NEW YORK, Oct 27: The US municipal bond market, a $2.5 trillion asset class with one of the world’s lowest default rates, is fretting over whether the downgrade of Merrill Lynch & Co Inc’s credit rating will do more damage.

Some painful effects have already been seen, and others might lie ahead, according to traders and portfolio managers.

This naturally raises the central question that so often faces almost any sort of shopper. Have these items, especially natural gas bonds Merrill brought to market, been discounted enough or will they be better buys later?

“I’m trying to decide when and if there is a good entry point there. I don’t know yet,” said George Strickland, managing director at Thornburg Investment Management in Santa Fe, New Mexico. He was referring to the bonds utilities use to prepay their long-term purchases of natural gas.

Prices for natural gas bonds that other broker-dealers brought to market have also been clipped since Wednesday, when agencies cut Merrill’s credit due to its bad subprime mortgage bets.

This kind of debt rises and falls with the underwriters’ credits because the companies also promise the utilities that they will supply them with the gas from their commodity arms.

Looming over the muni market niche is the broader question of trusts that take advantage of the difference between short- and long-term muni rates. This $200 billion sector is called tender option bond programmes.

Merrill Lynch is one of the biggest players among these programmes. If it slows or stops setting up new ones, that could slash demand for new and outstanding issues, the market sources said.

A Merrill spokeswoman was not immediately available for comment.

Speculation already has begun that some tender-option-bond programmes are being closed out. “I’m seeing tons of offerings of energies,” said Strickland, referring to natural gas munis.

Because many of these natural gas bonds were placed in tender-option-bond programmes or bought by arbitragers, the rush of offers might signal waves of selling lie ahead. That happened when the credit crunch hit this summer and some tender-option-bond programmes were forced to shut.

“Maybe we’re in for another round of deleveraging in the municipal market,” Strickland said.

Selling from tender-bond-option programmes can slam prices as just one programme can total several billion dollars.

Tender-option-bond programmes typically sell lower-yielding notes, invest in higher-yielding long-term debt, and pocket the difference.—Reuters