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Muni bond yields jump as states' fiscal woes worsen

December 10, 2008 |  6:14 pm

Yields on tax-free municipal bonds are soaring again, pushed up in part by deepening budget woes in California and other states.

One measure of investors’ concern about the safety of historically rock-solid munis: In the so-called credit default swap market, the average cost of insuring a basket of 50 muni bonds nationwide against possible default now exceeds the average cost of insuring high-quality corporate bonds -- the first such flip-flop in those markets.

And in that same insurance market, it costs more to insure against default on California state debt than on the Mexican government’s debt.

As investors have balked at buying muni bonds in recent weeks, prices of the securities have tumbled, pushing yields up.

Munisdec10The average yield on an index of 40 long-term muni issues tracked by the Bond Buyer newspaper rose to 6.53% on Wednesday, up from 6.49% on Tuesday and 5.84% in mid-November.

Because muni interest is exempt from federal income tax (and usually from state income tax in the issuer’s state), those yields are extremely lucrative compared with what investors can earn on, say, U.S. Treasury bonds. The 30-year T-bond yield now is just 3.09%, down from 4.23% in mid-November.

But many investors are leery of munis, leaving some bond issuers "begging for buyers," said Stephen Kelleher, head of muni bonds at brokerage Wedbush Morgan Securities.

For investors who already own muni issues, the value of their holdings is slumping as market yields surge, devaluing older bonds. The share price of the Franklin California Tax-Free Income mutual fund fell to $5.96 on Wednesday, a 2008 low and a drop of 8.3% just since mid-November.

This is the second spike in muni yields this fall. The first was in mid-October, at the height of the credit crisis, as hedge funds and other big investors dumped bonds in a rush to raise cash.

This time, the market appears spooked by worries about the dismal economic outlook for 2009, and the prospect that more muni issuers -- particularly smaller cities and local government agencies -- will have trouble making debt payments.

Although few analysts believe any states would default on their debts, "You could definitely see more defaults in smaller issues, and that would cast a pall over the entire market," said Matt Fabian, a managing director at Municipal Market Advisors in Westport, Conn.

Govarnold Many states are adding to the gloom by painting a dark picture of their budget situations. Gov. Arnold Schwarzenegger warned Wednesday that California’s budget gap had widened by $3.6 billion in recent weeks.

Although the states’ fiscal stress is real, it’s also in their interest to sound as dire as possible as they seek federal financial help, Fabian said.

The states’ warnings, in turn, are helping to drive up the cost of muni bond insurance using credit default swaps, he said. And as investors see those costs rise, it stokes more fear of defaults, whether warranted or not, Fabian said.

The cost to insure against default on $10 million of California state debt for five years was $387,000 on Wednesday, up from $308,000 a week ago, Reuters reported. By contrast, similar insurance on Mexican government bonds costs about $370,000.

For California investors looking for high tax-free yields, 10-year state general obligation bonds are paying as much as 5.75%, up from about 5% a month ago, said Bob Gore, a muni bond trader at brokerage Crowell Weedon & Co. in Los Angeles.

Among smaller municipal issuers in the state, "You can buy some pretty good-quality stuff at 6.5% yields," he said.

The problem in enticing potential buyers, Gore said, is that many believe yields can only rise further in 2009 as the economy worsens and bond issuers’ finances come under more pressure.

By historical standards, "Muni bonds are cheap, but there’s no assurance that they aren’t going to get cheaper," he said.

-- Tom Petruno

Photo: Gov. Arnold Schwarzenegger (Rich Pedroncelli / Associated Press)