What is going on with municipal bonds? The End of BABs (Build America Bonds) (from WSJ)

Muni Bonds Continue to Tumble
A Rush to Sell Build America Bonds Before They Are Gone.

By Romy Varghese and Kelly Nolan
Of DOW JONES NEWSWIRES

Prices of municipal bonds fell sharply for the second day Tuesday, driving yields on long-term bonds to the highest points in more than 18 months, as investors worried about the impact of the end of a federally subsidized borrowing program.

The yield on a closely watched index of high-grade, tax-exempt 30-year muni bonds rose to 4.84%, its highest level since March 2009, according to Thomson Reuters Municipal Market Data. The yield on 10-year bonds climbed to 3.24%, the highest since June 2009. Yields move inversely to prices.

.The market took a hit Monday as well, as the expiration of the Build America Bond program by the end of the year looked increasingly likely.

An extension of the program, which provides a 35% interest-rate subsidy from the federal government on taxable bonds issued by municipalities, on Monday wasn't included in legislation introduced in the U.S. Senate that continues Bush-era tax cuts.

Since the government started the BAB program in April 2009 as part of its economic stimulus, more than $165 billion of these bonds have been sold, accounting for about 22% of all new municipal debt, according to data from the U.S. Treasury Department.

Many municipal-bond market participants expect that, without BABs, state and local governments will issue more tax-exempt bonds next year and may overwhelm investor demand for that debt. This would force states and cities to raise their rates to attract buyers.

About $100 billion in long-term tax-exempt bonds would return to the market next year, estimated Robert Nelson, managing analyst at Municipal Market Data.

"With the loss of leveraged buyers of municipal bonds in 2008, there has been a dearth of demand for long maturity munis--this is where BABs came in and diverted this issuance to the taxable market," Nelson said. "Now without BABs the market is left to deal with the same supply/demand imbalance that plagued munis in 2008 and early 2009."

He added that long-term yields have generally returned to the same level seen at the outset of the Build America Bond program last year.

States with some of the lowest credit ratings have been especially battered by the recent muni-market turmoil.

The spreads on Illinois 10-year maturity general obligation bonds grew from 1.60 to 1.90 percentage points from Nov. 1 through Monday above a benchmark triple-A bond with the same maturity, according to Municipal Market Data.

Spreads on California general obligation bonds increased from 0.97 to 1.30 percentage points over the same time frame.

Meanwhile, municipal borrowers are plowing into the market with BAB deals in the last few market days of the year.

"We are hitting the market as quickly as we can because it's only going to get worse," said Harold Downs, treasurer of the Metropolitan Water Reclamation District of Greater Chicago.

Because of the market conditions, the water district is shrinking the size of its bond sale this week from $500 million to $280 million, he said. Most of the offering is BABs.

The Metropolitan Water District of Southern California is planning to sell $250 million in BABs this week, moving up part of a $450 million deal it had originally scheduled for the spring, said Brian Thomas, the water district's assistant general manager and chief financial officer.

"I think the market is still favorable if you look back over the last 10 years, but if you look compared to a month ago, it's a much more difficult market," Mr. Thomas said.

Higher yields may ultimately help stabilize the market by attracting buyers, said Dan Solender, director of municipal bond management at investment firm Lord Abbett in Jersey City.

And amid the volatility, some analysts are encouraging investors to buy municipal bonds from creditworthy issuers. Munis are now offering higher yields than U.S. Treasurys of comparable duration, which is the inverse of the usual relationship, noted Dan Loughran, senior portfolio manager at OppenheimerFunds. "Prices in the municipal bond market may continue to be volatile in the near term, but we believe relief is likely waiting in the wings once the New Year gets underway," he wrote in a report.

—Jeannette Neumann contributed to this article.
-By Romy Varghese, Dow Jones Newswires; 215-656-8263; romy.varghese@dowjones.com