May 23 (Bloomberg) -- U.S. municipal bond yields fell to the lowest in three months as ``sanity'' returned to the tax- exempt market following the auction-rate rout, helping borrowers escape interest costs as high as 20 percent.

The benchmark Bond Buyer 20 index of yields on long-term tax-exempt debt fell to 4.52 percent this week, the lowest since Feb. 14. Rates declined from a high of 5.11 percent Feb. 28, after investors abandoned the $166 billion market for municipal bonds with yields set through periodic auctions. State and local governments have spent the last three months replacing the debt.

While yields on 10-year municipal bonds are 0.1 percentage point less than Treasuries of similar maturity, they were 1.15 percentage points less last June, according to data compiled by Municipal Market Advisors and Bloomberg. Municipal bonds typically yield less because, unlike Treasuries, investors usually don't have to pay income tax on the interest.

``We're not normal, but sanity has returned to the credit markets, and that's flowed over to the muni market as well,'' said Craig Elder, the fixed-income analyst for Milwaukee-based Robert W. Baird & Co., which manages $65 billion in its private wealth division.

Munis Outperform

Municipal bonds are poised to outperform Treasuries for a third straight month in May, pushing yields on 10-year, top- rated securities to about 97 percent of what federal securities pay. That's down from 115 percent in March, when the seizure in credit markets caused investors to flee to the safest government securities and the failing auction-rate market stoked investor concern that refinancings would lead to a flood of new debt.

The 10-year yield index from Municipal Market Advisors finished the week unchanged at 3.74 percent.

Fixed-rate borrowing by states, cities and hospitals to replace auction-rate bonds hasn't been as large as some investors anticipated. Record cash inflows into tax-exempt money-market funds allowed many borrowers to convert into floating-rate debt, instead.

Tax-free money-market fund assets rose $8.11 billion during the week ended May 20 to almost $520 billion, the most on record, based on data compiled by iMoneyNet Inc. of Westborough, Massachusetts.

``One of the things that really backed us up was the anticipation of this huge amount of fixed-rate issuance that was going to come,'' said Joe Darcy, who manages about $4.7 billion of tax-exempt bond mutual funds for Dreyfus Corp. in New York. ``It has been not as great in terms of supply as originally was forecast and it has been received better than anticipated.''

Lighter Issuance

Sales of fixed-rate municipal bonds have totaled about $126 billion so far in 2008, down 19 percent from last year's record pace, according to data compiled by Bloomberg. In April, states and local governments sold almost $52 billion of bonds, a record for any month, according to Thomson Reuters data. Just about 60 percent was fixed rate, down from an average 75 percent in 2007.

The pace of fixed-rate sales helped municipal bonds rebound after their worst start to a year since 1996, losing almost 1 percent, including reinvested interest, according to Merrill Lynch & Co.'s Municipal Master Index. So far this year, the total-return gauge advanced 1.4 percent, compared with 1.9 percent for Merrill's U.S. Treasury Master index.

The auction-rate market collapsed when investors soured on the securities amid concerns that the creditworthiness of bond insurers backing the debt would deteriorate.

Auction Failures

Rates on the bonds and preferred shares sold by municipal governments, student-loan organizations and mutual fund companies are determined by bidding typically every seven, 28 or 35 days. If demand is insufficient, the auction fails and some holders are left with securities they wanted to sell. The issuer gets stuck with a penalty rate as high as 20 percent.

As investor demand waned, dealers that supported the market for 20 years suddenly stopped acting as buyers of last resort. About 99 percent of public auctions for student-loan and closed- end fund securities and 48 percent of the municipal bidding continued to fail this month, auction-agent data compiled by Bloomberg show.

Rush University Medical Center received orders for six times the $97 million of bonds it sold this week to replace auction-rate debt, said Catherine Jacobson, the Chicago hospital's chief financial officer. Rush's fixed-rate bonds, sold on May 19 through the Illinois Finance Authority, were priced at yields ranging from 3.85 percent to 5.38 percent.

``The demand was there for the supply, and that helped us,'' Jacobson said.

The largest bond sale of the week, a $503 million offering by Boston-area nonprofit hospital operator CareGroup Inc., also raised money to replace auction-rate bonds.

Variable-Rate Deals

The San Francisco International Airport this week sold $67 million of insured variable-rate demand notes to restructure auction debt. The District of Columbia issued $524 million of variable-rate debt, also to replace auction-rate securities. For the first week, Washington will pay 1.65 percent in interest.

Local governments converted or earmarked for redemption by July 15 at least $74.7 billion of auction-rate securities, or about 45 percent of those outstanding at the beginning of the year, based on Bloomberg data. That helped reduce an index of the yields on weekly auction-rate securities to 3.61 percent on May 14 from a record 6.89 percent on Feb. 20.

``The auction market is dead,'' former Securities and Exchange Commission chairman Arthur Levitt said this week. ``Companies that have been issuing these securities are going to have to go to more conventional means of raising money.''

To contact the reporters on this story: William Selway in San Francisco at wselway@bloomberg.net.

Last Updated: May 23, 2008 14:56 EDT