Yields in the US municipal bond market have soared to historically high levels compared with US Treasury bonds, as investors respond to uncertainty over bond insurers' fate and Wall Street withdraws support.

In recent weeks a downward spiral has engulfed the $2,600bn municipal debt market, where local government authorities, including universities and hospitals, fund their borrowing needs.

Municipal bonds normally trade at about 80 per cent of Treasury market yields because they are tax-free investments. Recent turmoil in the market has pushed municipal bond yields to an unprecedented 125 per cent of Treasury yields.

Such levels are attracting some buyers. But many investors remain wary as the credit crunch on Wall Street casts its shadow.

Problems came to the fore when funding of the $330bn short-term municipal market was thrown into disarray last month. Auctions of local government debt have failed, driving interest rates sharply higher. Concerns that bond insurers, which guarantee many municipal bonds, will lose their triple-A ratings sparked a buyers' strike. Wall Street banks stopped supporting the market amid worries about their balance sheet exposure.

Borrowers are trying to issue long-term debt, and the prospect that about $160bn of auction rate securities will be converted into regular bonds has weighed on valuations.

"There is a tremendous amount of supply and turmoil in the market that is driving up yields," said Jim Cusser, portfolio manager at Waddell & Reed. A zero coupon municipal 10-year was yielding about 4.10 per cent versus a Treasury yield of 3.57 per cent, he said.

Some investors with leveraged exposure to the municipal market, including hedge funds, have been hit with margin calls on their trades. The ensuing liquidation of portfolios has weighed on sentiment.

On Monday, JPMorgan said it had arranged new funding for Blue River, a municipal bond fund that had been forced to sell positions.

"The sell-off has been under way for several days, but it reached fever pitch at the end of [last] week," said Ben Thompson, port­folio manager at Samson Capital Advisors.

Mr Cusser said this could mark a buying opportunity. "Munis are not supposed to be so cheap, and it is an extremely attractive market if you can get beyond the next couple of months."

Savvy investors including Warren Buffett and Bill Gross at Pimco have been looking at municipal bonds.

Mr Buffett said he had bid unsuccessfully on a $3.5bn municipal bond portfolio on Friday.

"We were getting calls on large portfolios," Mr Buffett said in an interview on CNBC on Monday. "People who were out on a limb financially are getting that limb sawed off."

As investors reassess the use and value of bond insurance, investors are grappling with economic questions.

Local government borrowers face paying much higher interest rates as they move to issue long-term debt and deal with the prospect of lower taxation revenues from a weaker economy and falling house prices.