Yields on tax-free municipal bonds are soaring again, pushed up in part by deepening budget woes in California and other states.
One measure of investors' concern about the safety of historically rock-solid munis: In a first for the so-called credit default swap market, the average cost of insuring a basket of muni bonds nationwide against a possible default now exceeds the cost of insuring against defaults on high-quality corporate bonds.
And it now costs more to insure California state debt than Mexican government debt.
As investors have balked at buying muni bonds in recent weeks, prices of the securities have tumbled, pushing yields up.
The average yield on an index of 40 long-term muni issues tracked by the Bond Buyer newspaper rose to 6.53% on Wednesday, up from 6.49% on Tuesday and 5.84% in mid-November.
Because muni interest is exempt from federal income tax (and usually from state income tax in the issuer's state), those yields are extremely lucrative compared with what investors can earn on, say, U.S. Treasury bonds, the interest on which is subject to federal tax. The 30-year T-bond yield now is just 3.09%, down from 4.23% in mid-November.
But many investors are leery of munis, leaving some bond issuers "begging for buyers," said Stephen Kelleher, head of muni bonds at brokerage Wedbush Morgan Securities.
For investors who already own muni bonds, the value of their holdings is tumbling as market yields surge, devaluing older bonds. The share price of the Franklin California Tax-Free Income mutual fund fell Wednesday to a 2008 low, down 8.3% just since mid-November.
This is the second surge in muni yields this fall. The first was in mid-October, at the height of the credit crisis, as hedge funds and other big investors dumped bonds in a rush to raise cash.
This time, the market appears spooked by worries about the dismal economic outlook for 2009, and the prospect that more muni issuers -- particularly smaller cities and local government agencies -- will have trouble making debt payments.
Although few analysts believe any states will default on their debts, "you could definitely see more defaults in smaller issues, and that would cast a pall over the entire market," said Matt Fabian, senior analyst at Municipal Market Advisors in Westport, Conn.
Many states are adding to the gloom by painting a dark picture of their budget situations. Gov. Arnold Schwarzenegger warned Wednesday that California's budget gap had widened by $3.6 billion in recent weeks.
The cost to insure $10 million of California state debt against default for five years was $387,000 on Wednesday, up from $308,000 a week ago, Reuters reported. By contrast, similar insurance on Mexican government bonds cost about $370,000.
For California investors looking for high tax-free yields, 10-year state general obligation bonds are paying as much as 5.75%, up from about 5% a month ago, said Bob Gore, a muni bond trader at Crowell Weedon & Co. in Los Angeles.
Among smaller municipal issuers in the state, "you can buy some pretty good-quality stuff at 6.5% yields," he said.
The problem in enticing potential buyers, Gore said, is that many believe yields can only rise further in 2009 as the economy worsens and bond issuers' finances come under more pressure.
By historical standards, "muni bonds are cheap, but there's no assurance that they aren't going to get cheaper," he said.