For the $3.7 trillion municipal bond market, Washington’s political divide may be a good thing.

The coming year’s congressional elections weaken chances of a far-reaching tax-code overhaul that would roll back the break for buyers of state and local-government debt, said analysts including Morgan Stanley Wealth Management’s John Dillon and Matt Posner, who follows federal policy for Municipal Market Advisors. That may aid a market hit by losses this year as investors pulled out money amid speculation about rising interest rates and mounting distress in governments such as Puerto Rico’s.

“The likelihood of any changes to the treatment of the municipal bond tax exemption in 2014 are dim,” said Posner, whose firm is based in Concord, Massachusetts. “This Congress is unable to get much done at all.”

A change to the century-old tax break to state and local government debt would weaken the value of the securities, which sell for higher prices than other bonds because investors don’t have to pay federal taxes on the income. The subsidy also pushes down costs for states and cities, which borrow to pay for roads, schools and other public works.

Little Emerges

The possibility that the tax exemption could be eliminated or curtailed has persisted in Washington since 2010, when the leaders of President Barack Obama’s deficit-cutting commission proposed eliminating it as part of a broad package of changes. The following year, Obama sought to curb its value to the wealthiest taxpayers to raise revenue, a proposal that the administration has continued to endorse.

None of the proposals has advanced in Congress. The enmity between the Republican-led House and the Democrat-run Senate made 2013 its least productive first year of any session iun three decades, based on the number of laws passed, according to GovTrack, which follows legislation.

Yet the risk that Congress could roll back the exemption unnerved investors. Posner, the bond analyst, said it’s one reason that the gap between short- and long-term interest rates in the tax-exempt market is wider than for bonds that don’t carry the tax break. That reflects the risk of holding debt that will mature years from now. He said it may also be one reason why investors have been pulling money from municipal bond mutual funds, which lost $26 billion from March through September, according to Federal Reserve data.

“Just the uncertainty has to make for some selling pressure,” Posner said.

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