The municipal market was markedly firmer Friday, following news of a major bailout plan from the federal government that would see it insure money market mutual funds, purchase the debt of Fannie Mae and Freddie Mac, and take over troubled mortgage assets from financial institutions.

Traders said tax-exempt yields were lower by six or seven basis points overall, with muted gains on the short end but more extreme gains on the long end.

"Munis are back up after a bad week," a trader in Chicago said. "We were oversold. You had forced liquidations [Thursday]; no one is selling munis at 125% of Treasuries if they don't have to. So with the overselling, and the flight to quality off, we're coming back."

"It is firm, and it's crazy. I think this is the craziest week it's ever been," a trader in Los Angeles said. "People came in [Friday], and said, 'Buy everything,' because of what the Fed was doing. The long end is where the action is, and I'd say we're up 10 out there."

The Treasury market showed steep losses Friday, after news of the Fed's new bailout plan sent stocks soaring. The yield on the benchmark 10-year Treasury note, which opened at 3.54%, finished at 3.75%. The yield on the two-year note was quoted near the end of the session at 2.12% after opening at 1.70%. The yield on the 30-year Treasury finished at 4.36% after opening at 4.18%.

"I think people are going to look for alternatives from the Treasury finally, and munis, I'm very confident, will be their next direction because we're second to none underneath the Treasuries," a trader in New York said. "I think we'll see some buying, especially with the way yields came off a little bit. There's tremendous value in munis, so I think people will start to realize that. It always takes a little bit to sink in."

The reversal of the flight-to-quality bid along with the threat of increased supply of Treasuries related to government bailouts and promises has combined to rocket Treasury yields back up, said Eric Lascelles, chief economists and rate strategists at TD Securities. Yields "are off to a degree that is essentially unheard of," he said.

"It's just an explosive combination and that's what is pushing yields so astonishingly upward, especially at the short end of the curve," Lascelles said. "It's truly one of those unprecedented events, and the funny thing is you look back at the week and you've got yields pretty close to where they were last Friday."

The key risk in the Treasury market moving forward will be event risk, he said. The Treasury market will see "massive swings" in both directions until the credit crunch winds down, although the formation of a Resolution Trust Corp.-type entity by the Treasury to buy bad securities from banks could help smooth things out, he said.

"As much as there will be uncertainty, you will have removed the major source of market uncertainty and there will be a lot more confidence in the market," Lascelles said.

The bailout plan is the latest in what was an extremely turbulent week in the financial markets, caused by the fallout from Lehman Brothers Inc.'s bankruptcy and subsequent agreement to sell substantially all of its North American businesses and operating assets to Barclays Capital, as well as Bank of America's planned purchase of Merrill Lynch & Co. Then, the news that the Federal Reserve has decided on an $85 billion bailout of American International Group Inc. had a dramatic impact on the municipal and Treasury markets. And Thursday, the Federal Reserve announced that it would inject $55 billion into the banking system to try to alleviate the ongoing credit crunch.

Another symptom of the turmoil is that a plethora of deals in the primary market have been postponed indefinitely, reduced in size, or moved to the day-to-day calendar. However, despite the gains in munis Friday, at least one other deal was postponed. On Friday morning, an upcoming $28.3 million North Kentucky Water District competitive bond sale was removed from the calendar.

"You're still going to see a little bit more dumping of paper, but not as much, and with all the deals being canceled, we're going to be on short supply of paper if there's some real buying going on," the New York trader said.

The Bond Buyer's 40-bond municipal bond index has risen sharply amidst the turmoil this week, until finally dropping back down Friday. The index stood at 5.35% last Monday morning, before rising 15 basis points to 5.50% that day. It then climbed 27 basis points Tuesday, 11 basis points Wednesday, and 24 basis points Thursday, skyrocketing to 6.12%. However, on Friday, amidst firmness in the municipal market, the number dropped 23 basis points to 5.89%.

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