U.S. municipal bonds already have scored most of the out-sized, bounce-back gains from 2008's bear market and in 2010 will post only ho-hum returns.

The $2.7 trillion market for tax-favored debt used to build America's roads, schools and other government infrastructure will be shaped next year by higher tax-rate worries, Build America Bonds and fears about the wobbly finances of issuers.

Build America Bonds, a category of taxable debt that was allowed under the economic stimulus act in February, has reshaped the tax-exempt market in less than a year.

Looking at two decades of market data, Philip Fischer and other analysts at Bank of America Merrill Lynch said 2010 will look a lot like the earlier years of the current decade.

Previous bear markets were followed by powerful rallies and finally a year or more of more typical returns, the Merrill analysts said in a report. We would also anticipate a return profile similar to the 2003-2007 years.

Munis, which so far in 2009 have had total returns of 14.4 percent, generally produced a mix of interest payments and price gains ranging from about 4 percent to 6 percent in each of the five years from 2003, according to Merrill indexes.

At this time last year, munis had been whipsawed by the global credit crunch and had losses on a total returns basis of 5.5 percent. Treasuries by late 2008 had year-to-date returns of 14.6 percent, while so far this year they are down 3.2 percent, according to Merrill indexes.

Of the five years of tax-free debt trading highlighted by Fischer, the best was 2003, when munis returned 6.2 percent. The best year for munis, as tracked by Merrill, was 1995, when total returns were 17.68 percent.

The Merrill analysts made no specific munis forecast for 2010 but said, Historical return patterns also provide support for the notion that the second year following a bear market offers a reversion to the mean.

TAX HIKES ON HORIZON?

Most people, including us, look for a continuation of this year's themes going into 2010: tax hikes in the offing, continued sales of BABs adding to scarcity, and the same good flows into tax-free mutual funds, said John Mousseau, portfolio manager at Cumberland Advisors in Vineland, New Jersey.

News about state and local budget crises is expected to be again frequent next year, worrying many retail investors, who proved stalwarts of the muni market during 2008 and 2009 as hedge funds and other institutional investors fled tax-frees.

Mutual funds dealing in munis and favored by individuals were flooded with cash in 2009, often reporting net inflows of more than $1 billion a week, according to AMG Data Services. In the week ending December 16, net inflows were $663 million.

In the spring, you'll hear about issuers' risks, said portfolio manager Paul Brennan at Nuveen Investments in Chicago. There'll be a lot of headlines about budgets and cuts in spending, and you might have some cases of default here and there. For more on the outlook for states, see Big muni issuers such as state governments are not yet benefiting from the fledgling economic recovery. The nonpartisan Center on Budget and Policy Priorities expects the combined deficits of state governments in fiscal 2011 and 2012 to total $260 billion.

But Brennan, as well as analysts at leading credit evaluator Standard & Poor's Ratings Services, said governments' operating woes would be managed and have little effect on borrowers' ability to service outstanding debt.

Because of a mix of taxing powers, budget controls and laws requiring balanced budgets, governments were less likely to default on debt or suffer ratings downgrades than American corporate borrowers, S&P said in a December report.

Portfolio managers and traders dealing with the wealthy say fears of rising federal income tax rates have spurred a lot of investing in tax-free debt, whose interest payments are generally not subject to federal tax.

Next year the federal tax cuts the Bush administration put in place will expire, and it is unlikely Congress will keep them, Brennan said. That type of thing gets investors' interest.

BABS WILL BE BACK

2009 was the year of BABs, a two-year, federally subsidized debt program for local governments.

Taxable BABs are very popular, accounting through late November for $55.1 billion of issuance in the municipal market, according to U.S. Treasury data reported last week. That's 21 percent of all muni debt sold in the first 11 months of 2009.

BABs issues could be over $100 billion to $120 billion in 2010, Brennan said. They could be a quarter to a third of issuance. BABs have changed the landscape and skimmed off traditional tax-exempt supply, especially at the long end.

BABs, which typically save issuers about 35 percent of interest costs, are widely seen as often replacing traditional tax-exempt bond deals as demand for tax-exempt bonds appears to be rising.

Overall sales of new muni debt next year will rise to $435 billion from an estimated $415 billion in 2009, as a result of low interest rates, a return of national economic growth and changes in Treasury rates, according to an analysis by Loop Capital Markets.

Mousseau said he expected a rush in 2010 of refunding deals by government issuers trying to roll over borrowings at better terms.

BABs has kept a lot of government finance people busy, Mousseau said. As BABs deals get done, you will see refundings come back.

(Additional reporting by Ciara Linnane in New York and Lisa Lambert and David Lawder in Washington)

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