Issue of the week: Crisis in the muni-bond market

Chaos reigned this week in the normally staid municipal bond market, said Michael McDonald in Bloomberg.com, as “the worst slump in municipal bonds on record” showed no sign of abating. Just about everything that could go wrong in the market has gone wrong in recent weeks. Investors have lost faith in the companies that guarantee principal and interest payments on many bonds; the auction market where state and local governments borrowed at relatively low rates has collapsed; and hedge funds are dumping their muni-bond holdings to raise money to repay bank loans. Amid the turmoil, muni-bond prices fell 4.9 percent in February, according to indexes compiled by Merrill Lynch. They’re likely to fall further in coming weeks, as up to $166 billion in new bonds compete for investors’ dollars. Slumping prices translate to higher borrowing costs for municipalities, “squeezing states and towns just as slower growth threatens to cut revenue.”

Falling prices, though, also translate into record-high yields for investors, said Michael Mackenzie and Saskia Scholtes in the Financial Times. “Municipal bonds normally trade at about 80 percent of Treasury market yields because they are tax-free investments.” But this week, the relationship turned “upside-down.” Muni bonds are yielding more than Treasurys, with 10-year munis paying about 4.1 percent, compared to 3.57 percent for 10-year Treasurys. Those “unprecedented” yields have drawn some buyers, “but many investors remain wary” and are waiting for prices to fall even further. Billionaire Warren Buffett said last week that he was offered a chance to buy a $3.5 billion portfolio of municipal bonds. He and the seller couldn’t agree on a price, but he expects more forced sales in the future. “People who were out on a limb financially are getting that limb sawed off,” he said.

The fallout from the chaos is starting to spread, said Julie Creswell and Vikas Bajaj in The New York Times. Many municipal borrowers are now challenging the “complex system of credit ratings and insurance policies that Wall Street uses to set prices for municipal bonds.” Those borrowers seek high credit ratings to make their bonds attractive to investors. To obtain a high rating, though, they’re often required to buy bond insurance, which assures investors that the principal and interest will be repaid even if the borrower goes bankrupt. That insurance adds billions of dollars to municipal borrowing costs, as “money that could be used to build schools, pave roads, and repair bridges” is instead “siphoned off in the financial markets.” But a disastrous diversification into mortgage-bond insurance by the three big municipal-bond insurers has weakened their finances, casting “doubt over the value of the insurance policies municipalities buy.” The state of California didn’t insure $4.3 billion of bonds it sold recently, and the sale’s success may encourage other states to follow suit. “The value of bond insurance is not what it was a half-year ago,” said Tom Dresslar of the California treasurer’s office. “It would be a waste of taxpayers’ money to buy insurance on our bonds.”

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