06/11/07
by Matthew Hanson, The Bond Buyer
LOS ANGELES — A mad grab for yield by both traditional and new municipal investors makes the market ripe for sell-side parties to continue injecting structured-like innovations into the muni market.
Speakers on a panel at The Bond Buyer’s National Municipal Derivatives Institute said Thursday that deals modeled after collateralized debt obligations are one area they expect to grow.
The four panelists helped design, rate, and sell the first such tax-exempt deal, Non-Profit Preferred Funding Trust I, which began selling in the fall. All of the deal’s certificates are now sold, though the portfolio is still in a ramp-up period, said Andrew Hohns, a managing director at Cohen & Co.
Like the CDOs found in other fixed-income markets, this tax-exempt deal takes an underlying pool of credits and repackages them into stratified tranches, allowing investors to buy trust certificates rated as high as triple-A and as low as an unrated equity-styled level.
Merrill Lynch & Co. and Cohen underwrote the Non-Profit deal, while Shattuck Hammond Partners LLC and Non-Profit Capital LLC advised on it and Sidley Austin LLP was special counsel to the trust. Cohen will also help manage the portfolio of underlying credits.
“For many years we have been trying to figure out how to get it into the municipal marketplace,” Hohns said.
One of the main barriers to creating the deal — which they referred to as a structured tax-exempt pass-through, or STEP — was finding ways to maintain the tax exemption for investors who bough certificates in the trust, said Max Von Hollweg, a partner at Sidley Austin.
Von Hollweg said the concept of a municipal CDO is a misnomer. If the deal actually used the underlying bonds as collateral or provided debt obligations to the investors, then the investors’ income would be ineligible for the tax exemption, he explained.
“So we don’t have the 'C,’ we don’t have the 'D,’ and we don’t have the 'O,’ ” Von Hollweg said. “That’s precisely how we are able to successfully pass through to investors at the certificate class to create tax-exempt income from that underlying pool of assets.”
Another major part of bringing a STEP to the marketplace is finding issuers that agree to raise funds with this structure, rather than simply selling municipal bonds. One criticism voiced against the potential growth of STEP-like deals is that there are not enough reliable jurisdictions willing to raise capital using this type of transaction.
But Hohns said that his canvassing for issuers to include in Non-Profit has turned up thousands of potential issuers. He estimated there are probably 3,000 Non-Profit-type issuers big enough to access capital markets on their own, 15,000 too small to sell muni bonds, and 200,000 that are willing but have no business selling debt.
A January Fitch Ratings analysis of the Non-Profit deal shows that about 40% of the underlying debt was to be health care-related and 25% was going to be from the education sector. Though many of the underlying credits were unrated or below investment grade, more than 75% of the STEP certificates were given Fitch’s AAA rating.
When talking to investors, the group worked to make the certificates operate as much like municipal bonds as possible, panelists said. Traditional muni investors could become the main buyers of certificates in STEP-like deals, they said.
Even with rumors that another, similar deal is being put together, the market for these new tax-exempt structures is still in its infancy. But Hohns, who has developed CDOs from other fixed-income asset classes, is bullish on their potential for growth in the muni market. “I have yet to find a market where participants didn’t buy in once they understood and got comfortable with it,” he said.
© 2007 The Bond Buyer and SourceMedia Inc.
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