Muni industry seen risking more regulation

NEW YORK (Reuters) - The municipal finance industry risks more regulation as a result of an ongoing federal investigation into how municipal bond proceeds are invested, a portfolio manager said on Tuesday.

Thomas Metzold, who runs the $4.25 billion Eaton Vance National Municipals Fund and co-manages the firm's $1.1 billion High Yield Municipals Fund, said the industry should do a better job of regulating itself before some practices attract outside attention.

"As an industry we need to do a better job of playing by the rules and doing the right thing," Metzold told the Reuters Investment Outlook 2007 Summit in New York.

"If we don't have the integrity to self-regulate and do the right thing, we will only bring upon this bad news and this potential for more regulation," he said.

Last month, the U.S. Justice Department and the Securities and Exchange Commission launched the first publicly visible phases of an extensive investigation into potential bid-rigging for contracts used to invest muni bond proceeds.

At least two firms were raided by the FBI, and as many as 30 firms received federal subpoenas.

Metzold said so far the probe "has not created any negative impacts on liquidity or flows" in the $2.3 trillion municipal bond market.

Another issue that could have a broad impact on the municipal bond sector, particularly on state-specific mutual funds, is a Kentucky court case challenging taxation of municipal bonds.

Earlier this year, a Kentucky court ruled that the state cannot tax out-of-state munis while exempting its own. The muni bond market is now waiting to hear whether the U.S. Supreme Court will hear the case.

Metzold said he expected the Supreme Court to take up the case. If it upholds the Kentucky court decision, municipal bond prices could fall over time because the tax-advantage of in-state municipal bonds and hence lower yields and higher prices will disappear, he said.

"You could potentially see a cheapening of our market," Metzold said.