The municipal bond exchange traded fund market had a profitable year in 2012 due to low interest rates. However, circumstances are expected to change this year as automatic Federal spending cuts could start to trickle down after March 1.

“The ‘Fiscal Cliff’ compromise answered the question as to whether interest on municipal bonds would be taxed in 2013. Municipal bonds avoided all the various proposals to eliminate or reduce their tax exemption. In fact, the increase in the top income tax rate to 39.6% from 35.0% may make tax-free municipals more attractive for some high income investors,” Timothy Strauts, analyst, wrote for Morningstar. [BlackRock Cautious on Muni-Bond ETFs]

For the time being, muni bonds have maintained investor interest and remained in favor, but the tax treatment of these tools is unresolved. Going forward, state and city governments have scaled back spending on infrastructure, taken budget cuts and trimmed employees, but have not managed to dodge the possibility of a credit downgrade. Strauts reports that Fitch ratings is expected to downgrade dozens of municipalities in 2013, as property tax receipts lag tax base assessments and public-sector pension funds must be fortified. [Muni-Bond ETFs Keep Tax-Sheltered Status – For Now]

Furthermore, the sequestration of Federal spending is set to take place March 1, and is expected to slow local economies and take a 0.5% bite out of U.S. GDP this year.

Moody’s Investor Service points out some states that have overspent and carry a large default, indicative of how fragile the muni-bond market can become. Jefferson County, Alabama is $3.47 billion short, Washington State has overspent $2.25 billion, and Las Vegas, Nevada is $439 million in the hole, reports Andrew Zarivny for US News.

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