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Institutional Investors Give the Muni Market a Try

Institutions that generally avoid the retail-drive, tax-exempt muni market have been dipping their toes, looking for those higher yields.

Is the much-maligned muni market oversold? That well may be the case, at least in the view of many institutional investors. A powerful rally has been underway for the past few days, as institutions that generally avoid the retail-driven, tax-exempt muni market in favor of higher-yielding taxable bonds decide to cross over.

State and local budget problems from California to Illinois, New York, New Jersey, Pennsylvania and Rhode Island have raised concerns about the potential for defaults. Warren Buffett warned Congress last year that the muni market could face a severe problem over the next five to 10 years.

Those fears spiked on January 14, as New Jersey’s Economic Development Authority cut back the price of an offering by 40 percent to $1.1 billion, citing the cost of accessing the market. The average yield on AAA-rated offerings hit 5.01 percent, That’s up from 3.7 percent in August, according to Reid Smith, a portfolio manager who oversees $7.5 billion in municipal bonds for RBC Global Asset Management.

The city of Chowchilla, in rural San Joaquin Valley, California, has already defaulted on an issue. There are fears of more defaults, although Smith says they are largely overdone and that states are beginning to get a handle on problems such as budget and pension imbalances and pension costs. “Those risks aren’t going away. It will take years to address those issues,” he says.

But newly elected governors such as Jerry Brown in California and Andrew Cuomo in New York are talking about cutting costs without immediately raising taxes, inspiring some confidence that governments have the will to solve their problems. Fed chief Ben Bernanke and Republican leaders have warned states not to expect a bailout from the federal government.

Yields in the $2.37 trillion tax exempt muni market are historically about 80 basis points lower than they are in the taxable market, according to Smith. That spread narrowed to about 25 basis points earlier this month. As tax-exempt yields rose, and as governments inspired a bit of confidence, institutional investors decided that it was worth giving tax-exempt munis a shot. They already were buyers of Build America Bonds, taxable securities in which the federal government has subsidized 35 percent of the interest payment as a way to spur the funding of infrastructure projects that drive economic growth. So they were already comfortable with the taxable market, which is about $485 billion.

During the past three or four days, the spread between taxable and tax-exempt munis has widened to about 50 basis points, “and there is still some way to go,” Smith says. Institutional buyers — including, it appears, foreign corporations and other institutions from outside the U.S. — have been purchasing highly rated tax-exempt issues such as New York water bonds, New Jersey education bonds, and debt issued by top universities such as Harvard and Cornell, according to Smith. “Since the Build America Bond program was launched, the muni market is international now,” he says.

The market is still very tough for issuers. AA-rated taxable bonds now yield about 5.25 percent, or 3⁄4 of a percentage point above there they usually are. That is good news for investors, who are hungry for yields.

But for state and local issuers — who need to fund education and infrastructure projects that drive economic growth and create jobs—market access remains tight.

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