As 1993 winds down, municipal market strategists and generalists are already tuning their barometers to 1994.
In that vein, several of Wall Street's most respected and intrepid prognosticators have proffered their forecasts of major trends in the coming year.
"When you get into a major structural change in the economy, it opens the door for some major changes in the municipal bond market," said Richard A. Ciccarone, director of fixed-income research at Kemper Securities Inc.
Health care, the credit quality of general obligation bonds, and the credit quality of bond insurers will be key areas to watch next year, Ciccarone said.
Analysts at J.P. Morgan Securities Inc. forecast new money issuance at $110 billion in 1994, up only $10 billion from their $100 billion forecast for 1993.
Conversations with large issuers and states indicate that some project financing was done in advance and that new issuance won't be needed to fund 1994 projects, said Christopher M. Dillon, vice president of municipal market strategies at J.P. Morgan.
"We always have to be concerned that the investor side of the market has become so concentrated in mutual funds," said Aaron Gurwitz, vice president and manager of municipal capital markets at Goldman Sachs.
"If a large number of funds started to see net redemptions, it could be a problem," Gurwitz said, citing a similar occurrence in 1987.
However, the growth in intermediate-term bond funds indicates that investors are now more astute about the trade-off between yield and risk and could be less likely to panic if net asset values fluctuate, Gurwitz said.
In addition, the growth in closed-end funds - which are immune to redemptions - should help prevent a reoccurrence of the 1987 panic, "but it's still a risk," Gurwitz said.
Dillon and Gurwitz also expect the introduction of more derivatives products that allow investors to benefit from rising interest rates.
Expect to hear more about secondary market disclosure, said William W. Fish, senior vice president and manager of municipal research at Donaldson, Lufkin & Jenrette Securities Corp.
Spreads between bonds of different quality will continue to narrow as the number of insured bonds grow, Fish said.
Declines in interest rates and investment returns may force pension funds to boost their contributions to retirement funds. This could force some funds out of fixed-income securities and into equities, and might also be yet another drain on municipal coffers, Fish said.
Aaron Gurwitz
Goldman Sachs
A decline in issuance in 1994 may push municipal bond yields lower relative to Treasuries, said Aaron Gurwitz, vice president and manager of municipal capital markets at Goldman Sachs.
Over time, municipals could become less attractive versus Treasuries, although they will continue to maintain their allure for investors in need of tax-free income, Gurwitz said.
Although pressure for political reform will cause competitive issuance to rise next year, "when issuers realize how much they can save, they will come back, and the trend toward growth in negotiated issuance will continue again," Gurwitz said.
On negotiated deals, "issuers are able to benefit substantially from structuring their offerings in innovative ways," Gurwitz said.
With competitive deals, it's difficult "to make the most of new products and structures."
Gurwitz also sees a bright future for derivatives.
"The creative juices have just started flowing," Gurwitz said. Initially, derivatives products were designed for use in bull markets, but new developments will focus on products de-signed to flourish in declining markets, he said.
Gurwitz also said that credit quality will continue to be tenuous in regions of the country that historically have been heavily dependent on defense spending, such as California and Long Island, N.Y.
George Friedlander
Smith Barney Shearson
Watchwords for 1994 will be "shortage, shortage, shortage," said George Friedlander, a managing director and head of fixed-income strategy at Smith Barney Shearson.
"Volume is going to come down a lot," because refundings will decline, the analyst said. There also will be shortages of bonds in specialty states, he said.
The ratio of new money issues to refunding issues should be about 1 to 1 in 1994, due to the drop in refundings and a modest increase in new money and competitive issuance, Friedlander said.
Meanwhile, the continuing deluge of bond calls will help keep individual demand for bonds high, but shortages will make it more difficult for retail investors to refurbish their portfolios, Friedlander said.
Friedlander is forecasting a continued modest decline in interest rates next year, which will also tend to depress short-term note issuance.
"Money market managers are desperate for paper. What issuer in their right mind wants to take variable-rate risk when rates are so low you can lock in long-term rates of 5.25%?," he said.
Friedlander anticipates that derivatives will continue to be a significant factor in the market because portfolio managers like products they can tailor to their needs.
Richard A. Ciccarone
Kemper Securities Inc.
Interest rates may inch up during the current quarter and the first quarter of next year, before dipping again, said Richard A. Ciccarone, director of fixed-income research at Kemper Securities Inc.
Total new issue volume should fall into the $185 billion to $215 billion range, Ciccarone said.
The Kemper analyst also anticipates a slowdown in the growth of lev-eraged closed-end municipal funds due to the large number of existing funds and concerns about interest rates.
Competitive issuance could grow to 35% to 40% of the market from about 20% now, Ciccarone said.
"With all that's going on in government reform and the reduction in refundings, that takes away some of the reasons for negotiating," he said.
The growing buildup of municipal bonds in insurer's own portfolios could lead to liquidity problems in the future, Ciccarone said. If shareholders of the bond insurance companies push for higher returns on their equity as overall municipal volume falls, it could cause the bond insurers to turn to riskier lines of business. They also might divert more cash to dividend payments instead of building up capital reserves.
James Kochan
Robert W. Baird & Co.
"I think the main concern is going to be the possibility of rising short-term interest rates," said James Kochan, head of fixed income asset management at Robert W. Baird & Co. in Milwaukee.
Rising rates could lead to the "disintermediation" of open-end municipal bond funds due to volatile net asset values," Kochan said.
Whether there is a repeat of the widespread fund selling which followed interest rates leaps in 1987 will depend on how investors react.
Some investors "aren't used to seeing the value of their portfolio drop," Kochan said. That will leave fund managers wondering whether investors will be "quick to pull their money out of these funds at the first hint of a drop in net asset value or market value," he said.
"There's going to be some concern, but I don't think there's going to be a particularly serious problem," Kochan said. "I think investors are smarter than we give them credit for."
Kochan said that two factors should mitigate the turmoil seen in 1987: Interest rates shouldn't rise as much as they did then, and investors will be re-quired to pay only a portion of new tax liabilities by April 15, which should discourage some fund redemptions.
Elsewhere, credit quality could continue to be factor in California and in states such as New Jersey and Virginia where new administrations have campaigned on a pledge to cut taxes, Kochan said.
"There is tremendous pressure on state and local governments to control taxes. They had better also reduce spending or something's got to give, and that could be their credit quality," Kochan said.
Robert H. Muller
J.P. Morgan Securities Inc.
Voter antipathy to higher taxes and a slow construction cycle in areas such as health care and utilities will help keep 1994 municipal bond volume below 1993 levels, according to Robert H. Muller, managing director of municipal research at J.P. Morgan Securities Inc.
Muller also said he will be keeping an eye out for developments in the lease rental bond sector in 1994.
"Due to Brevard County, a lot of state courts are looking at lease rental debt," Muller said.
Market pressures kept Brevard officials from voting against appropriating funds to pay for their securities, so "maybe [lease debt] doesn't have the non-appropriation capabilities once thought," the market generalist said.
While courts are unlikely to strike down outstanding lease-backed securities, they could put the reins on new issues, Muller said.
Aversion to higher taxes and lease financings could prompt more debt to be backed by user fees, Muller said. However, the narrower funding base could make these bonds riskier than other securities.
"You could see more debt alternatives to leases to finance improvements, but it's not going to be a broad, tax-supported bond," Muller said.
In the health-care sector, "the number of losers will grow in 1994," he said.
Reform and the need to control costs will cause spreads between different types of health-care credits to widen as investors distinguish between them. This could lead to better disclosure, Muller said.
"You have an issuer-specific sector with no information," Muller said. "Disclosure will move a lot closer to the front burner, and we're going to find a way to pry information out of hospitals so there's better information for everyone."
Christopher M. Dillon
I.P. Morgan Securties Inc.
Analysts at J.P. Morgan are forecasting total municipal bond volume of about $145 billion in 1994, with $35 billion of that coming from refundings, said Christopher M. Dillon, vice president of municipal market strategies at J.P. Morgan Securities Inc.
That's a big drop from the total of $221.68 billion, including $147.52 billion of refundings, at the end of the third quarter this year.
Taking a contrarian view, Morgan analysts foresee a moderate rise in interest rates during the next few months, Dillon said. The yield on the Treasury long bond yield could hit 6.25% by mid-1994 and 6.40% by the end of the year, Dillon said.
The use of municipal bond insurance should also rise next year, Dillon said. As supply slows and the percentage of insured bonds grows, spreads between higher rated and lower rated securities should continue to narrow, he said.
The scramble to insure a smaller pool of bonds could increase some insurers' tolerance of risk, Dillon said. If insurers write coverage for the riskier securities, it could dampen the market performance of insured bonds, Dillon said.
"When there's less bonds, these people may be stretching themselves to make money, so investors should pay more attention to the un-derlying credit on insured bonds," Dillon added.
Another area of concern that may surface in 1994 is whether the option of selling bond calls will be extended to those issuers do originally sold bonds without detachable calls, Dillon said.
Bonds with detachable calls tend to trade at higher yields than other callable bonds. if the option of selling detachable bond calls is extended, it could change the trading relationships of the securities, and might pose tax consequences as well, Dillon said.
