NEW YORK, March 4 After declining for years, the outstanding amount of U.S. variable-rate demand bonds could begin to hold steady because of rising interest rates and improving credit conditions for the banks that support such debt, Moody's Investors Service said in a report released on Tuesday.
Outstanding balances of such bonds fell by $35 billion in 2013, the fifth straight year of declines. That's similar to reductions in 2012, but less than half of the $79 billion drop in 2011, Moody's said.
"We expect the contraction in outstanding VRDBs will continue to slow in 2014 and that VRDB balances may stabilize near current levels," Moody's said.
Issuance of variable-rate municipal debt fell during the recession. Issuers and investors also began to shun troublesome auction-rate securities, and many big banks, which issued letters of credit that backed variable-rate deals, were downgraded.
About $12.1 billion of variable-rate municipal bonds was issued in 2013, down 9.6 percent from the year before, according to Thomson Reuters data.
But the bleeding could slow and even stop this year, according to Moody's and other analysts.
For one thing, many big banks that were downgraded have regained their previous ratings. And some regulatory tightening, including a revised liquidity coverage requirement under Basel III, has either been delayed or is not as onerous as proposed, according to Jacqueline Knights, director of public finance at The Williams Capital Group, in New York.
"The (variable-rate demand note) market has begun to pick up," she told Reuters recently.
If interest rates continue to rise, more states and other issuers are expected to sell variable-rate debt in order to have a better blend of variable- and fixed-rate securities on their balance sheets, Moody's said.
THE ALLURE OF FLOATING-RATE BONDS
One pocket of the variable-rate world actually increased in 2013 and could remain a bright spot: floating-rate bonds. While issuance of more traditional variable-rate debt shrank in 2013, sales of floating-rate bonds, which are linked to an index like SIFMA or LIBOR, grew 3.8 percent to $11.8 billion, Thomson Reuters data showed.
Highly rated municipal issuers, such as states or major cities, can sell such bonds without a letter of credit, according to Doug Selby, a bond attorney and partner in the law firm Hunton & Williams, in Atlanta.
That's a big deal "because it means for my clients that they can get back into the variable-rate market even if they don't have a letter-of-credit bank, and the market is accepting them," Selby said. "There are big issuers doing it for the first time."
Such deals tend to be done by issuers "that are more sophisticated and have higher-rated credit quality, so they have the capacity to support those bonds from a credit perspective," said Robert Williams, managing director of income planning for the Schwab Center for Financial Research, in San Francisco.
"And there is demand from money market funds for these floating-rate notes."
Both taxable and tax-exempt money market funds "have been starved for supply. That's been the case for five years, even with ultra-low rates," said Peter Crane, president of Crane Data, a Westboro, Massachusetts-based company that tracks money market funds.
Eaton Vance Management also hopes that muni floaters will appeal to rate-sensitive investors looking far down the road.
In the fall of 2013, the firm revamped an existing fund, transforming it into its Floating-Rate Municipal Income Fund.
It's "more of a defensive fund when (short-term) interest rates go up," said Craig Brandon, a portfolio manager at Eaton Vance, in Boston. "One to two years down the road, you're looking at a fund that is going to benefit from a rising economy."