The municipal bond market has staged a strong rally in 2009 with longer duration and higher yielding securities leading the comeback. One catalyst for the rebound has been a new type of taxable bond introduced by the Obama administration that has broadened the investor base for municipal issuers.

But state budgetary woes, insufficient liquidity and wide bid/ask spreads remain key concerns for fixed-income investors, thereby making bond selection and curve positioning even more crucial to providing attractive returns.

This according to PIMCO’s municipal bond team – John Cummings, David Blair and Bob Fields – who highlighted the opportunities and challenges in the muni bond market on a recent conference call with advisors. “The municipal market is starting to heal after a horrendous year last year,” said Cummings, executive vice president and portfolio manager of the PIMCO Municipal Bond Fund.

Credit spreads have declined from their peak but still remain elevated, Cummings noted on the call. And muni yields have moved lower across the curve with the slope of the curve at its steepest ever. There’s been very little issuance of higher-yielding paper – BBB and below – while money has been flowing into high-yield funds. The standout performers within that group have been healthcare, industrial development bonds and tobacco bonds, Cummings said. “The fourth quarter of 2008 was a period where you had a dramatic delevering with broker/dealers, banks and single-strategy hedge funds,” Cummings said.

“This year we’ve seen a lot more stability.” Indeed, the Barclays General Muni Index is up 7.5% as of June 9 and the long end of the market is up almost 14% with high yield up 17% during the same period. Muni bond funds have garnered a net $31.3 billion year-to-date, reversing the $11 billion outflow they suffered in the fourth quarter of 2008, according to AMG Data Services. The record for inflows in an entire year is about $28.6 billion in 1993, according to The Bond Buyer.

Liquidity remains an issue after the market was hit hard when major municipal bond dealers Lehman Brothers and Bear Stearns collapsed in the wake of the sub-prime mortgage meltdown and Merrill Lynch was forced to agree to a sale to Bank of America. “Dealer inventories are a lot lower, bid/ask spreads are a lot wider,” Cummings said. However, regionals and boutique dealers are starting to grow in importance and will eventually have to pick up the slack, he added.

Build America Bonds, created by the Obama administration to help spur infrastructure projects, have been a source of relief for the municipal bond market. This new source of funding for issuers has helped municipalities raise cash after credit markets began to seize throughout 2008. The issuance of BABs has helped reduce traditional tax-exempt supply adding to the rebound in performance in the municipal market, especially for the longer maturity portion of the municipal yield curve.

“By introducing Build America Bonds, you opened up the market to levered players and non-taxable investors so that has helped the market dramatically,” Cummings said.

Under the program, municipalities issue taxable securities and receive a 35% tax credit on the interest payments, resulting in an expansion of the investor base for muni issuers. It has allowed issuers to expand their universe of bond buyers to a more diverse group of buyers, such as pension funds, endowment funds, and other institutional investors, many of whom have significant portfolios. In addition, they benefit from the credit diversification and attractive spreads versus corporate bonds. At the same time, the tax credit has helped lower interest costs for issuers.

Total issuance of the Build America Bonds has exceeded $11 billion, PIMCO said, with an estimated total issuance of $50 billion to $70 billion in each of the next two years. The largest issuer to date was California, which completed a $5 billion deal. Since most of the bonds are issued in longer maturities, the program has helped ease tax exempt supply in the longer maturities fueling a rally in longer bonds.

Despite improving conditions, the recession has taken its toll on state budgets with all sources of revenue down significantly, a characteristic that sets this downturn apart from other recessionary periods. Many states have been able to balance budgets by slashing costs, eliminating state-funded programs and raising taxes but the process has not been easy, PIMCO’s muni bond team said.

California is a notable outlier with a projected $24 billion deficit and seemingly little money to dig itself out of the hole. PIMCO’s muni bond team said it will take significant cuts and an unprecedented amount of short-term borrowing to close the gap. And despite its repeated requests for aid from the federal government, the Golden State is unlikely to get it, they said. California’s debt service is roughly 7% of state revenues and is behind only K-14 education in terms of priority.

Given the liquidity issues, lower dealer inventories and spread disparity, Cummings stressed the importance of being cautious when it comes to investing in munis in terms of bond selection and curve positioning: “It’s a bond picker’s market. We’re selectively selling lower-rated securities into this [recent] strength. We’re repositioning our portfolios with more of a higher-grade bent. With such a steep muni yield curve, we are focusing on gaining exposure to short to intermediate maturities, which will benefit most from the roll down.”

Meanwhile, Barney Frank, chairman of the House Financial Services Committee, has proposed new legislation that would reform the muni market by imposing new regulations on credit rating agencies and financial advisors. Two of its key tenets are the Municpal Bond Insurance Enhancement Act, which would provide reinsurance to municipal-only bond insurers to increase their capacity to insure new risk, and the Municpal Market Liquidity Enhancement Act, which would allow the Fed to fund new liquidity facilities for new variable rate demand notes (VRDNs). PIMCO believes that the new regs, particularly the one that benefits the money markets, if passed, would help nurse the ailing municipal bond market back to health.