Yields on municipal bonds has risen recently, with long-term yields rising more sharply than those on the short-end since the beginning of the November.

R.J. Gallo, senior portfolio manager and head of the municipal bond investment group at Federated Investors, noted that the 30-year, AAA-rated municipal yield rose 76 basis points through November 17, producing a loss of about 6 percent for the 22-years-and-longer portion of the Barclays Municipal Bond Index.

Similarly, the 10-year AAA muni yield rose 50 basis points and the 5-year yield rose 28 basis points over the same period, producing estimated losses on the corresponding portions of the Barclays index of 2.5 percent and 1 percent, respectively.

“We believe a sharp deterioration in the balance of supply and demand for municipal securities are driving this bear steepener,” Gallo said. “Uncertainty about whether the popular Build America Bonds (BABs) program… will expire at the end of this year has prompted a near-term supply surge. Meanwhile, investor demand has slowed due to a number of factors, including an increase in investors' risk appetite, the Fed's new quantitative easing program (QE2), calendar effects and, to a lesser degree, concerns about municipal credit quality.”

Initiated as part of the February 2009 federal stimulus bill, the BABs program provides municipal issuers with a cash rebate subsidy equal to 35 percent of a bond's coupon rate on taxable securities, allowing issuers to offer taxable bonds without fully paying the higher interest cost.

“These bonds have proven to be extremely popular as the net issuance cost of BABs is lower than that of traditional tax-exempt bonds for long-term securities,” Gallo explained.

About $155 billion of BABs have been issued since the program inception in 2009, 90 percent of which has been in securities with maturities of 10-years and longer, He added.

However, the Republican gains in the recent midterm elections have cast doubt over whether the BABs program will be allowed to expire at the end of the year, raising the prospect that many billions in long-term securities that would otherwise be issued in BABs will return to the tax-exempt market in 2011.

“The mere uncertainty over the future of BABs already is driving up yields,” Gallo explained.

“In fact, we are seeing a flood of issuers of tax-exempt bonds coming into the market in late 2010, seeking to issue now rather than wait to 2011 when tax-exempt yields could be higher without BABs. Of course, the acceleration of future borrowing to today is merely putting greater upward pressure on yields in the near-term.”

On the demand side, Gallo indicates, the flood of money into open-end municipal mutual funds that began in early 2009 began to fade a few months ago and is now about flat.

“The decline in municipal fund inflows occurred as muni yields had reached historically low levels, eroding investor interest,” Gallo noted. “Additionally, robust corporate earnings, better-than-expected economic news and QE2 have combined to bolster investor confidence, shifting money toward equities and away from Treasury and municipal securities.”

Still another negative factor has been the comparative lack of planned Fed purchases of longer maturity Treasury securities in QE2, causing longer-term Treasury yields to rise.

“Treasury and municipal yields tend to move somewhat in tandem, although this relationship has not held during periods of broad financial market stress, such as in late 2008,” Gallo stated.
“Lastly, bond dealers, who have had a very good year on strong municipal underwriting and trading, have little interest in expanding their municipal bond inventories as their calendar year-end approaches, and are thus not a strong source of demand for new issues.”

Gallo also suspects that negative press is also a minor contributing factor to the decline in investor demand for municipal bonds.

“Various news outlets have focused on rising credit risk in municipal bonds, often focusing on isolated troubles confronting a few issuers, such as Harrisburg,” he said. “Negative sentiment in this sector is also linked to the likely push toward austerity in Washington, which may lead to lower prospects of federal assistance to state and local governments than in the recent past.”

However, Gallo cautions that many of the key factors that have deteriorated the supply/demand balance for municipal bonds are likely temporary.

“The fate of the BABs program will be known soon,” he said.

“The current supply surge will be addressed at higher yield levels, while some borrowers may postpone their offerings until next year. Long-term Treasury yields seem to have stabilized in recent days, providing a more supportive backdrop for municipals. Also, dealers will likely become more active in the new calendar year. As these factors are resolved, new buying opportunities at higher yields are likely to emerge.”

Still, credit concerns that may have contributed to lighter mutual fund flows will take a longer time to address.

“State and local governments will struggle with the ongoing fiscal challenges brought on by the deep recession and fading federal support,” Gallo noted.

“Yet, we are seeing stabilization and a nascent rebound in tax revenues. Also, in many states, a political shift toward fiscal prudence may be emerging, where voters elect and support officials who take reasonable approaches to near-term budget challenges and long-term problems of underfunded public pensions.”

Indeed, Standard & Poor's recently determined that state and local governments should generally weather the economic turbulence, saying their challenges are more about tough decisions than potential defaults.''