The window of opportunity for municipal bond investors is garnering more attention.

Prominent investors and large brokerages alike have now publicly noted a phenomenon … The bargain prices available now for municipal bonds will probably evaporate after Dec. 31.

Prices dipped over technical, not quality issues

The roots of this unique situation stem from the recent decline in muni prices. Contrary to what some media and financial bloggers have suggested, the decline has not been caused by credit quality issues. The real culprits were technical factors affecting the delicate supply and demand dynamic in a market supported primarily by individual investors.

The most significant reason for the dramatic increase in the supply side of the equation was the growing concern of municipal bond issuers that the Build America Bond program (BABs) would be allowed to expire.

Consequently, municipal bond issuers were scurrying to bring their BABs issues to market prior to Dec. 31. This deluge of supply continues as the expiration of this program becomes a near certainty.

The BABs program was created last year as part of the Obama administration’s stimulus package, which in itself has made it unpopular with Republicans, regardless of the benefit it has provided to state and local governments.

Politics take precedence 

Since the program began in April 2009, more than $178 billion of these securities have been sold. The program enabled issuers to sell bonds, which although taxable, enjoyed a 35% subsidy from the federal government. It had become the fastest growing segment of the municipal bond market, expanding the market of muni investors to include institutions and foreign buyers who do not buy traditional tax-free bonds.

As it stands now, an extension of this program did not make it into the compromise President Obama and Republican leaders recently reached on income tax rates.

Window still open

We suggested in our November commentary, ‘So-called ‘Stampede’ Yields Opportunity in Muni Market‘ that these market conditions are providing an unusual buying opportunity and we expect this to continue through the end of 2010.

Come the New Year, however, this window of opportunity could be closing.

A recent report released by Citigroup analysts suggests that municipal bond volume is likely to fall as much as 20% in 2011 as many issues originally planned for next year are being pushed through the door prior to the end of 2010.

The report also found it meaningful that there are 30 new governors entering office next month who were elected on a platform of “fiscal conservatism” and this is expected to slow municipal issuance. Based on these assumptions, they predict that yields are unlikely to move higher next year.

Coincidentally, Bloomberg has reported that Bank of America in their “Year Ahead” report released Dec. 14 said that “tax exempt municipal bonds will provide some of the strongest fixed income returns next year, even as states implement austerity plans to cope with budget deficits.”

Clearly, FMSbonds and our clients are not the only ones focused on the unusual opportunities available today in the tax-free bond market.

Bill Gross, the “Bond King,” has put his money where our mouth is.

Dispelling concerns about the viability of municipal debt, Mr. Gross this month invested $4.4 million of his personal money in the municipal bond market, which more than doubled his holdings in PIMCO’s municipal bond funds. This was a well-publicized reflection of his optimism regarding the fundamental strength of municipal bonds.

This takes us back to our original thoughts regarding dramatic headlines calling for Armageddon in the municipal bond market from so-called “experts.”

As with all information, examine the source.

James A. Klotz is the President of FMSbonds, Inc. Email the Author12/15/2010