Buy Side

VRDO Market Continues Its Steady Descent

LOS ANGELES — The variable-rate demand obligation market continued to contract last year as some issuers opted for other alternatives and others sold less debt.

The par amount of VRDOs outstanding by the end of 2012 totaled $264.6 billion — a 12.1% decline from the year before, according to data compiled by the Securities Industry and Financial Markets Association.

The reason for the sharp decline can be attributed to the current interest-rate environment, muted supply and anticipated regulations, according to municipal bond strategists at Citi.

“Municipal entities are less reliant on banks for liquidity support given the environment of ultra-low yields,” George Friedlander, Mikhail Foux and Vikram Rai said in a recent market comment. “Given expectations for rising rates, issuers that have the ability to issue fixed-rate debt would rather do so and take advantage of the low-yield environment.”

In addition, municipal debt outstanding is somewhat static, and issuers typically maintain only a portion of their debt in floating-rate liabilities, according to the analysts.

As a result, floating-rate issuance has declined with net issuance.

The third factor involves the new liquidity-coverage ratio requirements anticipated under Basel III, which would increase the amount of capital banks must hold against assets.

Citi analysts said banks expect to find the provision of letters of credit that back VRDOs to be a less attractive play relative to direct ownership of tax-exempt debt.

“Consequently, a number of major banks have increased their public and private purchase of munis, while cutting back on provision of LOCs or sharply increasing their cost,” they wrote.

The VRDO market has been contracting since 2009, when the total outstanding amount dropped from $444.9 billion in 2008 to $405.9 billion.

In 2010, the market saw an 8.5% dip followed by an 18.9% drop in 2011.

In 2012, issuance declined among every area, except for the development and pollution sectors, with the health care, general purpose and higher education sectors leading the decline.

Among states, VRDO issuance declined in all but four — Hawaii, Iowa, Montana and New York — as well as in the Commonwealth of Puerto Rico.

Citi analysts noted that while VRDO issuance is declining, there still remain some issuers that are compelled to issue variable-rate debt since they have swaps outstanding.

In those cases, the variable rate debt is cheaper than the costly option of terminating swaps that are under water.

These issuers, however, are using floating-rate notes, as opposed to variable-rate demand notes, since the latter are more costly with liquidity and other fees.

Issuers are also using direct bank loans as another alternative to VRDNs.



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