(Bloomberg News) The biggest wave of tax-exempt borrowing in 2011 is widening the gap between municipal yields and Treasury rates to the most in more than two years as investors extract concessions after a 10-month sales slump.

Municipal issuers led by New York City, Minnesota and the District of Columbia are selling about $20 billion from Sept. 12 through Sept. 30, the biggest three-week total since December, according to data compiled by Bloomberg. The difference between yields on 10- and 30-year municipals and Treasuries is the greatest since April 2009.

"The supply's taking some kind of a toll on relative interest rates," said Alan Schankel, director of fixed income research at Philadelphia-based brokerage Janney Montgomery Scott LLC.

Muni borrowing costs are "not falling maybe as sharply as they would have otherwise," he said. "At least part of that reason is the increased supply."

Yields on 10-year municipals reached 117 percent of Treasury rates yesterday, compared with the average in the past five years of 94 percent. As a result, states facing a combined $125 billion of budget gaps in fiscal 2012, according to the Center on Budget and Policy Priorities, aren't able to gain the full savings on relative borrowing costs as Treasuries rally.

Ten-year U.S. government bond yields fell to 1.72 percent yesterday, the lowest since January 1962 as stocks fell worldwide on concern the global economy is sliding into recession.

Yields on tax-exempt debt maturing in 30 years were 126 percent of Treasuries yesterday, higher than the five-year average of 107 percent.

Record Low

Even with the wider spread over Treasuries, tax-exempt bond issuers are paying some of the lowest absolute borrowing costs in more than two years. Yields on top-rated 10-year municipals were 2.01 percent yesterday, the lowest level since January 2009, when Bloomberg data for the securities begins. That rate for tax-exempt bonds is still 29 basis points higher than comparable Treasury yields. A basis point is 0.01 percentage point.

Yields on top-rated 30-year municipals were 3.52 percent yesterday, also the lowest since Bloomberg records start. The yield is 72 basis points higher than the 2.80 percent 30-year Treasury yield.

Municipal yields may rise later this year to compensate for further increases in issuance as states and municipalities complete borrowing plans, said Chris Ihlefeld, who helps manage about $6.7 billion in municipal holdings for Thornburg Investment Management Inc. in Santa Fe, New Mexico. The spread over Treasuries may also widen, he said.

'Supply Pick Up'

"We often see supply pick up in the later part of the year and I would expect that as we continue to see an uptick, that muni rates would go up," Ihlefeld said in a telephone interview. "And if all other things held constant, that would potentially increase the ratio of munis to Treasuries."

While income from debt redemptions propelled purchases in recent months, the total from bondholders reinvesting proceeds of matured securities is expected to fall to a combined $55 billion in October and November from $61 billion in the previous two months, said Peter DeGroot, head of municipal research at JPMorgan Chase & Co.

Investors added about $296 million to U.S. municipal-bond mutual funds in the week through Sept. 21, Lipper US Fund Flows said. It was the third straight week of inflows.

Issuance this year has been slow compared with 2010, when states and cities took advantage of the taxable Build America Bond program and its 35 percent federal subsidy of interest. Total municipal sales in 2011 were $156 billion as of Sept. 16, according to Bloomberg data, compared with $269 billion sold during the same time in 2010.

Following is a description of a pending sale of municipal debt:

NEW YORK CITY, the most populous U.S. city, is to borrow $818 million of tax-exempt and taxable bonds as soon as Sept. 27. The transaction will finance capital projects and convert $168 million of variable-rate bonds into fixed-rate debt. The city is rated AA, Fitch Rating's third-highest grade. Siebert Brandford Shank & Co. LLC will lead a syndicate of banks marketing the sale.