Not so long ago, municipal bonds were considered the "belt and suspender" kind of investment that offered steady, tax-free returns with low volatility and virtually no risk.

But a perfect storm struck municipal bonds (climaxing toward the end of 2008), one that continues to reverberate in today's market. Its impact has prompted investors to doubt the ability of local, county and state budget officials to deliver on their tax-based bonds. And much of the same uncertainty has clouded convictions about various revenue-based municipals as well, including those supported by water, sewage, power, dormitory and industrial development authorities.

Turbulence came to a head as a severe bear market and recession drastically cut into government tax collections, challenging already precariously balanced budgets. Governments continue to commit more resources to restart growth and provide relief for an expanding number of unemployed. This sent the need for government borrowing soaring while credit markets were seizing up.
But at the core of this crisis were the deteriorating credit qualities of a half dozen monoline insurers, including MBIA, AMBAC and XL Capital Assurance, who were collectively insuring up to half of all outstanding municipal bonds just several years ago. By mid-2008, these companies were no longer considered viable financial backstops for missed payments, says Geoffrey Schechter, manager of the MFS Municipal High Income Fund. He surmises that no more than 10% of all new issuances carry bond insurance, and the Assured Guarantee Corporation is the only significant municipal bond insurer remaining.

Such insurance, which had produced AAA-ratings, sent demand for municipals soaring by various asset managers and funds who were borrowing short, at fractional rates, and investing long in municipals with supposedly guaranteed payments that were several times higher.

As monoline bond insurers were being downgraded, so too were many municipals' AAA ratings that they supported.  This subsequently  forced highly leveraged carry traders to unwind fast, flooding the market with unwanted bonds.   Ebbing investor demand couldn't absorb this oversupply, sending prices drastically lower and yields higher.  Suddenly, some investment-grade bonds had suddenly lost up to half their values, according to Schechter.

There were also doubts about the integrity of rating agency evaluations of corporate and subprime instruments. These doubts spilled over into the municipal arena, when a former chief compliance officer at Moody's Investors Service recently offered congressional testimony that his firm did virtually no follow-up "surveillance" on its municipal bond ratings after they were initially made, despite Moody's claims to the contrary.

This further intensified the global flight to quality from the fourth quarter of last year through the first quarter of this year, sending investors scurrying into Treasurys and pushing their yields lower.  

The result: Traditional spreads between Treasurys (which normally pay more) and municipals (which normally pay less because of greater tax advantage) inverted. At one point, investors were actually receiving up to 300 basis points more for AAA-rated triple-tax-free municipal bonds over state and local tax-free Treasurys of equivalent maturities.

The muni market recovered significantly over the spring and summer. As of mid-October, according to Konstantine Mallas, portfolio manager of T. Rowe Price's Summit Municipal Income Fund, weekly net inflows into munis soared from an average of $250 million to well over $1 billion over the past two quarters. This has helped yields to draw down to nearly even with Treasurys. But that ratio still suggests concerns about the health of municipals and the market environment in general, as demand remains strong for Treasurys. Mallas says 30-year Treasurys traditionally yield about 11% more than municipals to make up for their less-favorable tax treatment.

The Obama administration's introduction of taxable municipal bonds has helped relieve market distress for munis. Known as Build America Bonds (BAB), this federal program has not only enabled governments to access a larger, more liquid and globally accessible debt market, but has provided a significant subsidy in the process. The national government is paying 35% of these bonds' interest. In the third quarter, more than half of new long-term municipal issuances were BAB.

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