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Rebound in tax-free muni bonds may be running out of gas

January 21, 2009 |  6:30 am

The tax-free municipal bond market has had the wind at its back for the last five weeks, driving yields down -- and bond prices higher. But that may be changing.

Selling in the muni market has picked up since Friday. Some investors who were lured by high yields in December now are balking as yields have dropped.

In the California muni market, "It’s certainly a lot harder to find a bargain now, that’s for sure," said George Strickland, a muni bond fund manager at Thornburg Investment Management in Santa Fe, N.M.

Vanguardmunifundjan20_2 The market’s rally "has run very hard and very fast" since mid-December, said Steven Permut, who co-manages muni funds at American Century Investments in Mountain View, Calif.

That has helped many muni investors recoup most of the paper losses they incurred in the fall market meltdown, as the credit crisis deepened and muni and corporate debt was dumped indiscriminately, depressing bond values and sending yields soaring.

The share price of the Vanguard California Long-Term Tax-Exempt bond fund plummeted from $11.24 on Sept. 11 to a low of $9.77 on Dec. 16, a drop of 13%. For munis, that’s a big loss in a short period.

From the December low, however, the fund’s share price rallied back to $10.74 by last Thursday, a 10% rebound. On Tuesday the fund fell 0.8% to $10.63, the biggest one-day drop since Dec. 8.

As for interest rates, the Vanguard fund’s estimated annualized dividend yield was about 5.1% at the share price low in mid-December. Now the yield is about 4.7%.

That’s still a good tax-free return, particularly compared with yields on U.S. Treasury securities. But analysts note that one of the factors that triggered selling of munis in early December -- worries about the deteriorating finances of many states and municipalities as the economy worsens -- hasn’t gone away, even as yields have dropped. . . .

California is an epicenter for those concerns, given the state’s massive projected budget deficits, which Gov. Arnold Schwarzenegger and the Legislature still haven’t addressed.

The state can’t default on its general-obligation bonds; the California Constitution requires that the state honor those debts.

But Sacramento’s dire money woes, and the economy’s slump in general, are likely to make things tougher in 2009 for California cities, counties and other municipalities that don’t have constitutional guarantees on their debts.

Ultimately, the vast majority of municipal bond issuers will pay as promised. But I don’t know any muni market professional who isn’t expecting an uptick in bond defaults in the next few years. That will create more "headline risk" -- meaning that, skittish investors, reading scary headlines, may periodically demand higher yields on muni bonds to compensate for higher perceived risk.

That's an argument for being a patient investor, and buying into the inevitable market sell-offs. (Last fall presented two such opportunities, as the Vanguard fund chart shows.)

One factor buoying the muni market in recent weeks has been the promise of financial help from the Obama administration and Congress, which could include federally sponsored insurance of muni securities or direct purchases of short-term muni debt by the Treasury.

But Bob Gore, a veteran muni trader at Crowell, Weedon & Co. in L.A., says he wouldn’t bet on a further rally in the market based on help from the feds.

With the market’s rebound since mid-December, "The easy money has been made," he said.

-- Tom Petruno

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