WASHINGTON - The muni-CPI market is doomed to stagnation, some say, because too many variables are required to fall into place before a deal makes sense.
Others argue that the whole market can take off with a couple more high-quality deals or a bump up in consumer prices.
"What's going to happen is we need more inflation," said one public finance professional familiar with the three bond issues this year whose yields are linked to the consumer price index. "We are at a historic bottom. We can go almost nowhere but up."
Although some buyers say the offerings they've seen were simply too rich for their blood, others are more optimistic.
"The deals are becoming more reasonably priced, although it's certainly not a mature market yet," said one fund manager. "The first deal came at astronomical prices."
The three deals also represented a decline in the underlying credit, from Orlando to Gulf Breeze, Fla., to Adventist Health System/Sunbelt Obligated Group, an Illinois hospital group using the Illinois Development Finance Authority as a conduit issuer. Only the Orlando deal, which Goldman, Sachs & Co. underwrote, came uninsured.
Unfortunately, that's exactly the opposite of what the fund manager said he wants, namely "cleaner-story deals."
And it's likely to get worse. The public finance professional said the economics may only work for lower-grade issuers who can't access the variable-rate market cheaply.
"What I think you're going to see is stronger credits don't have to do CPIs, so only the lower-rated credits will do them," he said. "The same kind of thing occurred in the corporate-CPI market."
Lower-quality issuers have higher expenses for a variable-rate demand bond program, such as an expensive liquidity facility. That might make the CPI market a better option, he said.
Another market participant took partial issue with that.
"I think that is true only to the extent that weaker credits find it more effective to issue fixed-rate paper and swap it into floating-rate paper," said Dan Singer, a senior vice president in municipal trading at Lehman Brothers, which underwrote the Illinois deal.
Singer pointed out that only applies to an issuer who wants a floating- rate liability, but whose cost of purchasing a letter of credit is substantially more expensive than swapping from fixed to floating.
"That's going to be true whether they're issuing CPI and swapping into PSA or fixed swapping into PSA," he said.
On the Other Hand
However, a back-of-the-envelope calculation shows how muni-CPIs could save almost any issuer money, the public finance professional said.
A plain-vanilla, 20-year variable-rate issue can usually garner a rate about 20 basis points higher than the PSA index, he said.
In the muni-CPI market, the issuer could probably get 1.65% or 1.70% above the CPI, and swap out of the CPI exposure for a rate of about PSA flat. That means a savings of about 20 basis points.
The Orlando deal had a spread of 1.25% above the CPI; Gulf Breeze came at a 1.80% spread; and the Illinois authority had a 2.10% margin.
The Gulf Breeze and Illinois hospital pricings are in line given the insured, higher credit-quality swap on the Gulf Breeze bonds, said Peter Delahunt, national sales manager for Raymond James & Associates, which underwrote the Gulf Breeze deal. Another consideration is Florida's appeal as a specialty state, he added.
"What we're really trying to do is match the needs, objectives, and goals of the buy side with the funding targets that issuers have on the borrowing side," said Andrew Garvey, a managing director in Lehman's municipal swaps and investment products group. "We would say virtually all types of municipal issuers are candidates."
Garvey and Rob Taylor, a senior vice president in the group, noted that issuers can theoretically save money and reach their target funding level by issuing muni-CPIs and swapping to a fixed rate, a floating rate, or not swapping out of the CPI at all.
But so far, they said, all deals - including most corporate CPI bonds - have included a basis swap back to the issuer's desired index, such as PSA or the London Interbank Offered Rate.
Issuers may want to refrain from swapping out of the CPI if some aspect of the bonds' revenue stream is also tied to inflation, Singer said. Sales tax revenue bonds are prime candidates for a CPI issue.
The catch is that the local inflation rate may vary from the national CPI, he noted.
Just as strong issuers can borrow cheaply in the fixed-income market, they can save money with muni-CPI deals.
"There's a reality in the marketplace about different types of issuers and how their bonds trade," Singer said, noting that the transactions that have come to market so far were either strong underlying credits, specialty states, or insured deals.
"Right now, especially given the relative newness and novelty of the product, you want buyers to focus on the product and not have to focus on the credit."
The Buy Side
Although some fund managers complain that 1.25% to 2.10% is a low rate of return, Delahunt said the numbers are competitive compared to historical real returns.
According to Ibbotson & Associates, real returns on long-term government bonds from 1925 to 1993 averaged 1.39% after taxes. In the stock market, real returns for the 10 years ending 1982 averaged negative 3.7%. Subtracting the annual CPI from the annual Bond Buyer 20 index from 1955 to 1995 gives an average real rate of return of 1.5%.
According to Bloomberg numbers, the CPI averaged 3.54% from 1983 to 1997, with a low of 1.2% and a high of 6.3%. That would give an average coupon of 5.34% for the Gulf Breeze deal.
The CPI bonds are less than likely to develop into an actively traded market, Delahunt acknowledged.
"Though it's an emerging market security, it's actually a conservative investment, because it's more of a buy-and-hold investment," he said. "It's for someone who wants to lock in a specific real rate of return protected against inflation."
Fund managers can put muni-CPIs into their core portfolio and not have to worry about inflation exposure, Delahunt said. That frees up more time for managers to squeeze performance from the actively traded part of the fund.
Singer pointed out that inflation protection means more on a tax-exempt basis, since income taxes erode returns as inflation rises.
For example, he said, take an investor in the 35% tax bracket buying a 10-year taxable CPI bond that yields 350 basis points over the CPI. If the CPI rises to 6.5%, the real rate of return shrinks to zero - 35% of the 10% coupon payment is 6.5%, the same as the CPI.
"On the muni side, that cannot happen regardless of how high inflation goes," Singer said. "It presents a much more attractive opportunity."
Target buyers include property and casualty companies, crossover buyers from the taxable side, money managers, investment advisers, and possibly even retail.
"The potential is for a relatively wide universe of buyers," Singer said.
He remains optimistic about the future of the market. "Each deal brings out more people," he said.
Those who buy early on often get the best deals, because spreads for new products are typically too wide, Singer added.
The public finance professional agreed. "One of these days," he said, "those people will be viewed as visionary investors."
