Returns on the S&P Municipal Bond Index have fallen to minus 2.33% this year through Jan. 28, counting price changes and interest payments, the lowest year-to-date returns in at least 16 years.

“The message is getting increasingly clear that the timeline is shifting ahead and the Fed is going to be quicker,” said

Yingchen Li,

co-head of municipal research at Bank of America. 

The waning interest in muni debt in 2022 marks a reversal from 2021, when investors poured money into muni bond funds as federal stimulus and a bustling economy bolstered state and local government credit. That trend drove down the cost of school construction, sewers and other capital projects but now those expenses are rising.

Helping to exacerbate volatility in the historically calm $4 trillion muni market is a long-term shift in how bonds are bought and sold: Individual investors are increasingly likely to dump bonds at falling prices and bond dealers are increasingly unlikely to purchase them. 

The affluent households that make up the bulk of the market once treated munis as a buy-and-hold investment, hanging on until maturity while collecting regular interest payments that are often tax-free. Today these investors increasingly hold munis through mutual funds, separate accounts or exchange-traded funds—holdings that are easier to sell in the face of bad news.  

At the same time, rules made after the 2007-09 financial crisis left dealers less inclined to hold municipal debt on their balance sheets, meaning there are few ready buyers when skittish individual investors sell. 

“We literally had the discussion: OK guys, we’ve had now a week of outflows, what’s our cash? Should we be taking that cash up?” said Lyle Fitterer, who manages about $6.5 billion in municipal bonds as co-head of the municipal bond team at Baird Advisors. “We do not want to be the people who are forced to sell into this environment.”

The ease of outflows and scarcity of buyers aggravated the muni market’s March 2020 liquidity crisis, when fund withdrawals by panicked investors sent prices into such a tailspin that local governments had to cancel deals for lack of buyers. But the dynamic also plays a role in how the market responds to more minor shocks like the Fed’s announcement that it is ready to raise rates in March and could continue to lift them at an accelerated pace.

On Tuesday, the amount of debt sold by investors to bond dealers exceeded the amount investors bought by more than $1 billion, according to Municipal Securities Rulemaking Board data, a rarity in the high-demand, low-supply muni market. The last time that happened was September 2020.

Mutual and exchange-traded funds’ muni holdings are now even bigger than they were at the start of the pandemic, while dealer balance sheets have continued to shrink. Bond funds manage about $1 trillion combined, 20% more than at the beginning of 2020, according to Federal Reserve data from Sept. 30, the most recent available. Dealers are holding about $12 billion, down 27% from before the pandemic, though those holdings have grown slowly over the course of 2021.

“We’re dependent on mutual fund flows more than any other market,” said

Patrick Brett,

head of municipal debt capital markets at Citigroup, who also chairs the Municipal Securities Rulemaking Board, the muni bond industry’s self-regulatory organization. “We need buyers to step in when there are mutual fund outflows.”

Write to Heather Gillers at heather.gillers@wsj.com