Municipal yields level out amid light trading; muni fund inflows drop along with demand

By Sheri Kasprzak

New York, Dec. 20 - Municipal yields were firmer in spots as trading remained light, market sources said Thursday. With the holiday looming and both the primary and secondary markets quiet, yields shook off deep losses from earlier in the week.

"There's a sense that it's normalizing again," said one trader.

"I wouldn't say that it's exactly positive, but I will say that it's less negative. Some maturities are firmer, but the rest of the market is flat. It's an improvement, and I'll take it."

Secondary selling pressure has eased somewhat, said another trader, with spreads seen tightening on some bonds.

Uncertainty adds pressure

Even though market tone improved Wednesday and Thursday over the performance of the past couple of weeks, the market still faces pressure from news of the fiscal cliff and how big-picture economic factors will impact state and local governments.

"Reflecting on reasons behind the dramatic sell-off on recent days, we note much of it was related to Treasury market weakness, but uncertainty emanating from fiscal cliff discussions was a contributing factor," said Alan Schankel, managing director with Janney Montgomery Scott LLC.

"Questions about the economic and revenue impact on states and municipalities from federal spending reductions as well as potential changes to tax exemption contributed to muni market weakness, with last week's two notch downgrade of Puerto Rico, impacting 1.2% of outstanding municipal bonds, providing additional tailwinds.

"In another reflection of recently diminished investor demand, inflows to municipal mutual funds reached only $211 million in the week ending Nov. 12, compared to $1.1 billion average weekly inflows this year."

States have cushion

Despite the positive news that state governments have a financial cushion and revenues are improved, many state governments simply don't have the reserves they had before the economic downturn, said Laura Porter, managing director of U.S. state debt for Fitch Ratings, in a recent conference call.

"It's extremely unlikely that the federal government would provide assistance again," Porter said in the call.

"Most states are in the middle of their fiscal year. If the economy goes back into a recession that would quickly be reflected," she said.

Medicaid reductions could pose another challenge to state governments, said Porter.

"We expect that Medicaid, which requires large state spending, will be the focus as the implementations of health care reform approach," she said.

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