The tax-exempt market was flat Wednesday with very limited activity on its first full day of trading this week.

The markets reopened for a full day of trading after the Securities Industry and Financial Markets Association recommended an early close for U.S. bond markets Monday and a full close on Tuesday for Christmas.

Traders said liquidity in the muni market was limited this week and is not expected to increase much until after New Year's Day.

"It's really quiet," a New York trader said. "There are some steady trades but it's quiet though."

Other traders agreed. "The market is very quiet," a Boston trader said. "The phone only rang a couple of times."

The new-issue market was also very quiet Wednesday.

"I think that all new deals have been postponed until next year," the Boston trader said, adding issuers are not rushing to get deals done before the end of the year and might not be overly concerned about the status of muni tax exemption changing come January. "As of right now, it appears that people are looking at things as status quo."

While the primary market was quiet, the secondary saw a little more activity than Monday. Trades compiled by data provider Markit showed a mix of strengthening and weakening.

Yields on Boston 5s of 2022 jumped four basis points to 1.76%. Yields on Leavenworth County, Kans., Unified School District 3.375s of 2038 and Puerto Rico Sales Tax Financing Corp. 5s of 2040 rose one basis point each to 3.56% and 4.10%, respectively.

Other trades were stronger. Yields on Georgia 4s of 2023 fell two basis points to 1.94% while Montgomery County, Texas, 5.25s of 2032 fell one basis point to 2.65%.

Data from the Municipal Securities Rulemaking Board showed trading is extremely quiet. In Monday's abbreviated session, 14,184 trades occurred, down from the 30-day average of 42,136 trades. By par amount, $4.747 billion of bonds were traded, down from the 30-day average of $12.138 billion.

The Municipal Market Data triple-A yield curve ended steady Wednesday after a flat trading session Monday. The 10-year yield close flat at 1.77% for the third consecutive trading session while the 30-year yield also closed flat at 2.83% for the third session. The two-year finished flat at 0.31% for the sixth consecutive trading session.

After a big selloff throughout most of December followed by a few days of stronger trades last week, the 10-year MMD yield remains 30 basis points above its record low of 1.47% set Nov. 28. The 30-year still trades 36 basis points above its record low of 2.47% also set Nov. 28.

Treasuries posted gains Wednesday. The benchmark 10-year yield fell two basis points to 1.75% while the 30-year yield dropped one basis point to 2.93%. The two-year was steady at 0.27%.

And while some traders say municipal bonds aren't trading as if there could be a cap on muni tax exemption any time soon, other market participants say the threat is very real.

"The main risk to current market support levels and our 2013 outlook remains tax policy risk," wrote Justin Hoogendoorn, managing director of the strategic analytics group for the BMO Capital Markets fixed income team. "The odds for a cap on exempt interest deductions have increased significantly, as both sides of the aisle find this type of revenue boost feasible under a compromise scenario."

He added a 28% cap without any grandfathering of outstanding bonds could be the most likely near-term option used to get the rich to pay higher taxes, and that would affect about 32% of all municipal bond buyers.

"We find a direct 12- to 20-basis-point adjustment in taxable equivalent rates from 10-year and out, pushing exempt rates up by nine to 14 basis points," Hoogendoorn said. "While this does not take into account a number of soft variables that could likely drive the market toward over-reaction in the near-term, such as market sales due to institutional concerns and due to lack of faith in the sector remaining a tax-free vehicle, it may not ultimately be as extreme as some firms suggest."

Another near-term threat to municipal bonds is that Congress delays their decision even further and extends tax cuts and spending increases. "Depending on the length of the extensions and delays, both rating agencies and foreign investors could question the long-term sustainability of the ever expanding U.S. public debt, with negative implications for municipal bonds," he said. When Standard & Poor's downgraded the U.S. in the fall of 2011, S&P downgraded almost 200 public issues and put over 450 on credit watch. That could easily happen again if there were another downgrade, Hoogendoorn said.

Overall, he says the best outcome for the tax-exempt market would be marginally higher taxes with no cap on tax exemption. "This approach to deficit reduction should appease the rating agencies, produce a relief rally in municipals, helped along by additional Fed easing, and improve confidence in America's long-term economic outlook."

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.