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Ongoing talks over the so-called fiscal cliff and speculation of removing the tax-exempt status on municipal bonds has pressured muni bonds and exchange traded funds, although they recovered somewhat last week.

ETFs such iShares S&P National AMT-Free Municipal Bond ETF (NYSEARCA:MUB) fell hard in mid-December, but have bounced a bit recently.

The tax hoopla has depressed municipal bonds, with high-grade 10- and 30-year munis comparably yielding as much as taxable Treasury securities at 1.79% and 2.73%, respectively, writes Randall W. Forsyth for Barron's.

According to reports from trading desks, bids have become more scarce as a greater number of investors are sitting on the sidelines and waiting it out as the fiscal cliff goes down to the wire.

Congress has reportedly proposed levies on high-income investors in munis as part of of the deficit plan.

More pessimistic muni observers are wondering if taxes could be imposed retroactively on tax exempt securities. George Friedlander, managing director and chief municipal-bond strategist at Citigroup, though, believes this is a "pernicious concept" that could destroy confidence in the federal government's ability in the capital markets.

Friedlander has also pointed out that if there were a limit to the value of tax-exemption on munis up to a 28% cap, yields would rise 0.4% to 0.6%, which would devalue munis by $200 billion. Looking at the recent correction in muni ETFs, the potential tax hikes may have already been priced in.

Still, investors are worried that budget negotiations in Washington could result in new taxes on interest they receive from municipal bonds, The Wall Street Journal reported recently.

"The fact that there's support on both sides of the table is what freaked people out," Friedlander said in the WSJ story.

iShares S&P National AMT-Free Municipal Bond

(click image to enlarge)

Max Chen contributed to this article.

Source: Muni Bond ETFs Skid On Risk Of Tax Increase