UPDATE 2-US tax-free short-term yields hop, ma rt fears sales

(Recasts; adds details)

By Joan Gralla

NEW YORK, Sept 17 (Reuters) - Yields for some U.S. municipal variable rate demand notes spiked about 300 basis points to 5-1/4 percent on Wednesday, which could cause tender-option-bond programs to again hit the market with huge sales, portfolio managers said.

"That's very alarming," said a Midwest fund manager, who requested anonymity. Referring to tender option bond programs that profit by buying higher-yielding long-term tax-free bonds and paying for them by selling low-cost short-term notes, he added: "It makes leveraged trades difficult -- if they are not forced to sell them."

Variable-rate demand notes are floating-rate securities backed by liquidity enhancements that ensure investors can sell these issues when necessary.

Several factors sent variable rate demand note yields soaring, including an increase in widely used benchmarks such as the London interbank offered rates, the experts said. The three-month dollars jumped 18 basis points to 3.0625 percent, their highest level since late February.

These notes typically reset every day or every week, and the rise above 5.0 percent was seen in weekly paper. This unusual rally in yields was also blamed on Lehman Brothers' LEH.P, which was forced into bankruptcy on Monday after suitors spurned its poisoned mortgage-related investments.

Lehman was the re-marketing agent for some of the variable rate demand notes, one analyst noted. "They're re-marketing them higher to get them off the books," he said.

States, cities, hospitals and turnpikes are already replacing Lehman as the remarketing agent, according to material events notices these issuers filed.

The jump in yields of variable rate demand notes also stems from fears another taxable money market will "break the buck," meaning its net asset value falls below a $1 a share.

That happened on Tuesday to one of the oldest money market funds, the Reserve Primary Fund, whose assets have dropped 65 percent due to huge losses on securities issued by Lehman.

If short-term rates for variable rate demand notes rise high enough, fund managers could "flip" this debt into taxable funds, one analyst said. "The money markets are trying to get better yields to keep their clients in-house," he explained.

Tax-free yields for long-term bonds also rose, and when compared with U.S. Treasuries, were brushing record levels hit in February, one of the muni market's worst-ever periods.

Long-term muni bonds now yield around 22 percent more than the equivalent Treasuries. This underscores how badly the $2.6 trillion municipal bond market is suffering from the loss of major market-makers -- Lehman Brothers, LEH.P, Bear Stearns, which collapsed into the arms of JPMorgan Chase (JPM.N) earlier this year, and UBS AG (UBSN.VX), which cut this business.

Asked about liquidity, the fund manager said: "I think it's spotty and there's the sense that the level could deteriorate further should the surge in funding rates prompt the sale of tender-option-bond programs."

These programs unleashed huge municipal bond sales in February when the credit crunch drove up their borrowing costs.