The municipal bond market is facing dramatic changes in 2009 following a series of developments in 2008 that shook investor confidence and hurt issuers' ability to raise needed money.
Retail investors instead of institutions are now in the buyside drivers seat.
"We're basically expecting that muni issuance will be at whatever level retail demand can meet," Phil Fischer, a muni strategist at Merrill Lynch & Co. (MER.N), said about 2009. "It's a very different market."
Tax-exempt issuers will need major help to stay afloat.
"We need relief like a reversal in the economy or a handout from Uncle Sam," said Richard Ciccarone, a managing director at McDonnell Investment Management in Oak Brook Illinois, referring to federal help for states and local governments.
Without some help or change on the economic front, Ciccarone said more municipal bankruptcies and bond defaults may be in the cards.
In the second half of 2008, Fischer said he realized that problems in the muni market were not isolated events, but part of a fundamental shift in how tax-exempt bonds are bought and sold.
"This is about as radical a change we've seen," Fischer told Reuters.
"We knew about it very quickly, because in 2007 the insurers and the auction market got into trouble," he said of the market's rocky state at the start of 2008. "But it really came home to roost when the property and casualty insurers shifted from net buyers to net sellers."
RADICAL CHANGE
The list of events in 2008 included: most muni bond insurers lost their top ratings due to exposure to subprime mortgages; the auction-rate market froze and trapped investors and issuers; underlying muni ratings lost credibility; huge market liquidity providers like Bear Stearns & Co vanished; investors fled tax-free mutual funds; cross-over buying stalled and yields shot higher.
Finally, insurance companies like American International Group (AIG.N) that had reliably bought up munis started selling.
"You can't look back at any year and see so many factors that had gone negative for municipals all at once," Ciccarone said.
The market experienced "very extreme" bifurcation, Fischer said. The buyside, once dominated by institutional investors, is now the domain of retail buyers, who rarely look beyond highly rated bonds due in 10 years, he said.
An exodus out of tax-exempt muni funds began in September and has shown no sign of abating, increasing selling pressure in the already-troubled market, according to Fischer. And muni bonds with less than stellar ratings are saddled with high yields.
Merrill Lynch's Municipal Master Index had a negative 3.95 percent total return for 2008. While the index for triple-A-rated bonds was slightly positive, the return on triple-B-rated debt was negative 22.38 percent.
One of the best examples of how out of whack municipals became is in their current relationship with taxable U.S. Treasuries. Top-rated munis began 2008 yielding a normal 85 percent of 30-year Treasuries and 79 percent of 10-year government bonds, according to Municipal Market Data.
On Friday, 30-year munis yielded nearly 180 percent and 10-year munis yielded 146 percent of comparable Treasuries, marking an astounding turnaround in the relationship between the two markets.
While Treasuries benefited from a flight to quality out of the plummeting stock market, munis remained suspect due to their laundry list of problems.
Yields on triple-A-rated 30-year munis flirted with 6 percent in mid-October reaching 5.94 percent. For lower-rated debt yields were much higher. A-rated, 30-year hospital bond yields hit a peak of 7.60 percent in mid-December, according to MMD. Yields on 30-year California bonds reached 6.76 percent on December 15 as the state's severe budget situation continued to unfold.
Volatility for 30-year munis was at the highest level in at least 10 years, according to MMD.
(Editing by Leslie Adler)
