A steep interest rate yield curve and greater investor familiarity with hedging products prompted an increase in secondary-market municipal synthetic derivatives that started last year and remained strong through 2001.
Last year, secondary-market municipal derivative volume increased by 60%, according to analysts, who estimated that these deals totaled about $27 billion.
In 2001, the growth of these synthetics has continued and the year-end tally could surpass last year's all-time high total, sources said.
In the first quarter of 2001, Moody's Investors Service and Standard & Poor's rated a total of $7.16 billion of secondary-market muni derivatives, which is well ahead of the total of $5.5 billion for the first quarter of 2000.
Mitchell Wein, managing director at PNC Capital Markets, said that total volume of secondary-market derivatives in 2001 will be higher than last year, and he expects it to exceed $30 billion.
Secondary-market derivatives, especially tender option bond programs, become more attractive to investors as the yield curve steepens, said Wein.
Tender option bond programs are devices for creating short-term tax-exempt securities that put tax-exempt bonds into a trust that then issues securities. When the yield curve steepens, the spread increases between long-term bond rates and short-term bond rates, thus creating profit opportunities.
"Subject to the overall level of long-term interest rates, tender option bond opportunities increase as the yield curve steepens," Wein said.
Peter Shapiro, managing director of Swap Financial Group, used the taxable market to highlight the steepening interest rate curve by comparing short- and long-term rates on January 2, just prior to a series of Federal Fund Rate drops, and again on June 11.
On January 2, one month LIBOR was at 6.55%, two-year Treasury notes were at 4.86%, and 10-year Treasury bonds stood at 4.92%.
On June 11, one-month LIBOR had dropped to 4%, two-year Treasuries slid to 4.09%, but 10-year Treasuries rose to 5.29%.
Between the two dates the yield curve steepened appreciably as one-month LIBOR dropped by 255 basis points, while 10-year Treasuries actually increased by 37 basis points.
Shapiro noted that tax-exempt curve had not responded as dramatically as the taxable curve, but it had steepened sufficiently to make market players "want to take advantage of the floating-rate market."
Moody's analyst Michael Loughlin said that as investors become familiar with tender option bond programs, more programs appear, which increases volume. "Buyers of these products have become much more comfortable with buying them; therefore with comfort comes more demand," he said. "There are a lot more programs now than there were several years ago ."
One of the tender option bond programs that has experienced an increase in volume is the MERLOT (municipal exempt receipts-liquidity option tender) and BRUT (bullish receipts-unable to tender) program run by First Union National Bank in Charlotte, N.C. To provide bonds for the program, First Union increased its municipal bond holdings by 25.8% to $1.914 billion at the end of 2000, compared to a year earlier, said Arati Randolph, a spokeswoman for First Union.
The MERLOT and BRUT program consists of a tender-option, floating-rate piece with a market-adjusted rate, and a residual piece with a rate set by subtracting the floating rate from the rate of the underlying bonds that are deposited into a trust.
Other puttable variable-rate derivatives with a residual component include the J.P. Morgan Securities Inc. PUTTERs (puttable tax-exempt receipts) and DRIVERs (derivative inverse tax-exempt receipts) program; and the Salomon Brothers Holding Co. ROCs (reset option certificates) and ROLs (residual option longs).
Another factor driving tender option bond programs is the appetite money market funds have for high-rated, short-term, tax-exempt paper. The continuing instability in the equity markets has sent droves of investors into the relative safety of tax-exempt money market funds.
Total assets for all tax-free money market funds hit a record $249.8 billion on April 9, according to the Money Fund Report, a service of iMoneyNet, Inc. At the end of 2000, tax-free money market fund assets totaled $233.8 billion, and at the end of 1999 they totaled $199.6 billion.
John Hallacy, first vice president and manager of credit research for Merrill Lynch & Co., noted that there is "a lot of money in tax-exempt money market funds, and those money market funds need to be invested."
