America's $3.7 trillion municipal bond market has been riding up for two years, powered by tax-free yields that sometimes topped taxable Treasury payouts and a calming among small investors who had feared local governments were going to crash and burn.
Even after a muni selloff this month, the rise has delivered total returns of 18 percent since late 2010. But a further runup looks less sure in 2013 because of potential federal tax reforms, low yields that turn off income-seekers, and a dogged drag on government borrowers from the 2007-2009 recession.
"We have a number of questions and very few answers," said David Manges, municipals trading manager at BNY Mellon. "How can rates fall further? How do we handle a rising-rates environment?"
And what will Washington do?
That's the biggest question for 2013, according to institutional investors, analysts and traders.
"It is vitally important to stress that myriad fiscal policy and tax code changes are possible in 2013, which may substantially alter the contours of municipal bond performance," Morgan Stanley analysts John Dillon and Matthew Gastell said.
Not only are munis possibly facing a game-changing shift in federal tax-exemption policies on interest payouts, the securities' main attraction for investors, but they could be hurt by federal policymakers' desire to slash spending.
Washington policymakers are negotiating furiously to try to avert automatic spending cuts of more than $1 trillion over a decade are set to begin on Jan. 1. (Read More: Lawmakers Struggle to Break 'Cliff' Stalemate)
But given the political hunger for savings, America's 90,000 state and local governments that get federal monies and subsidies for operations and capital projects are preparing to receive fewer dollars from Washington.
Worst hit by the automatic spending cuts, also known as sequestration, will be cities and counties in New Mexico, Virginia and elsewhere with workforces built around federal contractors, military operations or agencies. The down shift in transfer payments could dull other local economies as well.
U.S. state and municipal governments, which have wrestled for five years with tight budgets, will soon see tax collections slow as federal deficit-cutting kicks in and federal dollars that go to hospitals and universities will dwindle, according to Janney Capital Markets analyst Alan Schankel.
"We believe ratings downgrades of municipal issuers will exceed upgrades in 2013, but overall credit quality erosion will be marginal, with an increase in the pace of default or bankruptcy unlikely," Schankel said in a report.
Puerto Rico's Still a Worry
One leading bond issuer, Puerto Rico, will be closely watched, Schankel said. The Caribbean island's widely held general obligation bonds were downgraded last week to near-junk status by Moody's Investors Service.
Other than some sectors, such as health care, benefiting from a tightening of yield spreads, overall muni gains during 2013 will lag 2011 and 2012, Schankel said in a report.
"We see a three-peat as unlikely," he said.
Puerto Rico and other weak issuers would likely be hurt the most by an overhaul of muni tax-exemption, even by a frequently mentioned 28 percent cap on the value of the muni exemption, according to a report by analyst Natalie Cohen of Wells Fargo Securities.
"Given the island's recent Moody's downgrade, weak fiscal condition and sorely underfunded pension, we could envision the commonwealth facing market access difficulties," Cohen said.