Muni Bonds May Still Not Be Safe From Congress

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Construction crews work along Highway 101 in Novato, Calif.

Municipal bond prices are bubbling up again as investors load up on the seemingly safe bet of tax-exempt bonds. But buyers should beware.

Even though the "fiscal cliff" has passed, industry experts believe Congress could still take aim at municipal bonds in its hunt for new tax revenues, and those discussions could heat up in the next couple of weeks.

"We're operating under the presumption it pretty much is on the table. Everybody you talk to on the Hill…even this week, will tell you it's very much being considered," said Bond Dealers of America CEO Mike Nicholas.

Nicholas organized the Municipal Bonds for America Coalition of dealers and issuers to take the industry's case to Washington. His concern is that muni income would be included in an effort to cap tax deductions, and one idea being floated is that it would be at 28 percent.

Muni bond buying has surged since the start of the year. The ICI reports that about $2.7 billion flowed into municipal bond funds during the two weeks ended Jan. 9, after about $4.1 billion flowed out of funds in the two weeks ended Dec. 26.

Selling was spurred in part by capital gains selling but also concerns that munis could lose their tax free status, or become less appealing to some investors if deductions are capped. (Read More: JunkBond Prices Point to Return of Bulls)

The yield on MMD 10-year AAA general muni was 1.65 percent Thursday. (Track Bond Prices Here)

"We had a week or two of out-migration. We had in-migration almost every week this year, and it looks like we're just picking up again," said Peter Bianchini, senior muni bond strategist with Mesirow Financial. "The higher federal tax rate, that is benefiting munis."

While Congress held off many tax increases that were scheduled to hit the economy Jan. 1, it did allow the highest tax rate of 39.6 percent to be reinstated for top earners, above $400,000 for individuals and $450,000 for couples.

There is also a new 3.8 percent additional tax from the Affordable Care Tax on certain investment income for couples making more than $250,000 a year. Dividend and capital gains tax rates also rose to 20 percent.

These new taxes have made now tax-free municipal bonds more attractive, and there's also a normal seasonal flow that occurs in January. (Read More: The Most 'Dangerous' Asset to Own Is...)

"The funds that flowed out in December flowed right back in in January," said John Donovan, head of municipal bond trading at Cantor Fitzgerald.

He noted that the yield was a record low 1.48 percent for the 10-year AAA muni in December, before the selloff. "We're 20 basis points off the record low but we're at the same ratio," to the 10-year Treasury, he said.

"We're at 91 percent of Treasurys which is fairly close to what those ratios were in December," he said. "We're not in historically low ratios and that is because there still is concern about the percentage of tax exemption that will be allowed."

The ratio was at 101 on average last year, but has averaged 90.9 percent over the last 10 years.

Donovan said it's unclear which way Congress will go, but the concern is there. "It still an overhang, but there's enough good news for the market, which is higher taxes," he said.

"If (prices) are very rich in late January, early February, the market could start getting more concerned…we'll be closer to the can kicked down the road, closer to the debt limit, closer to the next cliff and we'll be closer to the discussion probably about where the revenue is going to come from," said Donovan.

Nicholas said he is not comfortable that the industry is "out of the woods." Just this week, Rep. Sander Levin, D-Mich., the top Democrat on the House Ways and Means Committee, told a gathering of reporters that Congress should consider cutting tax benefits and loopholes, including the municipal bond tax exemption, according to the Christian Science Monitor.

However, Levin also said Congress may not get to tax and entitlement reform if the battles over the debt ceiling limit and automatic spending cuts, or the "sequester," stretch too far into 2013. (Read More:Sequestration—CNBC Explains)

"When we got through the fiscal cliff, everybody took a deep breath that we weren't included there," said Nicholas. "Most people thought tax reform is not likely this year. We're being very aggressive about this because the last thing you want to do is think you're safe and you're not going to be included and then read in the paper that you are."

"There's no question about what municipal bonds do, and who they benefit," Nicholas said. "The likelihood that the government raises much money at all from taxing munis by capping deductions…is slim. It will raise borrowing costs (for local governments) and it won't raise much money at all."

That would translate to higher property taxes.

"The reason that's attractive to members of Congress is it hits everybody, but I can tell you the issuers we are involved with make the case on the hill and in the media that property taxes are going to go up, that borrowing costs are generally going to go up. It's literally shifting the burden from the federal government to state and local governments," said Nicholas.