U.S. tax-free debt may face risks from Merrill

By Joan Gralla

NEW YORK (Reuters) - The U.S. municipal bond market, a $2.5 trillion asset class with one of the world's lowest default rates, is fretting over whether the downgrade of Merrill Lynch & Co Inc's (MER.N: Quote, Profile, Research, Stock Buzz) credit rating will do more damage.

Some painful effects have already been seen, and others might lie ahead, according to traders and portfolio managers.

This naturally raises the central question that so often faces almost any sort of shopper. Have these items, especially natural gas bonds Merrill brought to market, been discounted enough -- or will they be better buys later?

"I'm trying to decide when and if there is a good entry point there. I don't know yet," said George Strickland, managing director at Thornburg Investment Management in Santa Fe, New Mexico. He was referring to the bonds utilities use to prepay their long-term purchases of natural gas.

Prices for natural gas bonds that other broker-dealers brought to market have also been clipped since Wednesday, when agencies cut Merrill's credit due to its bad subprime mortgage bets.

This kind of debt rises and falls with the underwriters' credits because the companies also promise the utilities that they will supply them with the gas from their commodity arms.

Looming over the muni market niche is the broader question of trusts that take advantage of the difference between short- and long-term muni rates. This $200 billion sector is called tender option bond programs.

Merrill Lynch is one of the biggest players among these programs. If it slows or stops setting up new ones, that could slash demand for new and outstanding issues, the market sources said.