A traditionally sleepy corner of the fixed-income market has seen a relatively large move to the downside this week. Muni bond ETFs have tumbled on speculation wealthier investors may see the tax breaks reduced on income from municipal debt.

The largest ETF in the category, iShares S&P National AMT-Free Municipal Bond Fund (NYSEArca: MUB), was down for the sixth straight day to close the week. The fund slipped 0.6% on Friday while Market Vectors High Yield Municipal Index (NYSEArca: HYD) dropped 2.5% in afternoon dealings. HYD is down nearly 4% for the week on heavy volume.

“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,” The Wall Street Journal reported this week.

Municipal bonds are a $3.7 trillion market. [Can Muni Bond ETFs Extend Streak in 2013?]

Muni ETFs have been solid performers on expectations tax rates on capital gains and dividends for stocks will rise next year for some investors following President Obama’s re-election and as the fiscal cliff looms. Higher tax rates could make muni bonds more attractive because their income is tax exempt.

However, there has been talk recently of curbing or even eliminating the tax break. Investors apparently see a greater likelihood of this happening after this week’s WSJ story.

House Speaker John Boehner is willing to consider curbing the tax-exempt status of municipal-bond interest, subject to negotiations with the White House, the newspaper reported.

“By exempting municipal bond interest from federal taxes, the government creates an incentive for investors to buy them, which helps hold down the borrowing costs of the states, cities and other entities that issue them. Curbing the exemption would likely reduce demand for the bonds, pushing those borrowing costs higher,” according to the story. Obama’s proposal would limit the value of many tax deductions and tax breaks—including the tax-exempt status of municipal-bond interest—for singles making more than $200,000 a year and couples making more than $250,000.

“The tax break that U.S. states, cities and counties get on the bonds they issue is in growing jeopardy now that Republicans, in addition to Democrats, are considering limits on the exemption,” Reuters reported Friday.

Jim Colby, portfolio manager and senior municipal strategist at ETF provider Market Vectors, in a telephone interview Friday said this week’s sell-off is based on hearsay in the market about muni tax exemptions. He noted any tax change would hurt muni bond issuers and local governments as well as investors.

Market Vectors High Yield Municipal Index

Full disclosure: Tom Lydon’s clients own HYD.

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