The leading index of municipal short-term borrowing rates has fallen for the fifth week in a row and is expected to drop further. But as rates have dropped, investors have started to demand only high-grade paper, leaving many lower-rated issuers unable to access the attractive rates, market participants said yesterday.

The Securities Industry and Financial Markets Association municipal swap index, the widely used index based on variable-rate demand obligations, fell to 1.82% last week, continuing a retreat from its record high of 7.96% on Sept. 24.

Sources said the steady decline demonstrates how investors have bifurcated the short-term market by demanding the safest high-grade assets - which are in short supply and comprise the bulk of the index - while rejecting deals from lower-grade issuers.

"The flight to quality exists even within the short-term muni market," said Michael J. Marz, vice chairman with First Southwest Co. in Dallas. The spread between high-grade and lower-grade variable-rate demand notes is "creating some pretty big standard of deviations," he said.

The steady drop in the SIFMA index reflects how it is computed, he said. The index tracks the interest rates of about 650 variable-rate demand obligations and resets weekly. Only VRDOs rated VMIG-1 by Moody's Investors Service or A1-plus by Standard & Poor's are included in the index. SIFMA's calculation excludes trades for interest rates outside a certain standard deviation. Both of those factors are "helping influence some of the drop," Marz said.

"The reality is there's a lot of hesitation right now for floating-rate debt," he added. "People are extremely cautious."

The SIFMA index, along with other borrowing rates, surged after Lehman Brothers Holdings Inc. filed for bankruptcy protection on Sept. 15. Tax-exempt money market funds, which serve as the largest buyers of VRDOs, were forced to sell assets as investors withdrew their holdings, which drove up the interest rates on VRDOs. In the weeks after Lehman's bankruptcy, issuers with short-term deals structured on SIFMA were paying four times as much as they were before the credit crisis.

But the demand for short-term paper reversed course and current market conditions are expected to drive SIFMA lower. The index could fall to between 1.55% and 1.60% this week as the Federal Reserve begins buying commercial paper and moves to restore calm to money market funds, and as cash that traditionally flows into the funds at the beginning of each month will be used to buy variable-rate debt, George Friedlander, fixed-income specialist at Citi, said in a note to clients on Friday.

"The turnaround in the short-term tax exempt market was a direct result of the improvement in the short-term taxable market," he wrote. "While many of the programs, such as the Federal Reserve's decision to buy commercial paper from issuers, did not directly help the tax-exempt market, it did help dealers. Consequently, a general level of confidence has returned to the market, and market participants are starting the month of November with optimism."

The interest rates for tax-exempt debt are proving too tempting to resist as buyers have returned to the market, but only for high-grade paper. Short-term issuers looking to issue debt or refinance at the attractive, low rates may be left out of the market if they are rated below double-A.

The foreign and domestic banks that serve as remarketing agents, and broker-dealers who agree to buy VRDOs as a last resort, have had problems of their own during the credit crisis. Some smaller regional banks have stepped in to serve as remarketing agents, but lower-grade issuers have been unable to find the liquidity facilities necessary to finance variable-rate debt issuances.

"This may be a problem for the smaller health care and university issuers that relied more heavily on floating-rate debt and bond insurance to provide capital at a lower rate," said Matt Fabian, managing director with Municipal Market Advisors in Concord, Mass. "These issuers may be forced to look outside of the public finance market for capital for the time being."

Note issuance is on par with last year, according to Thomson Reuters. Issuers have sold $49.3 billion of short-term debt year-to-date compared with $47.0 billion in 2007.

"In the past, note issuance has been a good barometer of financial pressure in the states," Philip J. Fischer, municipal strategist with Merrill Lynch & Co., wrote in a research note to clients yesterday. "While the deficits are on the increase, the high financing costs may well be putting downward pressure on note issuance this year."

Broader economic conditions are also expected to lower the SIFMA index. The Fed lowered its benchmark federal funds rate by 50 basis points to 1.00% on Wednesday, which is expected to lower borrowing rates, sources said. Auction-rate securities settlements between broker-dealers and regulators will create opportunities for issuers to convert their ARS into VRDOs. High-grade issuers that restructure will be able to sell the VRDOs to money market funds, sources said.

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