By Yali N’Diaye

WASHINGTON (MNI) – Recent flow and yield trends signal a turnaround
in the $2.9 trillion muni bond market, where investors have returned
since the beginning of May.

The question, however, is whether they are here to stay.

On the demand side, tax trends and the search for yields offer good
arguments for investors to stay; yet default fears continue to justify
caution.

On the supply side, budget austerity has delayed or put a stop to
infrastructure and other projects, hence the need to finance them.

How all the forces will play out remains unclear, especially when
one factors in the U.S. federal debt situation — which impacts every
area of the economy.

For now, yield trends are showing concerns have diminished since
the start of the year following heightened fears of potentially
significant state and local government defaults. The yield on a U.S.
Muni triple-A rated general obligation bond was around 2.61% Thursday
afternoon, compared with 3.42% at the end of December 2010.

Likewise, flows show investors are willing to put their money into
the muni sector again.

Long-term muni bonds registered a $75 million inflow in the
week-ended June 15, the Investment Company Institute reported Wednesday.

While this is down from $298 million the previous week, it still
compares favorably to the outflows continuously registered between
November 2010 and the first week of May 2011.

Since then, inflows do not even add up to $1 billion. Still, they
are inflows and this is a positive development for a market that in
December last year saw suffered redemptions peak at $13.4 billion.

What to make of these latest trends is less obvious.

Fund data provider EPFR Global, for instance, believes retail
investors are coming back and are here to stay. Bond giant PIMCO, on the
other hand, says retail investors will likely continue to shed their
muni bonds for some time — though at a diminished rate.

While making sense of such uncertainty is a difficult exercise
given the many factors that are at play, default, supply and tax trends
should already provide a better idea of the overall outlook for the muni
market.

On the default front, the debate revolves around whether a systemic
crisis in the making is being overlooked or downplayed in a manner
similar to attitudes that prevailed prior to the housing and mortgage
market crisis.

One key aspect of the default issue is how state and local
governments are addressing their budget gaps: are they implementing
structural changes or one-time measures?

According to June 17 data from the Center on Budget and Policy
Priorities, states are projecting shortfalls for the 2012 fiscal year —
which begins July 1 for most states — totaling $103 billion (or $97
billion after taking federal assistance into account).

California leads the pack with a projected $23 billion FY’12
shortfall, followed by New Jersey at $10.5 billion, New York at $10.0
billion and Texas at $9.0 billion.

While the budget gaps are significant, estimates based on the CBPP
June survey were down from $112 billion and budget shortfalls are
expected to narrow to $46 billion in FY2013.

Still, states will virtually run out of Recovery Act Funds at the
end of June, meaning one less resource to help offset part of their
budget shortfalls.

Developments in California also continue to feed default fears and
raise questions about the contagion effect.

Tuesday, Standard & Poor’s warned that “California’s near-term
credit quality is affected by its budget situation more than most states
because of the implications for the state’s cash position.”

“In our view, the budget process is significant in California’s
credit profile because if a budget is not adopted in time for the state
to issue its revenue anticipation notes before its cash runs low, the
state’s basic operating liquidity can become inadequate,” the rating
agency added in a report titled “California Credit Quality And Ratings
Are At A Crossroad.”

Standard & Poor’s described three potential outcomes: a structural
budget with multiple-year balance, one-time deficit closing solutions —
which is “realistic” — and a budget stalemate which would likely result
in a downgrade.

That said, Standard & Poor’s did highlight that California is in a
different position compared with other states.

Overall, states have too much to lose to risk a default given the
tremendous long-term political and financial consequences for those
borrowers who need the market to finance their projects.

Second, States have the ability to strengthen their tax base.

Besides, Fitch Ratings notes that the latest revenue trends have
shown receipts are topping states’ expectations.

Treasury Secretary Timothy Geithner even said Tuesday that states’
revenue is starting to come back as growth recovers, which means the
pressure on them “is going to be more manageable.”

Third, States are also taking measures to reduce spending to meet
their obligations to balance their budgets, using measures such as
hiring freezes, layoffs, and services cuts.

Finally, pension and healthcare issues are real and sizeable, but
can be addressed over the long term.

The Center on Budget and Policy priorities believes that
“longer-term issues related to bond indebtedness, pension obligations,
and retiree health insurance” can “be addressed over the next several
decades.”

The message from rating agencies and analysts has been that states
and local governments have been taking the painful but needed measures
to close their budget gaps, going beyond one-time measures.

Still defaults continue to occur in the muni sector and the
question remains whether they could become widespread.

According to DWS Investments, referring to the Income Securities
Advisor (ISA), as of May 11, there have been 14 payment defaults
totaling $605 million of par value. If that trend continues, DWS
estimates there could be 39 defaults in 2011 totaling $1.69 billion.

That is in stark contrast to analyst Meredith Whitney’s
expectation of hundreds of billions of dollars of defaults, although she
doesn’t specify the time frame.

While her initial dire prediction sent shockwaves through the muni
market, many analysts do not share her views and investors seem to have
reassessed theirs based on flows and yields.

-more-

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** Market News International Washington Bureau: 202-371-2121 **

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