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A Question of Digestion

The municipal bond market is entering a critical phase as local governments hope a still-skittish market can digest a near-record volume of new bonds over the next 30 days.

The Bond Buyer's 30-day visible supply, which measures new bonds planned for sale in the next month, touched $21.29 billion on Tuesday. The supply has since eased back slightly, but remains heavier than any time except October 2002.

Supply has almost doubled in the last two months as issuers that postponed projects in the throes of the financial crisis are now testing the market again.

Robert J. Bendzinski, president of Bendzinski & Co., a muni finance advisory firm in Michigan, said the backlog suggests a potential rush of deals before Dec. 15 or so.

Activity usually slows around the holidays, he said, and municipalities craving cash will want to close their deals by the end of the year.

"If they've started a construction project in September of this year and their fiscal year ends Dec. 31, they're going to want to do a deal this year," Bendzinski said.

If governments can't close deals with their underwriters by the middle of this month, a crush of bonds will probably come to market in early 2009, he said.

This is not an ideal time for the second-heaviest slate in the history of U.S. public finance. Volume has slowed substantially, as the yield to par call on the The Bond Buyer 40-bond municipal bond index has swelled to 6.56% from 4.62% a year ago, and the yield to maturity on the index has mushroomed to 6.22% from 4.77% a year earlier.

Whether the retail buyers supporting the market right now have the appetite for a glut of new munis is far from certain.

On Wednesday, the Port Authority of New York and New Jersey failed to command a single bid for a $300 million taxable bond sale.

"These are not normal times," said Colin O'Neill, a portfolio manager at Bond Market Advisors LLC, a municipal bond investment advisory firm. "It could all come [to market], or half of it could come. ... That's the big question. The deals are on the calendar. Can they get them all done? We'll see."

The market has been too crazy for a reliable prediction of how successful the sales will be, he said.

Weekly bond sale volume has varied significantly since early October, when less than $3 billion was sold between Oct. 6 and Oct. 11 to last month when more than $8 billion sold in the week between Nov. 16 and Nov. 22, according to data from Thomson Reuters. The week of Thanksgiving and this week, through yesterday, totaled just over $4 billion in municipal debt sold.

Issuance of new municipal bonds shrank by a third in September and halved in October from a year earlier.

As the panic gripping financial markets scared buyers away from munis, interest rates spiraled upward and many projects were put on hold.

Part of the reason for the escalation in planned issuance is the slight easing of conditions in the bond market. More pervasively, though, as T. Rowe Price muni trader Tim Taylor put it: "Reality might have set in."

Some municipalities that delayed sales in September or October have realized they cannot postpone forever, he said. Eventually they will have to tap the bond market for financing.

While bond prices remain depressed and yields high, issuers that do not immediately need cash have the luxury of waiting out the turmoil, according to Sandra McDonald, a principal at McDonald Partners Inc., a municipal finance advisory firm.

Issuers can only postpone borrowing for so long before they need money, she noted.

"At some point, they're obviously going to have to borrow to finish" their projects, she said. "The people that really need to borrow are borrowing."

One of McDonald's clients, the Indiana Municipal Power Agency, shelved a roughly $30 million bond sale in September because interest rates spiked too high, she said.

The agency now hopes to complete the sale next month.

"It's still pretty much wait-and-see," McDonald said.

Meanwhile, municipalities may be dealt a blow if investors are unwilling to soak up the new supply.

Issuers are grappling with higher borrowing rates because money has fled the market seeking safer and more liquid climes.

Ten-year, triple-A rated munis much of this week have yielded more than 150% of Treasury bonds with the same maturity, by far the highest ratio on record, according to Municipal Market Data.

"If the market doesn't clear then levels are going to have to get cheaper," said Chris Mier, managing director of Loop Capital Markets LLC, meaning falling prices and rising interest rates. "I think it's an open question how the market will respond. It may be difficult."

Just as an erosion in demand squeezed muni prices after the Lehman Brothers Holdings Inc. bankruptcy, Mier said too much unabsorbed supply can squeeze prices now.

Bendzinski said municipalities considering coming to market are watching the deals on the calendar. If the sales are successful, he said, more municipalities are sure to offer bond sales to take advantage of the improving climate.

Two of Bendzinski's clients in Michigan postponed sales during the market upheaval, he said. Both issuers closed their deals a few weeks later when conditions eased.

If the muni market has had a savior in 2008, it is the retail investor.

With many hedge funds liquidating and institutional buyers busy sheltering their balance sheets, much of the buying support that had surfaced for munis this decade vanished.

Lured by attractive interest rates and comparably safe credit, retail buyers have picked up some of the slack in buying munis.

Mier said bonds that appeal to retail investors - namely high-quality bonds from well-known issuers - are going to fare better than less-recognizable names with dodgier credit.

This is the second-biggest slate in history, trailing only the October 2002 supply of nearly $24 billion.

That number is deceiving, though: Half of that supply was from a single issuer. The California Department of Water Resources sold $11.95 billion of debt in October and November 2002 to replenish cash drained from the state's electricity crisis, in which California bought and distributed power to consumers whose utilities went bankrupt.

After that issue, the supply moved to a more typical size. As an illustration, the peak supply in 2002 was from fewer than 200 issuers. The current supply represents planned sales for more than 300 issuers.

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