The market for variable-rate demand obligations has improved this year and is primed for a turnaround, according to a research report Moody’s Investors Service published.

The diminution of outstanding balances of VRDOs since 2009 has slowed in 2013 and could reverse course as the banking environment has stabilized through regulations and interest rates appear more favorable for issuance.

“We believe … that as the market reacts to greater certainty in the regulations governing it, the stabilization of banking sector credits, and the rise of long-term interest rates, the contraction of the [VRDO] market will continue to slow and may reverse,” says Ian Rogow, associate analyst at Moody’s.

A VRDO is a tax-exempt long-term loan with an interest rate that resets regularly. Because of this fact, they generally track other short-term interest rates.

A VRDO is remarketed to new investors when the interest rate resets. The issuer includes a “put” option, or the right for an investor to sell the VRDO back to the issuer whenever he wants, to make the VRDO more attractive in the short-term market.

The outstanding market for VRDOs has fallen from more than $400 billion in August 2009 to around $250 billion past April 2013. But the pace has slowed. Through June, the VRDO market has contracted by an average of 0.6% each month; that compares with monthly declines averaging 1.1% in 2012 and 2.0% in 2011, the Moody’s report stated.

In a similar vein, issuance of VRDO bank-supported debt fell in the first half of the 2013. By the beginning of August, about $1.6 billion of bank supported VRDOs had been issued.

Issuance of VRDOs for all of 2012 totaled just more than $8 billion, according to the report, published Wednesday under the title, “Municipal VRDB Market Facing Lighter Headwinds.” For comparisons to their heyday, issuers floated about $100 billion in VRDOs in 2008.

But Moody’s sees an improved landscape for VRDOs. For one, changes in regulations by the Securities and Exchange Commission and Third Basel Accord have created a more favorable and stable regulatory environment than previously anticipated, which has nurtured a wider availability of, and more stable prices for, bank-support facilities.

Second, banking sector credit quality will be more stable, the report said. This should reduce the counterparty risks usually tied to the issuance of bank-supported VRDOs.

“In late May of this year we changed our outlook on the U.S. banking sector to stable from negative,” Rogow wrote. “Our change in outlook reflected continued improvement in the operating environment and reduced downside risk to the banks in the event the economy falters.”

Finally, as long-term interest rates have been rising and short-term interest rates remain near historic lows, VRDOs and other short-term and variable-rate financing structures appear relatively more attractive to issuers because of their low borrowing costs and the flexibility they provide.

Some have noticed VRDOs’ lasting allure. “We continue to see strong demand for VRDO product from many funds and an increasing number of non-traditional buyers,” said John Anderson Rolander, vice president and fixed income trading manager for Fifth Third Capital Markets, in Cincinnati.

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