Buy Side

Issuance Drops 4.1% In 1st Half

SAN FRANCISCO - Long-term municipal bond issuance dropped 4.1% in the first half of 2008, as issuers with auction-rate securities rushed to refinance and most others tried to avoid a turbulent market.

Local governments, nonprofit organizations, and other muni issuers sold $221.7 billion of bonds in the first half, down from $231.3 billion in the first half of 2007, according to preliminary data from Thomson Reuters. The number of deals decreased to 5,730 from 6,646. In June, issuance fell 7.5% to $43.6 billion from $47.2 billion a year earlier.

"The first half of the year was really about the restructuring of auction-rate securities," said Terry Goode, head of tax-exempt research at Wells Capital Management in San Francisco. "Issuers that were considering new-money transactions in the first half of the year delayed them."

The Thomson Reuters data show that the ARS failure continues to be the main theme in the market. The numbers show sharp increases in refunding issues and variable-rate deals with credit enhancement - alongside a corresponding drop in new-money, fixed-rate, and insured deals.

While restructuring and fear dominated the market in the first half, the overwhelming influence of the credit crunch has begun to wane somewhat. Muni market new-issue volume decreased every month this year except April, when a surge of refunding hit the market in the wake of February's auction-rate crisis. But the volume decrease in June was much smaller than the 30%-plus volume declines in January and February.

Analysts said they expect to see the slow return to more normal market conditions continue in the second half, as issuers begin to re-enter the market to sell new-money deals they delayed in the first half of the year and buyers continue to adapt to a market with fewer insured deals and to global ratings scales that yield less differentiation in municipal bond ratings.

"We are about halfway through the muni auction conversion process," Philip J. Fischer, a municipal strategist at Merrill Lynch & Co. in New York, said in a research report yesterday.

The restructuring process is evident in the data for the first six months of the year. Refunding deals made up 29% of the market in the first half, up from 23% a year ago. Refunding volume jumped 20% to $63.1 billion from $52.8 billion in the first six months of 2007. New-money issuance fell 8.1% to $118.9 billion from $129.4 billion.

Sales of variable-rate debt with a short put surged to 31% of the market in the January-June period from just 7.9% in the first half of 2007, as issuers - many stuck in swaps that were deep underwater - tried to replicate their auction-rate bonds in the relatively stable market for variable-rate demand obligations.

That meant a surge in use of liquidity enhancement. The value of deals with letters of credit jumped 409% to $38.4 billion from $7.5 billion. The amount enhanced by standby bond purchase agreements surged 220% to $20.9 billion from $6.5 billion. All told, 26.7% of first half volume carried liquidity enhancement, up from just 6% a year ago.

While the market has improved since the worst days of the credit crunch and many issuers have finished their emergency ARS refinancing deals, the muni market isn't likely to see a full recovery anytime soon, analysts said.

"If you need the capital and you've got something to finance, you can certainly get it done in today's market place," said Chris Mier, a managing director at Loop Capital Markets LLC in Chicago. "Having said that, today's market place isn't as strong as it was two years ago" with the exit of tender-option bond programs and some major proprietary traders this year.

"Fundamentally, you've got less capital available for investment," he said. "The buy-side is a little bit smaller than it was before."

The continued impact of the credit crunch is most pronounced in the insurance market, where the value of insured deals collapsed in the first half. Insurers backed just 24% of the market's volume in the first six months of this year, compared to 49% a year ago. The value of insured deals sank 54% to $52.3 billion from $112.5 billion.

Paying "very high rates" on insured auction-rate bonds forced many issuers to question the value of insurance, Goode said. That skepticism will grow as the credit rating agencies migrate toward global rating scales that grade munis on the same scale used for corporate bonds, which could increase local government credit ratings.

"The value of bond insurance has been tested, and it will be tested going forward," Goode said. "In the second half, I think you're going to continue to see many fewer muni deals that are bond insured."


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