Tax worries rock munis' stability

Municipal bonds continue to provide a reliable refuge from stock-market volatility and a steady source of tax-free income.

An index of muni bond mutual funds has recently been yielding about 2.18 percent. While that's nothing to brag about, it's a substantially higher yield than the roughly 2 percent that 10-year Treasury bonds offer, without factoring in the tax-exempt advantage that munis offer.

But for all of munis' stability, investors have clearly been scared the last several weeks. While other mutual fund categories have consistently attracted new cash, investors have been pulling money out of muni bond funds. During the five-week period ended May 15, withdrawals exceeded deposits, with a net $171 million flowing out, according to the Investment Company Institute.

Although that's a tiny amount relative to the nearly $590 billion in muni fund assets, April wasn't the only recent month when investors pulled cash out. Net withdrawals totaled about $294 million in March, and more than $3.1 billion in December.

Investors, particularly those in the top tax brackets, fear a budget proposal by President Obama that would cap the amount of muni bond income that an individual can claim as exempt from federal taxes. If Congress accepts Obama's proposal, the tax-exempt benefit would be capped at 28 percent for the top 2 percent of earners.

Jim Colby is keeping a close eye on the tax issue as a muni strategist with the money manager Van Eck Global. He also manages a group of five exchange-traded funds that track muni bond fund indexes, using the Market Vectors brand name.

Colby discussed the recent muni market developments in an interview.

Question: What specific factors are behind the recent flow out of muni bond funds?

Answer: We had a presidential election where the issue of the tax exemption on muni income was on the table. And during the fiscal cliff negotiations in December, nobody really had a handle on whether drastic legislation might pass. But there was enough talk to push muni investors to the sidelines, where they pulled cash out. In April, there are often seasonal factors in play, as some investors liquidate their muni holdings to pay annual tax bills. But that has not been as big a factor in recent weeks as the Obama administration's budget and the proposal on capping exemptions. It has people scared, as do the automatic spending cuts now taking effect after Congress and the White House failed to agree on deficit reduction.

Q: What outcome do you expect from the budget negotiations between the president and Congress over the tax-exemption issue?

A: You'd think they'd hammer out a compromise. The fear is that the tax exemption becomes a pawn in the negotiations, and maybe it falls into an agreement where one party can't back out of a position it has staked out in the talks.

Q: Should muni investors in the top income brackets be worried?

A: Munis have been a stable asset class historically, and they continue to be so, regardless of how the exemption issue will be resolved. Municipalities are generally in good financial shape, with tax collections rising. And even if the muni exemption is capped for top earners, munis still offer attractive tax-equivalent yields.