Muni bond yields fall to six-week lows; Illinois raises $3.7 billion

The rally in the battered municipal bond market continued on Wednesday, with benchmark tax-free yields falling to six-week lows.

It helped that fiscally struggling Illinois was able to sell $3.7 billion of taxable bonds to investors. The proceeds will be used to make mandated payments to the state?s employee pension funds.

The bonds, issued in a series maturing between 2014 and 2019, were sold at an average annualized yield of 5.56% -- well above what companies with Illinois? credit rating would pay to borrow on similar taxable bonds.

Illinois is rated A1 by Moody?s Investors Service, which ties with California for Moody?s lowest rating among the 50 states.

Despite the high cost of the debt, the sale was a relief to the muni bond market because it showed that investors were willing to fund even one of the most financially challenged states.

The muni market suffered a severe sell-off in November, December and January, sending yields soaring, on fears of a surge in bond defaults by cash-strapped local governments. The selling was fueled in part by now-infamous default predictions from Wall Street banking analyst Meredith Whitney.

CNBC's John Carney, blogging on the network's website, continues to worry that investors are underestimating the risks in munis. See here and here for examples of his reasoning.

Still, after peaking in mid-January at two-year highs, longer-term muni yields have fallen sharply as buyers have returned to the market. It also has helped that relatively few new bonds have been issued this year.

The annualized tax-free yield on the Bond Buyer newspaper's index of 40 long-term muni issues nationwide (charted at left) slipped to 5.60% on Wednesday, down from 5.61% on Tuesday and down from the January peak of 5.95%.

High muni yields have attracted so-called crossover buyers in recent weeks, meaning investors such as hedge funds and life insurance companies that normally wouldn?t hunt in the muni market. They have made up for continued selling by individual investors via muni bond mutual funds.

The mutual funds overall have had net cash outflows every week since early November, according to the Investment Company Institute. The latest data show muni funds had net redemptions totaling $1.45 billion in the seven days ended Feb. 16, about the same as the previous week but down from a recent high of $5.7 billion in the seven days ended Jan. 19.

The funds still hold about $460 billion of muni bonds.

-- Tom Petruno

A checklist for muni investors and potential buyers