Muni-Bond Market Tumbles As Investors Demand Higher Yields on Shaky Finances

California's efforts to sell $10 billion in short-term bonds last week attracted only tepid interest, adding to concerns that some local governments are on shaky financial ground and may have to pay more to attract investors.

The widely watched sale drew interest from around the country as debate continued over whether the stability of municipal finances has been a factor in market prices. The tax-exempt bond market has been overwhelmed by a deluge of supply that has decreased demand, depressed prices and forced yields higher.

"The tax-exempt municipal bond market is a cold, cold world right now for issuers and taxpayers," Tom Dresslar, a spokesman for the California State Treasurer told The Wall Street Journal. He added that the state decided to cancel another $267.3 million bond sale it planned to price this week "in light of market conditions."

Poor reception by investors led America's beleaguered states and cities to pull about $700 million worth of borrowing deals from the municipal bond market last week, even as yields on the tax-exempt vehicles handily exceeded Treasuries.

That represented roughly 3% of the week's planned sales, according to data The Journal obtained from Ipreo. Many of the bond sales were aimed at refinancing outstanding debt at lower rates, meaning the governments didn't immediately need the money.

The muni-bond market, normally a picture of stability, is suffering through its steepest decline in nearly two years, as investors demand higher interest rates for bonds issued by states, cities and counties to finance their operations.

After pouring billions into municipal bond funds most of the year, investors pulled $115 million out of the funds last week, the Investment Company Institute (ICI) said. That was the first weekly outflow in seven months, ICI told The Journal.

Local governments have been slammed by a drop in tax revenues and budget shortfalls as the economic downturn spawns rampant unemployment and dampens consumer spending. Unlike the federal government, most local governments are barred constitutionally from running deficits.

Municipal bonds, issued to fund public projects such as roads and public buildings, have historically been seen as one of the safest places to invest, which is why 80% of municipal bond holders are individual households and mutual fund investors, Jeffrey Cleveland, municipal bond analyst at Payden & Rygel Investment Management told Forbes.

The National League of Cities says municipal governments will probably incur $56 billion to $83 billion of budget shortfalls between now and 2012. But that could increase, Matt Fabian, managing director at Municipal Market Advisors told Forbes.

Several downtrodden cities have been on the verge of defaulting on their debt, leaving states and taxpayers legally on the hook to pick up the tab.

Pennsylvania's capital city of Harrisburg narrowly escaped default in September when it made a $3.3 million payment on a 1997 general-obligation bond for a trash incinerator. The city paid up after it was sued by its home county, Dauphin, and Bermuda-based bond insurer Assured Guaranty Municipal Corp. The state of Pennsylvania provided funding for the bailout.

Moody's Investors Service added to the uncertainty surrounding municipal finances last week when it downgraded its debt ratings on the city and county of San Francisco, as well as the city of Philadelphia.

Moody's cited "continued weakness of the city's finances" in its downgrade of Philadelphia, affecting $3.85 billion in outstanding debt, according to The Journal. San Francisco “ended fiscal 2009 with a balance sheet that was weaker than at any time in the prior ten years," the ratings agency said.

Representatives from major rating firms and municipal-bond participants told state insurance regulators at a hearing in New York last week that the danger of states and cities defaulting on their debt remains small. But some urged regulators to increase credit analysis for muni-bond-backed enterprise projects.

Regulators expressed concern that municipalities are understating their liabilities by assuming inflated rates of return on their investment portfolios.

The ratings agencies testified that they thought states and cities would do whatever necessary to meet their obligations, including raising taxes, or cutting benefits for current or new workers to meet under-funded pension plans.

Bond-backed funding for enterprise projects, such as steam plants, housing projects, or even private companies that access the public debt markets deserve closer scrutiny, the agencies and investors testified.

State regulators "might take a long hard look at that which passes for municipal debt," Bill Brandt, president of the Illinois Finance Authority told The Journal. "It's not your grandfather's municipal bond anymore," he said referring to so-called private-activity bonds.

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