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Tax Uncertainty Puts Muni Bonds Back in the Spotlight

The outcome of the general electionand the looming "fiscal cliff" have put the municipal bond market in the fixed income spotlight, as investors and analysts speculate about higher taxes and how they will impact the tax-friendly bonds preferred by high-income earners.

In a short-term post-election move, the 10-year yield on the Municipal Market Data benchmark scale fell to a record low of 1.57 percent while the 30-year MMD yield skidded to a new bottom of 2.66 percent on Friday.

"We're getting a tailwind from a drop in rates in the Treasury market," said Peter Hayes, managing director and head of the municipal bonds group at BlackRock.

"We also continue to be in an environment with strong demand of fund flows into munis," Hayes said. (Read More: Why Muni Demand Will Remain Strong.)

Muni bond funds saw inflows for 58 of the past 62 weeks, according to industry chronicle "The Bond Buyer." For the week ended Nov. 7, net inflows totaled $866 million compared with outflows of $123 million the week before, according to Lipper data.

The municipal bond market, which has historically yielded less than the one for Treasurys, returned about 8 percent in the last year, according to the Bank of America Merrill Lynch Muni Master Index, compared to about 3 percent for 30-year Treasurys.

With $600 billion in federal tax hikes and spending cuts set to kick in automatically on Jan. 1, the allure of the largely tax-exempt munis has increased to investors seeking a safety net.

"It's a positive for things like municipal bonds, which are tax-free," PIMCO CEO Bill Gross said on CNBC's "Squawk Box"the day after the election.

A sampling of mini-bond funds and exchange traded funds shows investors have been relatively well rewarded in 2012.

The Vanguard Long-Term Tax-Exempt Fund has gained over 6 percent from a year ago, the Fidelity Intermediate Municipal Income Fund is up 4 percent and the BlackRock National Municipal Fund has edged up over 8 percent in the same period.

On the ETF front, the iShares S&P National AMT-Free Municipal Bond Fund has gained almost 7 percent in the last 12 months.

Tax Scenarios Abound

The new interest in munis, however, is matched in some camps by a sense of caution. Changes to the tax code, of course, remain an uncertainty, and there's the possibility munis might lose some of their tax-exempt status at the same time other income taxes rise.

While the market has not factored in a potential loss in tax benefits, Hayes said he is taking this threat more seriously than before.

"We do think there is an air of compromise in Washington, post-election. That means some of the items of the fiscal cliff [the scheduled onset of automatic tax hikes and spending cuts on Jan. 1.] will be postponed, but it means tax reform will be undertaken more broadly," said Hayes, who manages $106 billion in municipal bond investments.

President Barack Obama wants to cap the value of the muni tax exemption at 28 percent, rather than its current 35 percent.

In addition, he wants to keep the Bush-era tax rates only for families making less than $250,000. The top two tax rates would rise 3 to 4 percentage points to 39.6 percent and 36 percent, respectively, while rates on capital gains and dividends for the wealthy would also rise.

Higher taxes for the wealthy would make tax-free munis more attractive to those investors, but capping the muni tax exemption would curb some enthusiasm for the debt. A lot depends on the mix of changes.

"There is a higher probability that the tax-exempt muni market will shrink in one way or another. There has been talk on limiting issuance size," noted Geoff Urbina, managing director of KeyBanc Capital Markets.

Urbina, who has underwritten over $24.2 billion in municipal bond transactions, said small issuers will bear the brunt of any tax-exemption changes because their cost of capital will rise.

"It's going to impact all the stakeholders in the [muni] market," he added. "There will be less supply of munis and potentially higher income tax rates."

Plagued with the uncertainty of tax reform, the muni market may very well be a "tale of volatility" in 2013, said Hayes.

"Next year will be about 'what's the income,' so that's probably more a low single-digit type return," he added.

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