Bond Buyers Tug Muni Yields Back to Earth

By TOM LAURICELLA
April 19, 2008; Page B1

Municipal-bond yields, which soared this winter as hedge funds dumped the bonds, have finally begun coming down.

Still, yield-hungry investors shouldn't fret. Muni yields are likely to remain elevated compared with taxable debt such as Treasurys -- just not at the sky-high levels reached earlier in the year.

What happened was that buyers such as mutual funds, lured by the high yields, piled back into munis in recent weeks and reversed the impact of a winter selling frenzy by hedge funds. With bonds, yields move in the opposite direction from prices. So the new bidding action pushed up prices and thus reduced yields from high levels.

Mutual-fund manager Joseph Deane of Western Asset Management said that as March began, "I was buying my shoes off."

But the buyers' rekindled ardor for munis has cooled as yields have fallen. "We have been selling into this market," said Mr. Deane, who helps oversee about $38 billion at Western. "We've come a long way from where we were five weeks ago."

The yield on the average triple-A-rated municipal bond has fallen to 4.60% -- or 0.09 percentage point above that on a 30-year Treasury, according to Thomson Reuters. That is down from a record gap hit in March, when muni yields were 0.72 point higher than Treasurys. On top-rated 10-year muni debt, yields averaging 3.60% now are 0.14 point below Treasurys. In late February, the average 10-year muni was yielding 1.17 points more than Treasurys.

While muni yields may not be the kind of screaming buy they were five weeks ago, they're still attractive. Historically, municipal debt yields less than Treasurys because holders don't pay federal taxes on the interest income. And the tax exemption means that an investor in the highest federal tax bracket earns the equivalent of a 6.96% yield lately on a 30-year municipal obligation. That plus munis' longtime low default rates were enough to lure investors in the past.

At the center of the recent turmoil in the municipal market are the hedge funds and other traders. They loaded up on munis, using even cheaper short-term debt -- as low as 1% not long ago -- to buy them and benefited from the spread.

Then in late February and early March, the traders ran into trouble from higher short-term rates and the credit crunch. The traders needed to raise cash to shore up their balance sheets. So they unloaded their muni positions.

The flood of munis over the winter sent the bonds' prices plummeting. Muni yields jumped.

Contributing to the muni price plunge was the plight of bond insurers, which many state and local governments use to protect their bonds -- and win them lower interest rates. Bond insurers such as Ambac Financial Group Inc. and MBIA Inc. were themselves burned badly by their guarantees of mortgage-backed investments, and their insurance didn't look so solid anymore.

Another problem for muni issuers was the seizing up of the market for debt known as auction-rate securities. Many local governments also used these instruments to raise money. These are essentially debt vehicles carrying floating rates that are reset weekly or monthly. But the banks that run the auctions stopped committing their own money to make sure the sales ran smoothly.

Eventually, muni yields rose high enough to tempt buyers. A rally took hold in late March and early April as the forced selling abated and customary buyers of muni debt -- mutual funds, individual investors and insurance companies -- came off the sidelines.

"When yields got up to 5% on 30-year [triple-A] debt, there was very strong demand," says Basil Williams, chief executive at hedge-fund managers Concordia Advisors.

Other factors helped boost demand. Recently, the Securities and Exchange Commission began temporarily allowing local governments and other auction-rate issuers to buy back debt that didn't get enough demand at the auctions. In addition, some in the market expressed concerns about its ability to absorb about $125 billion of these orphaned securities that municipalities and organizations planned to reissue as debt backed by strong guarantees to appeal to money-market funds. Those reofferings, though, have gone far better than expected.

Nevertheless, restoring the customary set-up, in which munis yield less than Treasurys "is likely to take us a little bit of time," said Philip Fischer, municipal-bond-market strategist at Merrill Lynch. Mr. Williams is even more pessimistic: "It's unlikely we're going to get back anywhere near the levels we had seen in late 2005 through early 2007."

Headwinds include pent-up issuance, which means more new muni bonds will be on the market, further holding down prices; the economic woes of some governments that will depress prices on their paper; and the lingering financial troubles of bond insurers. The hedge funds which once propped up prices appear to be gone from the field.

Even if the conditions for munis improve, trouble elsewhere in the fixed-income world could well continue to damp enthusiasm for them, according to Merrill's Mr. Fischer. "This problem will persist in varying forms well into the summer," he said.

Treasury Prices Fall

The week ended with another day of losses for the Treasurys market, as surging stocks and the prospect of fresh supply next week weighed on the market for most of the session.

The 10-year note ended down 4/32 point, or $1.25 for every $1,000 invested, to yield 3.743%, up from Thursday's 3.729%.