The tax-exempt market finished 2012 on a very quiet note after what has been a very active year in the municipal bond market.

Traders Monday said there was no primary activity and very limited secondary action. The Securities Industry and Financial Markets Association recommended bond markets close at 2 p.m. EST Monday and are closed Tuesday.

The Municipal Market Data scale finished the last trading session of the year on a steady note. The 10-year finished flat at 1.72%. The 30-year yield was steady at 2.83% for the sixth session while the two-year closed flat at 0.31% for the ninth consecutive session.

Treasuries were weaker on news that a fiscal cliff deal might be reached. The benchmark 10-year yield jumped five basis points to 1.76% while the 30-year yield spiked up seven basis points to 2.95%. The two-year yield increased one basis point to 0.26%.

When markets reopen Wednesday for trading, the primary market should see $161.3 million of tax-exempt bonds, up from last week's revised $14 million. In negotiated deals, $156.9 million of bonds are expected, up from last week's revised $14 million. On the competitive calendar, $4.4 million is expected, up from no reported deals last week.

While muni yields fell throughout 2012, they reversed course in December, jumping on concerns over tax-exemption and a spike in new issuance.

"Investment grade municipals have given up 1.78% in return bringing their total return to 6.46% year-to-date," as measured by the Standard & Poor's National AMT-Free Municipal Bond Index, wrote J.R. Rieger, vice president of fixed income at Standard & Poor's Dow Jones Indices. "The weighted average yield-to-worst of bonds in this index moved cheaper by 34 basis points in November ending at 2.07% or a taxable equivalent yield of 3.18%."

High yield bonds also did not escape the wrath of December and moved cheaper by 10 basis points, bringing the weighted average yield-to-worst to 5.28% as measured by the Standard & Poor's Municipal Bond High Yield Index, Rieger said. Still, these high yield bonds have returned 18.4% through the year.

The 10-year spot on the curve was hit the hardest with yields cheapening by 34 basis points through December, ending at a tax-free yield of 2.31% as measured by the Standard & Poor's National AMT-Free Municipal Series 2022 Index, and approximately 60 basis points higher than the 10-year Treasury yield, Rieger said. "The taxable equivalent yield of the bonds is a 3.55%, or over double the yield of the 10-year Treasury bonds," he added.

Most state bonds declined as well. State general obligation bonds returned negative 1.57% in December, but are still up 4.92% year-to-date. Similarly, local general obligation bonds are down 1.51%, but are still up 6.78% through the year.

With its downgrade in recent weeks, it's no surprise Puerto Rico bonds plummeted. Through December, Puerto Rico munis declined 4.43%, and are up only 2.72% for the year. New Jersey muni bonds are down 1.44% for the bond but are still up a whopping 8.31% for 2012.

California and Illinois - the two lowest rated states by the rating agencies - declined 1.41% and 1.25% for the month, respectively, but soared 8.83% and 9.01%, respectively, for the year.

Looking to 2013, many analysts expect muni yields to follow the path of Treasury yields, and expect another year of low yields as the Fed continues its bond buying program. But when new issuance starts hitting the market mid-January, munis are likely to underperform Treasuries, according to analysts at Morgan Stanley Smith Barney.

"We generally expect 10-year benchmark AAA yields to mirror Treasury yield changes, with 95% or higher as the applicable municipal-to-Treasury ratio," said John Dillon, chief municipal bond strategist. "The upcoming year may prove to be one of simply clipping coupons, as municipal benchmark yields already reside at 50-year lows." This would most benefit bondholders who have purchased bonds with coupons above 5%.

While following Treasuries, munis will also be impacted by how serious the threats to tax exemption become. If capping tax exemption is put on the table as part of negotiations, munis are likely to underperform their taxable counterparts and remain above 95% Dillon noted in a recent research report. If tax exemption is removed, munis will likely outperform.

"We expect munis to settle back into underperformance mode if concerns continue to linger regarding the prospect of tax reform, which is our expectation," Dillon wrote.

"In the unlikely scenario that tax reform is truly taken off the table, the stage would then be set for continued and sustainable underperformance toward the long-term average of 84%."

Any many believe that after a powerful rally in 2011 and 2012 that brought yields to record lows, muni investors should be cautious heading into next year.

"The hindsight of the powerful price rally that ran through year-end 2011 and became overextended into late February this year comes to mind," Dillon noted. "In light of the powerful 2012 post-election rally we have just experienced, it may be prudent to proceed with caution once the 2013 new-issue calendar fully arrives."

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