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Short-Term Debt

A Day Late and a Dollar Short

The municipal floating-rate note may have begun to take off at precisely the wrong time.

The past six months have been rough for an instrument that gains allure as interest rates rise.

Municipal governments began selling FRNs in a brief flurry earlier this year, but issuance soon petered out.

In this year’s first quarter, issuers sold at least eight SIFMA-based floater deals with $1.42 billion in par value. Since the end of March, they have sold three with $238.6 million par value.

As the economy has languished and the Federal Reserve has repeatedly stated its commitment to low interest rates and a steady stream of quantitative easing, it has been a little tougher to sell investors on the appeal of debt carrying floating rates.

Market participants portray the municipal FRN as paper with a conservative posture, a riskier cash alternative most appropriate for investors seeking protection from a spike in rates.

“It’s a very good vehicle for someone who is worried about rising interest rates,” said Sandy Panetta, a short-term portfolio manager at Evercore Wealth Management. “The benefit to me is strictly to buy if you think interest rates are going to rise.”

Panetta said she has not purchased FRNs for clients, but is paying attention to the market.

Municipal FRNs are notes, issued by state or local governments or other muni issuers. Interest rates on the notes reset regularly based on a short-term benchmark index.

Most FRNs yield the Securities Industry and Financial Markets Index swap yield or the one- or three-month London Interbank Offered Rate plus a fixed spread.

The rates reset monthly or quarterly.

Some of the biggest tax-exempt FRN deals this year have come from Massachusetts, Louisiana, and the District of Columbia.

Municipalities have already pulverized the previous record for sales of “linked-rate” notes in a year, according to Thomson Reuters, with $6 billion issued in the first three quarters.

Floating-rate debt has possible appeal to any investor vulnerable to an increase in interest rates — in other words, almost everybody.

Most of the known bond universe gets destroyed when rates rise. So do most kinds of stocks, as well as real estate, gold, the put options investors hold on variable-rate debt obligations, and the call options municipalities hold on much of their own debt.

A note the cash flows on which increase when rates rise helps to neutralize duration — the decline in a bond’s value owing to a spike in interest rates — any bond investor’s greatest fear.

Most of the investor demand for FRNs reportedly has come from short-duration participants, such as short-term bond funds and money market funds.

Kyle Pulling, JPMorgan’s head of short-term remarketing and trading, said much of the demand for FRNs this year has come from short-duration bond funds, asset managers, trust departments, and retail.

When Massachusetts floated its $538.1 million FRN deal in March, it commanded $2.5 billion in orders, according to the state treasurer. More than 20 fund complexes submitted bids, some for entire maturities.

Issues with maturities of 13 months or less might be eligible for purchase by money market funds, a nice bonus at a time when the money fund industry is buying everything that isn’t nailed down.

The rampant demand from the $333 billion tax-free money fund industry — which is losing eligible product faster than it’s losing investable cash — left its imprint on Massachusetts’ one-year note sale. Those notes priced at a remarkable spread of zero over the SIFMA index, which was 0.24% at the time, even though the SIFMA rate measures tax-free variable-rate borrowing costs for seven days, not a whole year.

Same for Washington, D.C., whose one-year FRNs priced at just two basis points over the SIFMA swap rate. Still, like other cash alternatives, the past half-year has been unkind to floating-rate instruments.

“Whether FRNs make sense now depends on how long the Fed remains on hold, and ultimately when rates begin to rise,” John Hallacy, head of municipal research at Bank of America Merrill Lynch, wrote in a report last week.

By all indications, that will take a while. In April, according to Bloomberg LP, trading of futures contracts implied that the Fed hiking its interest rate target by the middle of next year was a virtual lock. Today, those same contracts imply the likelihood is just 13%.

Analysts surveyed by Bloomberg in March had an average federal funds rate target estimate of 1.4% for mid-2011. Today the average estimate is about 0.25% — essentially what the target is now.

The minutes of the latest Fed meeting released yesterday showed central bank officials are prepared to ease monetary policy further to accommodate growth.

The short-term benchmarks FRNs are based off have been tilting downward since July. Three-month Libor underwent an incredible period from July to September during which it fell or was flat every day for 37 straight trading days — almost halving in that time, to 0.29%.

The International Monetary Fund last week shaved its forecast for Libor in 2011 by 10 basis points, to 0.8%.

The SIFMA swap rate, which measures average seven-day yields on tax-free VRDOs, also remains under 0.3%.

The fixed spread negotiated on FRNs depends mainly on maturity and credit risk. Placing a price on these risks can usually be accomplished by assuming a “law of one price” parity with the fixed-rate bond market. In other words, an investor should get the same yield for the same risk in different markets.

When Massachusetts brought its deal in March, for instance, its four-year fixed-rate bonds were trading at about 1.2%, according to Municipal Market Data.

An FRN from the same issuer with the same call characteristics should theoretically trade at 1.2% plus or minus the after-tax cost of a swap locking in a 1.2% rate in exchange for a floating rate equal to the rate paid on the note. Otherwise, investors could arbitrage one against the other for risk-free profit.

Chris Alwine, head of municipal operations at Vanguard, said he also would add five to 10 basis points for a liquidity premium, since municipal FRN activity in the secondary market is thin.

The four Cusips in the Massachusetts deal traded somewhat vigorously when they were first issued in March, but for the most part sparingly since then.

The two-, three-, and four-year maturities in that deal have traded a total of 87 times, according to trades reported through the Municipal Securities Rulemaking Board, though only a handful have been since March. These trades were all at or around par.

Though ascertaining bid-ask spreads is methodologically difficult because trading is so infrequent, dealers appear to sell this paper for about five to 10 cents per $100 more than they buy it for.

The District of Columbia’s deal hasn’t traded since it was issued in March.

Just because the municipal FRN neutralizes duration risk does not mean it neutralizes all risk, Alwine said.

While FRN yields drift in accordance with prevailing benchmark interest rates, the spreads to those benchmarks are fixed. Massachusetts’ four-year note priced at a spread of 53 basis points to SIFMA If Massachusetts’ credit deteriorated, investors would demand a fatter spread in the fixed-rate market, but the rate on the note would already be locked in. That would make the note less valuable.

This risk is called “spread duration.”

“For individual investors thinking this is just a way to boost income over cash, they have to realize they are taking more risk compared to cash,” Alwine said.

Hallacy also pointed out a form of “basis risk” that could plague FRNs. The spread of Massachusetts’ four-year note over SIFMA is theoretically established commensurate with the spread over the benchmark fixed-rate tax-exempt MMD yield, through the arbitrage arguments between the fixed- and floating-rate markets mentioned above.

Now imagine the SIFMA yield went down relative to the benchmark MMD yield; the yield on the FRN would then go down without any corresponding decline in fixed-rate yields. Without any change in spreads, the investor is then stuck collecting lower interest payments on the FRN when he could be collecting higher payments on a fixed-rate bond — violating the arbitrage argument.

Spread duration and basis risk are ­greater for longer maturities, which may explain why most of the demand for FRNs has been concentrated toward the front end of the curve.

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