As fiscal cliff negotiations come down to the wire, one asset class that has been sought as a relative safety play – municipal bonds – is coming under fire.  With the recent deterioration in muni prices, my team has been fielding a number of questions from clients who are wondering what’s behind the selloff.

Uncertainty around taxes in 2013 is certainly one of the key drivers.  President Obama’s most recent proposal lowers the value of many tax deductions and tax breaks – including the tax-exempt status of munis – for high income households.

As changes to the tax treatment of munis seemed less likely in the fall, the latest market move is an unpleasant holiday surprise for many investors.  Prior to this development, munis had been a benefactor of fiscal cliff concerns.  For example, the iShares National AMT-Free Muni Bond ETF (MUB) has seen $250mm in inflows since November 1st, partially due to investors believing munis would remain tax-free in the midst of a variety of proposed tax hikes or limitations in deductions. [Muni ETFs Drop on Tax Jitters, Bond Flood]

But there are also a few other factors driving the selloff.  First, supply of new bonds in December has been higher than expected, with the 30-day visible supply peaking at $13bn on December 11th. Also, some clients are looking to take profits (and capital gains) on municipal positions that have appreciated significantly this past year.

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