Your know it's bad when munis get hit!!

By Michael A. Pollock
A DOW JONES NEWSWIRES COLUMN

NEW YORK (Dow Jones)--Because of low defaults and moderate volatility, the municipal bond market long has been viewed as one of the safest havens in fixed-income land.
Still, it turns out that munis aren't entirely immune to the contagion that has hit stocks hard and roiled credit-sensitive sectors of the bond markets in recent days.
Although investors aren't worried about credit quality in munis as they are in corporate and mortgage issues, the $2.3 trillion muni sector has been pressured by selling. It also has suffered a major drop in liquidity, making it more difficult for people to quickly and efficiently sell bonds.
Investors remain cautious about moving in to buy bonds at cheaper levels because, they say, it's unclear whether the market has yet reached levels where it might stabilize.
"The market tone is very negative in munis," says George Strickland, who manages tax-exempt bonds at Thornburg Investment Management in Santa Fe, N.M. "And it doesn't make you very hungry for bonds when you buy some and then the next day, they are a little bit cheaper."
As elsewhere in the markets, the tax-exempt area has been battered by events that many investors couldn't have anticipated. These stem from developments in other markets - such as subprime mortgages - that historically have had no relationship to munis.
Earlier this decade, as U.S. bond yields languished well below historic norms, muni investors began relying more on complex, leveraged strategies - marketed by big Wall Street firms - as a way of pumping up returns.
More recently, the muni market saw an influx of non-traditional money, from hedge funds, foreign investors and arbitrageurs. Arbitrage strategies seek to exploit unusual shifts in the relationships between securities within an asset class or between market sectors or different markets.
Some sought to exploit the more normal shape of the muni yield curve - meaning that along the entire yield spectrum, long-term rates remained higher than short-term yields. In Treasurys, the curve had inverted, with short-term issues yielding more, making some trades that involved combinations of maturities less workable.
But the more complicated transactions being used in the muni market, like those in other market sectors, require financing. And in recent weeks, liquidity has been squeezed as lenders have backed away from providing money for riskier, leveraged plays.
"The muni arb trade really started in June of 2006, and anyone who has put muni arb positions on since then has lost money," says Matt Fabian, a senior municipal market analyst for Concord, Mass.-based Money Market Advisors. And those players likely are facing margin calls, he adds.
In one sign of selling, a list of more than $300 million long-term muni bonds was put out for bids Thursday morning, and traders said this represented an unwinding of a position by an arbitrage account.
Meanwhile, institutional players such as insurance companies, who gravitate to munis at times when that market appears cheap on a relative basis to taxable bonds, are likely focusing more on corporate and mortgage issues, Fabian says. Those have been battered much more than munis, and thus present even better bargains.
With unwanted bonds being offered in large amounts in the muni market, valuations have dropped dramatically - although the market hasn't closed to new issues.
Spreads, or the gap between yields of triple-A rated and lower-rated muni issues, have doubled for some issues since mid-summer.
Another sign of declining valuations is the rising ratio of muni to taxable bond yields. When that ratio moves higher, it means investors can buy tax-exempt issues and get nearly the same yield on a tax-free basis as they could on a taxable bond.
Wednesday, a $500 million Port Authority of New York and New Jersey issue included 10-year issues priced at a yield of 4.24%, or 90% of the yield of the 10-year U.S. Treasury note, says Strickland of Thornburg Investment Management. Historically, such munis have yielded closer to 80% of the yields of Treasurys.
All of this hasn't proven as traumatic for individual investors in munis so far - although individuals usually are much slower to react to major market developments.
AMG Data Services of Arcata, Calif., reported under $200 million in outflows for muni funds it tracks on a weekly basis for the period ending Aug. 8. That followed an inflow totaling more than $100 million the previous week.
But after the drop in muni valuations recently, this could be an opportunity for investors to increase their holdings of individual bonds or of muni mutual funds, says Fabian. "If you are a person who just buys and holds munis, now is a decent time to go in and throw out lowball offers for riskier credits," he says. "The muni high-yield market has sold off considerably."
But in the view of some investors, the riskier areas of the muni market were overdue for a correction, similar to riskier parts of the credit markets. This summer's retrenchment has brought such issues down to more reasonable levels, they believe.
Robert B. MacIntosh, chief economist and co-head of municipal investments at Boston-based money manager Eaton Vance Corp., says he believes it may not be long before some bigger players return to the muni market to take advantage of the cheaper levels - although he notes that it's not easy to track what arbs or hedge funds are actually doing in the muni sector.
"They are the ones that will realize the value," he says of such bigger participants. "So we will probably hear about them coming back in soon."

(Michael A. Pollock, a special writer at Dow Jones Newswire, covers global fixed-income investment.)
-By Michael A. Pollock, Dow Jones Newswires; 201-938-2004; michael.pollock@dowjones.com

(END) Dow Jones Newswires
08-16-07 1332ET
Copyright (c) 2007 Dow Jones & Company, Inc.- - 01 32 PM EDT 08-16-07