Financial markets are becoming increasingly anxious about the mauling in the US municipal bond market, which has seen borrowing costs for state and local governments jump sharply in recent weeks.

The municipal bond market is suffering its sharpest sell-off in two years, which has pushed interest rates on the top-quality, long-term muni bonds up by more than half a percentage point since the beginning of the month.

Investors, who had been pouring money into muni bond funds since the beginning of 2009, suddenly appear to have had second thoughts since the mid-term elections. They’ve begun to worry that the Republican success is likely to mean the end of US government economic stimulus packages, which can’t be good news for state and local governments struggling with crippling budget deficits.

At the same time, states are rushing to raise new debt before the Build America Bonds program expires at the end of the year. This program was introduced as part of the Obama Administration’s stimulus package in early 2009. The federal government subsidised the interest cost of the bonds — either directly through a payment to the bond issuers, or indirectly through a tax credit for bondholders — which cut borrowing costs for state and local governments. The idea was to help them raise low-cost funds so that they could build new capital projects, such as schools, hospitals and roads, and which would help generate jobs.

These bonds appealed to different types of investors, which helped increase the overall demand for municipal bonds. Of the $US340 billion in municipal bonds issued so far this year, $84 billion has been in through Build America Bonds. The fear is that these new investors may vanish when the program ends, further reducing demand for muni bonds at a time when the supply is billowing.

Confidence in the muni bond market was rattled this week when there was only tepid interest in a $10 billion sale of “revenue anticipation” notes sold by California. Retail investors took up just over 60% of the notes. In a similar sale in September 2009, California sold 75% of the notes to retail investors. California also had to offer investors higher yields on the notes.

The bleak financial predicament of many states and local governments was highlighted this week, with ratings agency Moody’s Investors Service downgrading Philadelphia and San Francisco.

Moody’s said Philadelphia’s rating downgrade reflected the city’s weak finances, along with “ongoing economic challenges, weak demographics and high unemployment, modest property value growth, and a heavy burden of tax-supported debt”.

And it pointed to San Francisco’s looming fiscal challenges, noting that “the city ended fiscal 2009 with a balance sheet that was weaker than at any time in the prior 10 years”.

Investors were also shaken this week when the Michigan city of Hamtramck asked the state for permission to file for bankruptcy. The city, which faces a $3 million deficit, wants to use bankruptcy protection to stave off creditors and force its unions to agree to concessions.

Investors worry that many more US state and local governments will take a similar route in coming months. Many have seen their revenues — particularly those based on various property taxes — collapse after the housing market collapse. At the same time, they face massive spending commitments, particularly for pension payments.

As a result, state and local governments will be forced to introduce savage spending cuts, and tax increases in an effort to close their budget holes. They’ll also likely be looking to reduce their outgoings on wages, by laying off staff, and by reducing wage rates and pension payments.

But investors fear that those state and local governments that fail to achieve budget cuts will be forced to follow Hamtramck’s lead and seek bankruptcy protection. And this could cause muni bonds to forfeit their long-standing reputation as an ultra safe investment

*This article was originally published on Business Spectator.