The short-term, tax-exempt market features a variety of securities designed to satisfy different classes of investors.

There are two broad classes of variable-rate, short-term securities. Some securities are backed only by the issuer, while others are backed by a variety of credit enhancement, such as letters of credit, bond insurance, securitized mortgages, and put rights with liquidity support.

Fixed-rate short-term issuance is straightforward. The securities generally trade as expected, based on trends in the underlying credit and the overall interest rate environment.

Money market mutual funds must buy credit enhanced notes in accordance with Rule 2a7 of the Investment Company Act of 1940. The funds are the primary buyers of variable-rate demand obligations -- securities that have put rights and either a liquidity backing or a letter of credit.

A remarketing agent, usually a Wall Street firm, adjusts the rate on the notes at each reset date. Investors unhappy with the yield can exercise their put rights to dump the notes.

Other investors seeking variable-rate securities, such as mutual funds and corporate treasury departments, have little need for the added expense of credit enhancement. These investors, which are not subject to Rule 2a7, are the primary buyers of unenhanced variable-rate notes. The yields on these securities are reset at a daily or weekly dutch auction.

For issuers, cost is the key question. An enhanced note usually yields less than a similar unenhanced note. But the issuer must pay for the enhancement and sometimes runs the risk that the enhancement will be more expensive in the future or even unavailable.

The fees associated with an auction note are lower, but the issuer pays a higher rate. If the auction process fails, an unlikely but not unprecedented event, the rate rises dramatically.

Tremendous Growth

The investor base for enhanced notes has grown tremendously following the growth of money market mutual funds as an alternative to bank savings accounts. Tax-exempt money market funds had total assets of $114 billion as of May 10, according to IBC/Donoghue's Money Fund Report.

The rising appeal of the funds creates an almost insatiable demand for enhanced products.

The demand is subject to strong seasonal fluctuations since many individual investors use money market funds like bank accounts. When taxes are due in April, when tuition bills must be paid in September, and when holiday gifts are bought in December, investors tend to withdraw more money than they deposit.

The funds must then liquidate some of their holdings, which increases the supply of the enhanced securities, so yields rise. For the past two years, for example, the Public Securities Association's municipal swap index rose significantly in late December and in April. Last year the index also rose in September and October, and is expected to do the same this year. The PSA index reflects the yield on variable-rate demand obligations.

But most of the year, demand outstrips supply, helping the enhanced note market outperform the taxable short-term market. For example, the PSA index was lower at the end of March than before the Federal Reserve Board moved to raise rates on Feb. 4. But the Fed's move sent taxable market indexes, like the London Interbank Offered rate, straight up.

As tax season approached, however, the PSA index rose.

In addition to primary market, short-term issuance, some firms buy ordinary long-term bonds, place the bonds in a trust or partnership, and issue short-term securities backed by the bonds.

Rating Them

Moody's Investors Service said it rated $4.1 billion of such secondary market note structures this year, which included some inverse floating-rate securities in addition to variable-rate notes. Standard & Poor's Corp. also rates secondary market structures but does not provide volume information about short-term structures.

Changes in the regulation of money market mutual funds now under consideration could profoundly alter the landscape of the enhanced note market, opening the door for new players and new innovations.

But some industry participants fear that the regulatory changes proposed by the Securities and Exchange Commission would complicate fund manager's lives without improving investor protection. Some existing providers of credit enhancement that are not commercial banks fear the new regulations will reduce demand for their products.

The proposed rules will probably require more diversification among the credit enhancers. The final rules, expected this year, could limit the amount of notes backed by a single credit enhancer that any fund could own.

One innovation that should expand the universe of enhancers is issuers' use of internal liquidity support to back their note offerings. The trend began among university issuers, which are using the millions of dollars in cash in their endowment fund to back their notes.

Now some states have begun providing liquidity backing, and at rates well below those available from commercial providers. Texas was the first state to offer issuers liquidity backing secured by its investment holdings.

On a variable-rate issue sold by the Texas Veterans' Land Board in February, the state agreed to provide a three-year liquidity backstop for just four basis points plus a commitment fee of two basis points.

Others are following Texas' lead. The California State Teachers' Retirement System recently unveiled a program to provide credit support for up to $1 billion of debt issued by California municipalities.

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