Municipal bond funds were pummeled this week on renewed concerns that the U.S. government will begin taxing muni interest in some form. The market has largely shrugged off this threat in recent weeks, and municipals have in fact performed very well due to the likelihood that personal income taxes will rise in 2013 (thereby raising demand for tax-free investments).
This past week, however, the Wall Street Journal put a renewed spotlight on the issue, noting "A rare area of potential agreement between the White House and Republicans in the fiscal-cliff debate could come as a surprise to many investors: Both sides are willing to consider taxing at least a portion of municipal-bond interest paid to higher-income households." Investors, seeing increased odds of an unfavorable policy shift, reacted by hitting the sell button:the largest municipal bond ETF, iShares S&P National AMT-Free Municipal Bond Fund (ticker:MUB) tumbled 1.92% on the week, while the Market Vectors High Yield Municipal Index ETF was hammered for a loss of 4.46%. Prior to this week, HYD had returned 17.4% year-to-date.
The change may not come to pass, and if it does the impact may be limited to individuals making over $200,000 a year and couples earning more than $250,000. Still, this marks the first time the market has taken this threat seriously since Citigroup's research group flagged it as an issue in late October. The fiscal cliff negotiations affect all Americans, but now it's clear that muni investors have a particularly important stake. Stay tuned - this issue could have a tremendous impact on municipal bonds' performance in 2013.