Municipalities borrowing short term are increasingly taking on "refinancing risk" - a risk that used to fall on the investor, according to a Fitch Ratings report released yesterday.

Municipalities are increasingly relying on bond anticipation notes and extendable-maturity commercial paper for short-term financing, Fitch said.

A crucial characteristic separates these instruments from the variable-rate debt obligations and auction-rate securities that have gone out of vogue.

When a VRDO or ARS fails to find a bidder upon remarketing, it is the investor or the bank that is stuck. When an issuer fails to remarket a Ban or commercial paper, it is the issuer that is stuck.

An ARS that fails on remarketing typically saddles the issuer with paying a penalty interest rate, which is usually higher than the short-term rate it had been paying.

The investor cannot redeem the ARS for the principal, even if he or she only planned on holding the paper for two weeks.

Most VRDOs are backed by bank letters of credit. If a remarketing fails, the bank usually ends up holding the paper.

These markets have largely collapsed. Municipalities stopped selling ARS after the auctions failed and issuers were burdened with penalty rates. Issuance of VRDOs with short puts shriveled 88% last month from the June 2008 level, according to Thomson Reuters, as obtaining letters of credit has become prohibitively expensive.

Karl Pfeil, a managing director at Fitch, said the commercial paper and note markets have grown recently because issuers want access to the historically low rates on the short end of the yield curve.

Issuers for now are using these products prudently, Pfeil said, matching more precisely short-term cash flow with liabilities.

But Fitch sees risk if issuers lean too heavily on short-term financing, making it a bigger part of their debt portfolio and requiring continual refinancing.

The concern is that if an issuer could not refinance, it would not simply face higher costs - as with a failed ARS or VRDO remarketing - but an obligation to pay off the debt all at once.

"Fitch's concern is in the event that an issuer has too much of these securities as part of their permanent debt structure without adequate liquidity support," Pfeil said. "The risk is that in the event of a failed remarketing the issuer is relying solely on market access to take those notes out."

Market access, which was relatively easy in the years before the financial crisis, can be more difficult under current conditions, as investors may not always be willing to lend to issuers, especially those in more dire circumstances.

Fitch has not taken any rating actions on issuers because of reliance on these products.

Pfeil said the rating agency is conducting stress tests on issuers, measuring their short-term debt's resilience against various interest-rate environments.

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