The tax-exempt market continued its sell off as traders said dealers were cleaning out inventory ahead of the end of the year.

Bid-wanteds out in the morning provided selling pressure throughout the day.

"The market feels OK compared to recent days," a Chicago trader said, adding, however, that some say the market is at least five basis points weaker. "But it doesn't feel that weak to me."

Still, this trader added the market feels less cheap every day. "You buy a bond yesterday and it feels like a steal. The market sells off. You don't move them and the next day or two after another couple rounds of cuts it's not that cheap anymore."

Other traders said the market was indeed weaker. "The market is still off five basis points," a New York trader said. "Customers are showing bids. Levels are adjusted but in fact there are still bids. This selloff is going to continue as long as the bid-wanteds keep up."

And while most traders agreed the market was cheaper, not all agreed on the reasons why. "With little supply and more inflows, the selloff seems unwarranted," a Boston trader said. "There is expected to be more flows in January and funds have cash. Yet no one is willing to step up to stop the bleeding."

He added, "Even if there is a 28% cap, munis are still the most attractive fixed income asset on a tax-exempt basis. And that 28% cap isn't even set in stone."

Others agreed that with flows still positive and if munis are grandfathered in with a possible 28% cap, the tax-exempt market should survive the panicked selloff.

"The market has been tumultuous over the last week," said Dan Toboja, vice president at Ziegler Capital Markets. "What seemed like a simple price correction beginning last week has continued into a full selloff. Yields have risen 25 basis points for many general market bonds. And bids for product have thinned out significantly."

He added munis are collapsing due to reports that munis may lose a portion of their tax exempt status as part of the fiscal cliff negotiations. Still, he added there is no guarantee munis will be a part of negotiations and existing bonds will increase in value if they are grandfathered in. Next year is expected to have negative net supply and fund flows have remained positive.

"So while we do think the current market selloff remains a good reminder to participants of the fragility of muni liquidity, the current selloff may begin to slow especially as 10-year muni ratios near 100% again," Toboja said. "With very little supply coming before year end all attention will be focused on the D.C. rumor mill."

In the secondary market, trades compiled by data provider Markit showed weakening.

Yields on Golden State Tobacco Securitization Corp. 5.3s of 2037 jumped 10 basis points to 6.41% while Connecticut 5s of 2016 increased six basis points to 0.77%.

Yields on Missouri Board of Public Buildings 2.5s of 2025 and California Statewide Communities Development Authority 5s of 2042 spiked up six basis points each to 2.59% and 3.51%, respectively.

Yields on New York City Municipal Water Finance Authority 5s of 2047 rose four basis points to 3.34% while New York State Tollway Authority 5s of 2042 increased one basis point to 3.58%.

On Tuesday, yields on the Municipal Market Data scale continued to soar. The 10-year yield jumped eight basis points to 1.82% while the 30-year yield spiked up seven basis points to 2.86%. The two-year yield rose one basis point to 0.31% after holding steady at 0.30% for 56 consecutive trading sessions.

Since hitting record low yields on Nov. 28, the 10-year MMD yield has jumped 34 basis points while the 30-year yield has soared 38 basis points.

Treasuries continued to plummet Tuesday as stocks jumped on the risk-on trade. The benchmark 10-year yield increased five basis points to 1.83% while the 30-year yield climbed six basis points to 3.00%. The two-year yield rose three basis points to 0.29%.

So far in December, muni exchange-traded funds have plummeted. The iShares S&P National AMT-Free Municipal Bond ETF — ticker MUB — dropped 3.87% so far this month and is up only 0.37% so far this year.

The SPDR Nuveen Barclays Capital Short Term Municipal Bond ETF — ticker SHM — fell 0.50% for the month and 0.16% for the year. The PowerShares Insured National Muni Bond ETF — ticker PZA — dropped 3.14% since the start of December, but is up 4.62% year-to-date.

Other popular ETFs, including the Market Vectors High Yield Municipal Index ETF — ticker HYD — plummeted 3.16% this month but soared 8.91% so far this year. Meanwhile, the Market Vectors Long Municipal Index ETF — ticker MLN — fell 4.34% in December but is up 5.25% for the year.

And most muni ETFs have fallen more than Treasury ETFs.

The ProShares Ultra Seven to 10 Year Treasury ETF — ticker UST — fell 2.77% this month, but is up 5.99% through 2012.

Most muni ETFs also underperformed corporate bond ETFs for the month and the year.

The iShares iBoxx High Yield Corporate Bond ETF — ticker HYG — rose 0.63% for the month and gained 4.71% throughout the year. The iShares iBoxx Investment Grade Corporate Bond Fund ETF — ticker LQD — rose 1.39% in December and is up 5.78% so far in 2012.

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