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Once again, tax-exempt municipal bonds outperformed the Treasury market last week, although this may have been due to inattention during a holiday-shortened trading schedule and the large East Coast snowstorms. Still, demand remains exceptionally strong, fueled by investors fleeing the tax-exempt money funds and looking for a safe shelter from rising income tax rates.

The TIPS/Treasury Bond spread is an oft-used metric to analyze inflation expectations. Analysts on CNBC, on the WSJ, and in other business media frequently refer to it. What is it? And what is it showing? Right now, it has returned to a pre-crisis level that shows neither heightened inflation nor deflation expectations.

Municipal bonds have performed well this year as buyers pursue the credit protection and income in both taxable and tax-exempt markets. Last week, munis rallied despite some flight to safety flows into Treasuries that in past weeks of the current crisis might have precipitated broader weakness. This year, investors appear to be more confident that the scarcity of high grade tax exempts will persist while the Federal government increases the income and capital gains tax rates and dilutes the value of competing tax shelters like the mortgage interest and charitable giving deductions.

The global bond markets have come under increasing pressure recently, amid growing calls for investors to short bonds. Is this a foolproof trade?

With buyers feeling some trepidation over low nominal yields, rich relative valuation to Treasuries, concerns over a diminished BAB presence in 2010, and eroding credit quality, the municipal market experienced a modest correction at the end of January. However, weakness appears to have faded, in particular with the President’s weekend announcement of a proposal to expand the BAB program.

Once again, municipals held on to low nominal yields; however, tax-exempts did lag the Wednesday and Thursday flight to safety rally in Treasuries last week. More muni participants are actively discussing the possibility of a correction in prices this week: a reasonable development noting moderate institutional gains taking on Friday and the potential for a stock market rebound early this week. If yields do rise, long bonds appear most vulnerable.

Municipal bonds survived last week with slightly lower yields, a flatter yield curve, tighter credit spreads, and aggressive price bumps in many of the larger primary market loans. These were all despite a large new issue calendar, another downgrade for California, and a rally in Treasuries that made tax-exempts a relative drag on performance.

Municipal bond interview with Tom Doe, Founder and CEO and Matt Fabian, Manager and Lead Director of Municipal Market Advisors. The interview summarizes the municipal bond market for the week of January 11, 2010.

The municipal bond insurance market took a beating during the financial crisis, virtually disappearing. Now the question everyone is asking is, do we need it?