more than $5 billion per month and totaled nearly $54 billion during the first 11 months in 2012, compared with total net outflows of $12.7 billion a year earlier.
The Barclays Municipal Bond Index gained 6.8% last year, despite a 1.2% decline in December when it looked as though Congress might cut the tax exemption on muni gains.
Market watchers fear such volatility could hit the muni market again as lawmakers debate the muni tax exemption, which is estimated to cost the Treasury about $40 billion a year.
“Now that we're past Jan. 1, we have an adjustment in income taxes that makes the muni tax exemption that much more attractive” to investors, said James Colby, senior municipal strategist at Van Eck Global. “But meanwhile, it appears the assault on tax exemption is not over yet.”
In some respects, the new taxes on high earners, combined with the looming next wave of budget talks, have created an almost schizophrenic mood in the muni bond market.
“In December, the muni markets sold off, based on fears that did not come to pass. As we get closer to the deadline on the debt ceiling debate, if we hear more about cutting the tax exemption, the market will sell off again,” said Eric Friedland, head of municipal credit research at Schroders Investment Management North America Inc.
The muni market is already assuming that Washington will honor President Barack Obama's request to cap the exemption on muni bond income at 28%, Mr. Friedman said.
For those in the highest tax bracket, such a cap would mean an exemption equal to about 9%.
But the 28% exemption cap, representing the first time in the muni market's 100-year history that income wouldn't be fully tax-exempt, would also introduce a whole new set of calculations for bond investors and financial advisers.
It is relatively simple to calculate the advantages of tax-exempt income, compared with the taxable income from high-yielding fixed-income investments.
But reshuffling that deck, either with an elimination or reduction of the tax exemption, has left the market on edge.
jbenjamin@investmentnews.com Twitter: @jeff_benjamin
