Dec. 19 (Bloomberg) -- Wall Street's three-year love affair with debt sold by U.S. states and cities is over.
Municipal bonds, whose returns trounced Treasuries and corporate debt from 2004 to 2006, are headed for their worst year since 1999, according to Merrill Lynch & Co. indexes. They may remain laggards after securities firms reduced their holdings during the third quarter by the largest amount in at least 12 years, data compiled by the Federal Reserve show.
Citigroup Inc., Goldman Sachs Group Inc. and the rest of the securities industry reduced holdings of municipal bonds in their trading accounts by more than 16 percent, to $45 billion as of Sept. 30 from a record $53.9 billion at the end of June, according to the most recent Fed data released Dec. 6. The sales raised yields on municipal debt relative to Treasuries and increased financing costs for state and local governments planning bond sales by as much as $320 million through 2017.
``There's no money flowing into the market right now from hedge funds, banks or anywhere else,'' said Thomas Metzold, manager of the $6 billion Eaton Vance National municipal fund in Boston. ``The banks have other needs for their capital.''
Subprime Damage
Securities firms are putting less into state and local debt after about $62 billion of writedowns on securities related to subprime mortgages. Barclays Capital estimates losses may increase by $200 billion.
Subprime-related losses also hit bond insurance companies that guarantee about half of all U.S. municipal debt, weakening investors' confidence in the AAA corporate ratings that are applied to the obligations and hurting prices last month.
Munis returned 3.02 percent this year, compared with 3.85 percent for corporate securities and 8.42 percent for government debt, Merrill indexes show. That's the worst performance since 1999, when state and local government debt lost 6.34 percent.
As investors retreated from corporate and asset-backed bonds to the safety of Treasuries, some also sold munis as losses on mortgages made to people with poor credit began to spread in August. Municipal yields rose to the highest compared with Treasuries since 2003, data compiled by Bloomberg show.
Yields on 10-year municipal bonds averaged about 93 percent of what the U.S. government pays, compared with 83 percent on average in the two years before August. Investors typically accept lower rates on state and local debt because interest is exempt from taxes.
Structured Investments
Municipal debt has suffered as structured investment programs that sell short-term debt backed by long-term tax- exempt bonds have pulled back, CreditSights Inc. said in a report.
``Their structured nature -- like anything else structured in recent months -- has forced investors to re-examine their true quality,'' Christian Stracke wrote in the report. Such ``tender-option bond'' programs make up almost 8 percent of the $2.6 trillion municipal market after being ``almost non-existent at the beginning of the decade,'' Stracke added.
Borrowing costs are also rising in part because the housing market is enduring its deepest slump in 16 years. Falling property values may slash tax revenue for states and cities by more than $6.6 billion in 2008, according to a November report by the U.S. Conference of Mayors.
``Reduced demand from some traders may keep municipal yields higher than they ought to be for an extended time,'' said James Kochan, fixed-income strategist at Wells Fargo & Co.'s Funds Management Group, which oversees $3.2 billion of municipal bonds. ``Eventually, buyers will emerge and we will see this was a major opportunity.''
Greater Risk
That's the opposite of what happened a year ago, when firms such as New York-based Citigroup, the biggest U.S. bank, along with hedge funds piled into munis, Fed data show.
``The market became more reliant on trading accounts and arbitragers, and now it faces a greater risk of capital being pulled from those kind of buyers,'' Kochan said.
The higher yields relative to Treasuries means local government borrowers pay 34 basis points, or 0.34 percentage point, more in interest than if municipal bond yields had stayed at 83 percent of Treasuries as in the two years ended in July.
A 34-basis-point increase on $9.4 billion of bond sales -- the amount local government borrowers including Chicago's O'Hare International Airport have pending over the next 30 days --means about $320 million in additional interest through 2017.
Connecticut, Costs
Connecticut sold $15 million of 10-year notes on Dec. 3 at a yield of 3.66 percent, or about 95 percent of the similar maturity Treasury yield. If the state offered the bonds at 83 percent of the Treasury yield, the rate would have been 3.2 percent, and the state would have saved 46 basis points, or $690,000 over 10 years.
The same week, the Alabama Public School and College Authority obtained a yield of 3.67 percent on notes due in 2017, or 93 percent of Treasuries. The yield would have been 38 basis points lower if the authority obtained a rate equal to 83 percent of the Treasury yield.
Citigroup, the largest underwriter of municipal bonds in 2005 and 2006, reported a $3.1 billion, or 15 percent, decline in local government issues in its trading account between June 30 and Sept. 30 to $18.1 billion. New York-based Goldman Sachs had a $1.36 billion drop, or 31 percent, to $3.06 billion, company filings with the Securities and Exchange Commission show.
`Volatile' Holdings
``Their holdings were a lot more volatile than people expected,'' said Matt Fabian, senior analyst and managing director at Municipal Market Advisors, the Concord, Massachusetts-based municipal bond research firm.
Marc Kandel, a spokesman for Goldman Sachs, and Citigroup spokesman Stephen Cohen didn't respond to requests for comment.
Municipal bond hedge funds, which helped fuel the market gains, have also reduced their investments, Eaton Vance's Metzold said. Municipal hedge fund losses through early November ranged from 5 percent to 30 percent, according to Evan Ratnow, an analyst at Fortigent, a Rockville, Maryland-based consultant who monitors municipal hedge funds on behalf of investment advisers who control $18 billion of assets.
``The funds are seeking new accounts, but their recent performance was a lot worse than some people thought possible,'' Ratnow said. ``On the positive side, the funds have a history of producing big gains after months with big losses.''
To contact the reporters on this story: Michael Quint in Albany, New York, at mquint@bloomberg.net ; Jeremy R. Cooke in New York at jcooke8@bloomberg.net .
Last Updated: December 19, 2007 11:09 EST
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