Dizzy from '08, U.S. muni market looks to '09

By Karen Pierog and Lisa Lambert - Analysis

CHICAGO (Reuters) - The municipal bond market is facing dramatic changes in 2009 following a series of developments in 2008 that shook investor confidence and hurt issuers' ability to raise needed money.

Retail investors instead of institutions are now in the buyside drivers seat.

"We're basically expecting that muni issuance will be at whatever level retail demand can meet," Phil Fischer, a muni strategist at Merrill Lynch & Co. MER.N, said about 2009. "It's a very different market."

Tax-exempt issuers will need major help to stay afloat.

"We need relief like a reversal in the economy or a handout from Uncle Sam," said Richard Ciccarone, a managing director at McDonnell Investment Management in Oak Brook Illinois, referring to federal help for states and local governments.

Without some help or change on the economic front, Ciccarone said more municipal bankruptcies and bond defaults may be in the cards.

In the second half of 2008, Fischer said he realized that problems in the muni market were not isolated events, but part of a fundamental shift in how tax-exempt bonds are bought and sold.

"This is about as radical a change we've seen," Fischer told Reuters.

"We knew about it very quickly, because in 2007 the insurers and the auction market got into trouble," he said of the market's rocky state at the start of 2008. "But it really came home to roost when the property and casualty insurers shifted from net buyers to net sellers."

RADICAL CHANGE

The list of events in 2008 included: most muni bond insurers lost their top ratings due to exposure to subprime mortgages; the auction-rate market froze and trapped investors and issuers; underlying muni ratings lost credibility; huge market liquidity providers like Bear Stearns & Co vanished; investors fled tax-free mutual funds; cross-over buying stalled and yields shot higher.

Finally, insurance companies like American International Group (AIG.N) that had reliably bought up munis started selling.

"You can't look back at any year and see so many factors that had gone negative for municipals all at once," Ciccarone said.

The market experienced "very extreme" bifurcation, Fischer said. The buyside, once dominated by institutional investors, is now the domain of retail buyers, who rarely look beyond highly rated bonds due in 10 years, he said.

An exodus out of tax-exempt muni funds began in September and has shown no sign of abating, increasing selling pressure in the already-troubled market, according to Fischer. And muni bonds with less than stellar ratings are saddled with high yields.