US tax-free debt may face risks from Merrill

NEW YORK, Oct 27 (Reuters) The U.S. municipal bond market, a NEW YORK, Oct 27 (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 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.

A Merrill spokeswoman was not immediately available for comment.

Speculation already has begun that some tender-option-bond programs are being closed out. ''I'm seeing tons of offerings of energies,'' said Strickland, referring to natural gas munis.

Because many of these natural gas bonds were placed in tender-option-bond programs or bought by arbitragers, the rush of offers might signal waves of selling lie ahead. That happened when the credit crunch hit this summer and some tender-option-bond programs were forced to shut.

''Maybe we're in for another round of deleveraging in the municipal market,'' Strickland said.

Selling from tender-bond-option programs can slam prices as just one program can total several billion dollars.

Tender-option-bond programs typically sell lower-yielding notes, invest in higher-yielding long-term debt, and pocket the difference.

They use leverage to boost returns.

But many money market funds cannot buy any short-term paper that is not at least rated ''AA,'' and that could pose a problem for Merrill because its credit now has been cut below that.

''If I was running a money market fund, I'd rather exit that (TOB-linked) market or ask for a lot more yield versus plain vanilla paper,'' said a Midwest portfolio manager.

Merrill, the nation's biggest brokerage, could use at least two other strategies to boost the short-term paper's credit back up.

Merrill could buy insurance for the notes that help finance the tender-option-bond programs. Or it could ask rating agencies to upgrade the notes' credit -- above its own -- based on an analysis that shows the underlying bonds are unlikely to default at the same time as the bank, explained the experts.

Another tender-bond-program issuer whose rating is also below ''AA'' uses this ''joint default'' analysis strategy.

After Merrill wrote down $7.9 billion, its credit was cut to ''A-plus'' from ''AA-minus'' by Standard&Poor's and Fitch Ratings.

Moody's Investors Service cut it one notch to ''A1.'' Spreads for nat gas bonds Merrill brought to market fell on Thursday to plus 95-105 basis points, Strickland said, adding he saw one trade at a 125 basis point spread.

These spreads, which compare the bonds' prices to what top-rated munis fetch, began the week at 70-75 basis points.

Earlier this year, many natural gas bond spreads were much narrower, at 40-45 basis points, the Midwest portfolio manager said.

''One of the few things I've done right is not buying gas bonds this year,'' added the manager, who requested anonymity.

Even gas bonds underwritten by Citigroup Inc, Goldman Sachs and JPMorgan Chase have been hit.

Though subprime plays did not gore these banks as badly as Merrill, investors fear they might take more write-downs.

Estimating spreads for gas bonds Goldman underwrote ''just' this week grew 20 basis points to 95 points, the portfolio manager said, adding, ''My thought is that if you can buy Goldman (nat gas bonds) at 95, it's probably a better bet to me at 110.'' REUTERS SR RN1146 .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 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 0 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.

A Merrill spokeswoman was not immediately available for comment.

Speculation already has begun that some tender-option-bond programs are being closed out. ''I'm seeing tons of offerings of energies,'' said Strickland, referring to natural gas munis.

Because many of these natural gas bonds were placed in tender-option-bond programs or bought by arbitragers, the rush of offers might signal waves of selling lie ahead. That happened when the credit crunch hit this summer and some tender-option-bond programs were forced to shut.

''Maybe we're in for another round of deleveraging in the municipal market,'' Strickland said.

Selling from tender-bond-option programs can slam prices as just one program can total several billion dollars.

Tender-option-bond programs typically sell lower-yielding notes, invest in higher-yielding long-term debt, and pocket the difference.

They use leverage to boost returns.

But many money market funds cannot buy any short-term paper that is not at least rated ''AA,'' and that could pose a problem for Merrill because its credit now has been cut below that.

''If I was running a money market fund, I'd rather exit that (TOB-linked) market or ask for a lot more yield versus plain vanilla paper,'' said a Midwest portfolio manager.

Merrill, the nation's biggest brokerage, could use at least two other strategies to boost the short-term paper's credit back up.

Merrill could buy insurance for the notes that help finance the tender-option-bond programs. Or it could ask rating agencies to upgrade the notes' credit -- above its own -- based on an analysis that shows the underlying bonds are unlikely to default at the same time as the bank, explained the experts.

Another tender-bond-program issuer whose rating is also below ''AA'' uses this ''joint default'' analysis strategy.

After Merrill wrote down .9 billion, its credit was cut to ''A-plus'' from ''AA-minus'' by Standard&Poor's and Fitch Ratings.

Moody's Investors Service cut it one notch to ''A1.'' Spreads for nat gas bonds Merrill brought to market fell on Thursday to plus 95-105 basis points, Strickland said, adding he saw one trade at a 125 basis point spread.

These spreads, which compare the bonds' prices to what top-rated munis fetch, began the week at 70-75 basis points.

Earlier this year, many natural gas bond spreads were much narrower, at 40-45 basis points, the Midwest portfolio manager said.

''One of the few things I've done right is not buying gas bonds this year,'' added the manager, who requested anonymity.

Even gas bonds underwritten by Citigroup Inc, Goldman Sachs and JPMorgan Chase have been hit.

Though subprime plays did not gore these banks as badly as Merrill, investors fear they might take more write-downs.

Estimating spreads for gas bonds Goldman underwrote ''just' this week grew 20 basis points to 95 points, the portfolio manager said, adding, ''My thought is that if you can buy Goldman (nat gas bonds) at 95, it's probably a better bet to me at 110.'' REUTERS SR RN1146