Municipals gained 5/8 to 3/4 points yesterday after the Federal Reserve unleashed 50 basis point increases in both the federal funds rate and the discount rate.

The tax-exempt market was up 1/4 point before the tightening, and advanced another 1/4 after the Fed's move, one municipal analyst said. The full 1/2 point gain appeared shaky for a while, but the market eventually used steam from the rally in Treasuries to achieve higher levels. Dollar bonds ended the day 5/8 point higher overall, while yields on high-grade issues generally improved by seven basis points, and more in the longer maturities. Trading was moderate to active.

In debt futures yesterday, the September municipal contract raced ahead of cash, settling up 1 1/8 points at 91 21/32. Yesterday's September MOB spread was negative 395, compared with negative 386 on Monday.

The 30-year Treasury bond finished up more than 1 1/2 points to yield 7.36%. The Fed's 50-basis-point moves, which came out of the Federal Open Market Committee meeting as expected, brought the Fed Funds rate to 4.75% and the discount rate to 4%.

For the Fed "to go 50, and to be unanimous about it, leads me to believe that there's something they see that spooks them about inflation," one municipal trader said, adding "I could be paranoid."

The trader said that yesterday's market gains reflected actual buying instead of a short covering rally. Because a credit tightening was so heavily expected, few shorts were in the market, he said.

Also yesterday, the market was looking ahead to today's $700 million of California general obligation bonds, scheduled for competitive bidding. One analyst described the deal as "a big municipal market test."

If he likes what he sees, today's California offering could mark the first time in two years that Reid Smith, an assistant vice president at the Vanguard Group of Investment Cos., has bought California GOs or GO-related paper.

"We feel we are going to take a look at the deal and see if it's priced accordingly," said Smith, who manages Vanguard's just under $1 billion California Insured Long-Term Portfolio.

Smith said Vanguard has recently come to look upon the California credit in a more favorable light.

"We just feel it's reached the bottom," he said, adding however, that "it's going to be a long, slow recovery." Moody's Investors Service, Standard & Poor's Corp., and Fitch Investors Service downgraded the credit in July, but California actually began to show improvement shortly after January's earthquake, he said.

Smith said that while the recovery is "going to be a slow and arduous process," California's economy will recover along with the nation's. The portfolio manager also envisions nothing that will hurt the credit in November's gubernatorial election that pits incumbent Pete Wilson against state Treasurer Kathleen Brown.

"Just looking at the economic statistics out there, it appears that most of the downtrends have bottomed," Smith said.

Overall, Smith said he continues the same "neutral stance" that he has maintained for the past eight months. He thinks the economy is stronger than many people realize, and he sees to reason to believe bond prices will improve dramatically, he said.

David MacEwen, senior municipal portfolio manager at the Benham group -- including money market funds, the group has $1.8 billion of California paper under management -- said he would be uninterested in the deal unless it is insured. While the California economy is definitely "perking up off a low bottom," the state is two to three years away from an upgrade, he said.

California has to resolve its budget deficit problem, MacEwen said. The state is currently suing the U.S. government for federal aid to defray immigration costs, but there is "zero chance" that the state will get the full amount it is looking for, he said. Despite that, California's uses those projections to help balance the budget, MacEwen said. He added, however, "I think the worst is over.'"

Pat Dolan, a managing director at the Prudential said she will look at the California offering for her Prudential National Municipals Fund and Prudential Municipal Bond Fund-Insured Series, which total roughly $750 million each.

"A lot will depend upon the price," Dolan said, adding that the deal does have some strikes against it.

"The structure of this deal is rather poor," Dolan said.

The offering is concentrated in the short end, which will be hardest hit by yesterday's tightening by the Federal Reserve.

In addition, the bonds are callable and California is not allowed to provide much of a discount. The puny discount will lead to negative convexity, which makes the offering unappealing for total return buyers, she said. When bonds are priced between 98 and par, if rates go down, they trade to the call. If rates go up, "you don't want to own it anyway," Dolan said.

Today's negotiated calendar features $329 million Massachusetts Ambac-Insured HFA bonds and a $250 million New York State Dormitory Authority deal.

The dormitory issue, which finances capital needs for the State University of New York, is known as appropriated debt. These bonds are repaid through annual appropriations made by the state legislature. Because repayment of the debt is contingent on a vote, appropriated debt is often rated lower than state general obligations.

Some bond analysts believe New York State is an improving credit, following the surplus last year in its fiscal 1994 budget.

Michael Brooks, a senior municipal credit analyst at Sanford C. Bernstein & Co., is one of those. Brooks recommends purchasing the dormitory authority bonds based on his belief that bond raters will soon upgrade the state GOs, a move that he says will lead to an upgrade in the dorm issue.

An upgrade, Brooks said, will allow investment trusts and other buyers unable to purchase securities rated Baal or BBB-plus to acquire the dormitory securities.

"If the state GOs are upgraded the appropriated bonds will be upgraded as well," Brooks said. "That will open up investment opportunities, and increase the demand and price."

Charles Gasparino contributed to this column.

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