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Long the preserve of wealthy but risk-averse savers, US municipal bonds (munis) were until recently among the dullest of investments. The $2,500bn market came alarmingly unglued from its link to federal debt in 2008 and remains stressed just as states face big funding gaps, prompting the Obama administration and Congress to offer unprecedented support. Huge costs and an emerging bid-rigging scandal may complicate its plans.

Normally, highly-rated munis of intermediate maturity have yielded about 80 per cent of equivalent Treasury notes due to their tax-free status, but that ratio briefly topped 200 per cent late last year. This mostly reflected panic selling by funds facing redemptions but, even after a recent rally, yields remain elevated. Fears about creditworthiness now explain some of the discrepancy as munis’ historically minuscule default rate may surge in a deep recession.

California, the largest issuer, is the greatest worry. An independent state body recently predicted a budget gap of $42bn in fiscal 2009 and 2010 versus an annual $144bn budget. Unlike other states, general muni obligations only have second claim on tax revenue there after schools, and benchmark bonds now yield 65 basis points over national averages. New York, Nevada and Arizona also face yawning deficits.

This would be bad enough at the best of times but is compounded by the added expense of issuing new debt. Congress wants to help with a bill that would allow federal bail-out dollars to buy and insure munis. Another would extend the tax-free status of certain infrastructure bonds.

Tax-free munis already sap federal coffers of billions each year and the additional costs could be significant. The plan would also divert cash intended for ailing financial institutions. Momentum for the plan appears strong, but a nationwide corruption scandal in municipal finance may raise unpleasant questions. Any blank cheque from Washington to the states should come with greater transparency and oversight.

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