Investors have been pouring money into tax-exempt bonds in anticipation of the tax increases that could occur.
Changes to the bonds tax-exempt status could cause a rush out of such investments. This could put a strain on the municipal bond market as it tries to accommodate a high rate of redemptions.
Municipal bond investors have already demonstrated that they respond to factors other than the underlying fundamentals of the market.
A massive sell-off was triggered in 2010 by the comments of analyst Meredith Whitney who predicted an apocalyptic scenario for the market due to the number of bankrupt municipalities suffering from high pension benefits costs and lower tax revenue collections.
Liquidity in the marketplace would be severely constrained by sustained losses in municipal bond funds.
Changes to the bonds’ tax exempt status would make the investor base even narrower, make the market less efficient, and more vulnerable.
Some type of change to the tax-exempt status does seem likely in light of the fiscal challenges faced by the government.
The current scenario may cause individual investors to think twice about their municipal holdings.
But for now, there are some cross-over buyers in the institutional market who find current bond prices attractive and are not affected by tax considerations.

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