Default fears weigh on U.S. muni bond market

NEW YORK (Reuters) - U.S. states and local governments are heading into dangerous territory as a strained municipal market forces them to delay deals while fund managers worry that a lasting recession may lead to defaults.

The prospect that cities, hospitals and transportation systems may be unable to pay bondholders frightens investors drawn to the $2.7 trillion market by default rates of less than 1 percent.

The New York-New Jersey Port Authority and the Dallas Independent School District, which enjoys the backing of one of the top U.S. credit enhancers, are the latest examples of issuers experiencing unusual strains.

"Muni prices are gong to be in for a bumpy ride for maybe the next year," said Vincent Harrison, a portfolio manager at DuPree Mutual Funds in Lexington, Kentucky.

Bondholders' reluctance to take on risk is evident in the fact that they have not reinvested billions of dollars they get in December from redemptions and coupon payments.

This is puzzling experts and making them wary of buying munis, even though tax-free debt now yields 70 percent or more than its taxable rivals.

"Under normal circumstances, if the market backed up like this, I'd be buying everything I could get my hands on," said one money manager, who said investors are expecting even bigger discounts.

Evaporating demand on Thursday made the Transmission Agency of Northern California delay a $424 million issue, while Oglethorpe Power Corp in Georgia pulled a $380 million issue.

On Wednesday, the Port Authority delayed a $300 million taxable debt sale after failing to attract a single bid.

Meanwhile, the Dallas Independent School District has decided to delay the first coupon payment on a $394 million bond sale. That may signal the start of a worrisome trend.

The district will not make the first coupon payment until February 15, 2010, about six months later than the norm, even though the deal is backed by the highly rated Texas Permanent School Fund Guarantee Program.

A school spokesman was not immediately available. The debt is rated "Aa3" with a negative outlook by Moody's Investors Service, a full three notches below the top rating. Moody's said the rating reflects strains, including teacher layoffs and limited reserves.

Houston managed to sell debt also rated "Aa3" by Moody's albeit with a positive outlook. The city sold $430 million of taxable pension obligation bonds to overseas investors at an interest rate of 6.29 percent, below estimates of up to 8 percent, said a market source.

Foreign investors favor taxable munis as they are unable to benefit from tax-free deals.

"They're looking at the overall yield," one source said. "It's a general obligation; there's no reason not to like it," he said.

General obligations, backed by an issuer's full faith and credit, for decades have been viewed as the safest possible munis, though the low-risk category also includes most debt that legislatures are obliged to repay each year, and securities sold by services considered essential, like utilities and mass transit systems.

"Since the Great Depression, defaults in these subsectors have been extremely rare," a recent Merrill Lynch report said.

But this might not hold true if the U.S. recession drags on for two to three years, fund managers said.

"There's not a lot of defaults; that could change," said one.

On Thursday, the cost of protecting muni debt against potential default spiked higher. The main credit derivative index for the market widened a full 75 basis points, as 'AA'-rated munis traded wide of 'BBB' corporate bonds, according to Tim Backshall, chief strategist at Credit Derivative Research.

Still, some experts say fears are a bit overblown.

"There's been a lot of screaming of fire but let's not forget the underlying credit quality of munis," said Timothy McGregor, a fund manager with Northern Trust Global Investments in Chicago.

Some New York deals are backed by personal income taxes, a declining revenue, but coverage is 12 times, he said.

(Additional reporting by Karen Pierog in Chicago.)

(Reporting by Joan Gralla; Editing by Chizu Nomiyama)