Moody's: VRDB Market Decline to Continue, at a Slower Pace

After declining for four years in a row, the municipal variable rate demand bond market will continue its descent in 2013, but at a slower pace, according to Moody’s Investors Service.

Last year the outstanding balance of VRDBs declined by 12% to $264 billion, which was significantly less than the 19% drop experienced in 2011.

The continued decline in the outstanding balance of VRDBs has been driven by low interest rates motivating issuers to opt for fixed rates over variable rates, as well as a shrinking pool of support providers and concerns about future regulation.

A preference among some banks for on-balance-sheet assets over letters of credit and liquidity facilities supporting VRDBs has also contributed to the drop in VRDBs.

In tax-free money market funds — the principal holders of VRDBs — assets under management have also declined. Since mid-year 2009 through the end of 2012, assets under management dropped from around $450 billion to $285 billion.

“The emergence of direct bank loans has reduced variable rate municipal issuers’ reliance on money market funds which have been the principal holders of variable rate municipal financing since the auction rate market collapsed in 2007 and 2008,” Moody’s analysts Coby Kutcher, Thomas Jacobs, and Timothy Blake wrote in a report released Wednesday.

Last year the top three providers, J.P. Morgan Chase Bank, Wells Fargo Bank, and Bank of America, accounted for 37% of all credit and liquidity support to the Moody’s rated bank backed VRDB market, down from 39% at the end of 2011.

However, many of the top providers increased their aggregate exposure in 2012, suggesting banks’ capacity to provide support to the VRDB market will be relatively steady in 2013, according to the report.

Analysts said that in 2013, conversion to fixed rate alternatives will subside, and this year’s decline will be determined by interest rates and the evolving regulatory environment.

“Many issuers motivated to take advantage of historically low fixed rates by converting VRDBs to fixed rate alternatives have likely already done so,” they wrote. “The early January easing of Basel III liquidity coverage requirements, which we expect to positively affect banks’ appetite to write LOCs and [standby purchase agreements] in support of VRDBs and the pricing of such facilities will also contribute to stabilization.”

The market this year will also be affected by developments in credit profiles of liquidity support providers and possible changes in the tax treatment of tax-exempt income.

For reprint and licensing requests for this article, click here.
MORE FROM BOND BUYER