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Muni bond market roiled as investors demand higher yields

June 10, 2009 |  7:13 pm

The municipal bond market is stumbling as investors turn more cautious while states and local governments ramp up borrowing.

Tax-free yields on muni bonds rose Wednesday, continuing a reversal that began about two weeks ago. California state bonds were hit particularly hard. And Los Angeles County paid double what it expected as it raised more than $1 billion by selling short-term notes.

The market’s demand for higher yields is pushing down prices of older fixed-rate bonds. That’s depressing share values of muni bond mutual funds.

Case in point: The share price of the Franklin California Tax-Free Income fund slipped 3 cents, or 0.5%, to $6.54 Wednesday. The fund is down 2.7% since May 22 -- a relatively modest decline so far.

Fi-munis11-2In Wednesday’s trading, the annualized yield on the Bond Buyer index of 40 long-term muni bonds nationwide rose to 5.54% from 5.51% on Tuesday. The yield has risen from 5.22% on May 21.

The muni market’s sudden troubles, after a strong rally for much of the spring, in part reflect the surge in U.S. Treasury bond rates: As Treasury yields rise they’re putting upward pressure on other interest rates.

A heavy supply of new muni bonds also is weighing on the market, giving buyers the upper hand in setting interest rates. About $12 billion in new muni issues are expected to be sold this week, the most since the end of April, according to Bloomberg News data.

For the California muni market there’s another issue, as most investors ought to know by now: As the state’s budget woes have deepened in recent weeks the market has begun to focus more intently on the potential fallout. Although Wall Street doesn’t believe the state could renege on its debts, investors have begun to demand much higher yields on California’s general obligation bonds to reflect the greater perceived risk of financial calamity.

The yield on 10-year California general obligation bonds soared to 4.89% on Wednesday from 4.76% on Tuesday, according to Bloomberg data. The yield was 4.37% four weeks ago.

"The whole muni market has gotten hurt, but California is leading the parade," said Stephen Kelleher, manager of the muni bond unit at brokerage Wedbush Morgan Securities in San Francisco.

Of course, higher yields also mean opportunity for investors -- if they can stomach the risks.

The state’s budget mess forced Los Angeles County to pay much more than it had planned on a sale of $1.3 billion in so-called tax and revenue anticipation notes, a normally routine borrowing counties undertake at this time of year.

The county on Wednesday paid an annualized tax-free yield of 0.8% on the 12-month notes, said Glenn Byers, assistant treasurer. It had expected to pay as little as 0.4%.

Investors demanded a higher rate after credit-rating firm Standard & Poor’s cut its rating on the notes one notch, to "SP-1" from "SP-1-plus," citing uncertainty about the effect of possible state welfare-funding cuts on the county’s budget.

Those worries weren’t shared by S&P’s rival, Moody’s Investors Service, which affirmed its highest rating for the county’s notes. But given the market’s dour mood at the moment, "we paid a heavy penalty for not having the highest ratings" from both of the rating firms, Byers said.

By contrast, Orange County on Wednesday paid 0.4% on a similar note offering, though its deal was much smaller at $150 million. Orange County had top ratings from both Moody’s and S&P.

-- Tom Petruno

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