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Muni bond yields fall further as market panic ebbs

February 16, 2011 |  7:30 am

Crisis over?

The municipal bond market increasingly looks like it's moving out of panic mode, as selling abates and buyers come in from the sidelines.

That's showing up in falling bond yields and in rising share prices of muni mutual funds.

On Tuesday, the annualized tax-free yield on the Bond Buyer newspaper's index of 40 long-term muni issues nationwide (charted below) slipped to 5.71%, down from 5.75% on Monday and a two-week low.

Bbfeb15 The Bond Buyer muni yield had peaked at a two-year high of 5.95% on Jan. 18. It began to pull back after that, then briefly moved higher again in early February as U.S. Treasury bond yields also resurged.

What's significant about the muni rally since last week is that it set in before yields hit new highs -- or, to put  it another way, before bond prices fell to new lows. That suggests some buyers were anxious to get in at current yields.

By contrast, buying interest evaporated quickly after yields temporarily fell in mid-November and again in mid-December.

The muni market suffered a vicious sell-off beginning in late October, first as investors shied away from bonds in general, then as fears mounted about the strained finances of many state and local governments. Wall Street banking analyst Meredith Whitney's now-infamous late-December prediction of a wave of muni bond defaults in 2011 triggered another wave of selling in January.

But in the last few weeks traders say the market has been buoyed by interest from so-called crossover buyers -- investors such as hedge funds and life insurance companies that normally wouldn’t hunt in the muni market, but found tax-free yields too enticing to pass up.

It also has helped that redemptions by muni mutual fund investors have eased. The net cash outflow from the  funds totaled $1.2 billion in the seven days ended Feb. 2, down from $2.7 billion the prior week and $5.7 billion the week before that, data from the Investment Company Institute show.

Another ray of light: This week the Obama administration proposed reviving the Build America Bond program, which for the last two years allowed many state and local governments to sell taxable bonds subsidized by Uncle Sam. The program, which expired Dec. 31, kept the supply of tax-free munis limited.

Still, it may be premature to bet on the return of Build America Bonds: Republican opposition to the  program seems steadfast.

And the Bond Buyer's Dan Seymour noted last week that the muni market rally since mid-January has occurred amid a dearth of supply, as new bond issuance has plunged. The real test for the market will come when issuance rises significantly.

From Seymour:

It is far from clear what will happen when municipalities finally come to market with a hefty, or even normal, amount of [long-term] tax-exempt supply. Few market participants believe the crossover buyers who have somewhat buoyed the market amid a small amount of municipal supply so far this year can sustain the market permanently.

But for now, at least, the fear factor in the muni market continues to recede.

-- Tom Petruno

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