June 20 (Bloomberg) -- U.S. municipal bonds dropped, driving benchmark 30-year yields to the highest since July 2004, as local governments sought buyers for the heaviest debt calendar since October and investors sought to sell holdings.

States, municipalities and other tax-exempt borrowers this week sold about $8.6 billion of fixed-rate bonds and $4.6 billion of notes, weighing on a market already burdened by investors seeking to unwind tax-exempt trades. Bloomberg's index of investors seeking bids on holdings for possible sale rose to a 10-day average of $868 million, the highest in three months.

The municipal market sagged for two weeks amid above- average issuance, selling related to bond-insurer downgrades and property-and-casualty companies liquidating to meet flood- related claims in the Midwest, according to David Thompson, president of Chicago-based bond dealer Griffin, Kubik, Stephens & Thompson Inc.

``A `perfect storm' of supply'' has been driving declines, Thompson said in market commentary today.

Yields on top-rated, 30-year general obligation bonds rose to 5.03 percent today, 21 basis points more than two weeks ago, according to data compiled by Municipal Market Advisors. A basis point is 0.01 percentage point.

The 10-year tax-exempt yield gauge rose to 4 percent, the highest since March 3, or about 96 percent of the rate on taxable Treasury notes with similar maturities.

Most benchmark yields rose this week to levels last seen after the collapse of the auction-rate securities market and liquidations by some municipal-bond hedge funds in late February.

Quarter-End Sellers

Municipal bonds have fallen since March 6, as investors trying to sell before quarter-end confront weak buyer interest amid a volatile market in U.S. government debt, traders said.

``There's virtually no bid out there right now,'' said Michael McKenna, a trader with Livingston, New Jersey-based GMS Group LLC. ``There's such a huge liquidity issue in municipals again. We're getting hit.''

Merrill Lynch & Co.'s Municipal Master Index fell 1.4 percent during June through yesterday, compared with a 0.7 percent decline for the Treasury Master Index. Both account for price swings and interest income.

This month, the two largest municipal bond insurers, MBIA Insurance Corp. and Ambac Assurance Corp., lost their top AAA/Aaa ratings from Standard & Poor's and Moody's Investors Service, after Fitch Ratings previously slashed the guarantors. Moody's actions came yesterday.

Assured, FSA

Wilbur Ross, whose firm is the second-largest shareholder in Assured Guaranty Ltd., said in a television interview today that the moves should help solidify confidence around the three remaining top-rated bond insurers. They are: Assured, Financial Security Assurance Inc. and Warren Buffett's Berkshire Hathaway Assurance Corp.

``Now, it's quite clear that it's a gang of three,'' Ross said. ``That should clear the air and hopefully let municipals trade at a little better level. We've got to restore stability to the municipal bond market.''

Other investors have started questioning Financial Security Assurance, or FSA. Hedge fund manager Bill Ackman, who correctly predicted shares of parent companies MBIA Inc. and Ambac Financial Group Inc. would tumble, said this week he is betting against FSA, the firm that has been writing the most new-issue business in the U.S. municipal market this year.

Florida's state-run Citizens Property Insurance Corp., the week's largest borrower, used FSA for part of its $1.75 billion debt offering this week. Proceeds of the sale will provide cash in case the home insurer must pay claims this hurricane season on high-risk, wind-only policies around the coastline.

Bigger Power Deal

Also this week, American Municipal Power-Ohio boosted its sale of bonds maturing over the next 35 years by 90 percent to $761 million as part of its plan to finance a share in a new coal-fired electric station.

South Carolina's Tobacco Settlement Revenue Management Authority sold $276 million of bonds due in 2018 and priced to yield 5.327 percent, or about 133 basis points more than top- rated debt.

The deal refinances bonds issued in 2001 and secured by South Carolina's share of annual payments from a 1998 master settlement between U.S. states and tobacco companies. Goldman Sachs Group Inc. managed the sale of bonds, rated Baa3 by Moody's, BBB by S&P and BBB+ by Fitch.

To contact the reporter on this story: Jeremy R. Cooke in New York at jcooke8@bloomberg.net.

Last Updated: June 20, 2008 16:44 EDT