Nine days after New Jersey set a market record for the largest swap in municipal market history, California yesterday broke the record again, splitting a $1.25 billion note deal among four swap providers.
The variable rate portion of the California deal was the last leg of a $5 billion note offering. On Wednesday, Lehman Brothers as senior manager priced $3.75 billion of fixed-rate notes.
The swap, which allows the state to issue variable-rate debt but pay at a fixed rate, beats by $250 million last month's $1 billion swap from New Jersey.
California split the swap into five equal pieces, but limited bidders to no more than $500 million apiece.
Morgan Stanley & Co. submitted the two lowest bids, taking the first two portions. Citicorp Securities Markets, Merrill Lynch Capital Markets, and First Boston Corp. each took single $250 million portions with the next best bids.
Peter Shapiro, manager of the municipal derivatives unit at Citicorp, said one of the most attractive features of the deal was that California structured it to allow the swap providers to also act as remarketing agent for the variable-rate bonds, a feature the New Jersey deal lacks.
The advantage, Mr. Shapiro said, is that the swap provider is responsible for the remarketing that will ultimately determinate the firm's variable rate payment, and is not forced to rely on the success of someone else's remarketing effort.
Because the swap payments are based on the bond's actual variable-rate, rather than a market index, they generate no basis risk associated with differences between an index and the actual rate.
"So, performance of the remarketing agent is critical because that's what sets the rate," Mr. Shapiro said. "If you're the remarketing agent, you're in control."
A spokeswoman for California Treasurer Kathleen Brown said the deal was structured with the remarketing feature "because we thought it would be in the state's best interest in getting the lowest swap rate."
Mr. Shapiro added that Citicorp did not bid on the New Jersey deal because it lacked the remarketing feature.
Morgan Stanley, in bids market sources called "extremely aggressive," won the first piece with an offer of 2.095%, plus a remarketing fee of six basis points. It took the second with a bid of 2.18%, and a remarketing fee of six basis points.
Citicorp's winning bid was 2.30%, with a remarketing fee of 12.5 basis points; Merrill Lynch won a piece with a bid of 2.36%, and a remarketing fee of 7.5 basis points; and First Boston's piece came off a 2.395% bid, and a four basis point remarketing fee.
The liquidity facility was handled by a team of nine banks headed by Morgan Guaranty Trust Co. of New York. The liquidity costs were 22.5 basis points, according to sources involved with the deal.
The other banks on the team were the Bank of Tokyo, Credit Suisse, Canadian Imperial Bank of Commerce, Dai-Ichi Kangyo Bank, Industrial Bank of Japan, Swiss Bank Corp., Sumitomo Bank, and Union Bank of Switzerland.
California paid about 3.18% on a its fixed rate note sale Wednesday, including fees associated with the deal.
The all-in costs of yesterday's swap were 2.574%, or about 61 basis points less. On a $1.25 billion deal, the savings to the state were almost $4 million, market sources said.
"What you're seeing here is another major state using the derivatives market to obtain significant savings that wouldn't be available elsewhere," Mr. Shapiro said. "It's a sign of the innovative thinking going on in major state governments today."
The Series V notes are rated MIG-2/VMIG-1 by Moody's Investors Services, SP-1/A-1 by Standard & Poor's Corp., and F-1-plus by Fitch Investors Service.
While Moody's and Fitch gave California the highest ratings possible on the notes, Standard & Poor's was lower than last year's A-1-plus rating.
"Despite the overall success of this note sale, the investors and rating agencies remain concerned about the state's short-term financial health," Ms. Brown said in a release.
Lehman Brothers served as senior manager on the New Jersey deal. That swap was executed on Wednesday, Sept. 23.
The Treasury market rallied one point higher on the long end yesterday.
But late in the day, Texas billionaire Ross Perot announced he was re-entering the presidential race, and Treasuries came off their highs.
Municipals were not affected by the news, but it added more uncertainty to the market, traders said.
Tax-frees were dragged 1/4 to 3/8 point higher in sympathy, with the strongest demand from crossover buyers in the 10-year range and under, traders said.
The credit markets were encouraged after The National Purchasing Managers' index dropped to 49.0% in September, down from 53.7% in August. This is the first time the index fell below 50% sine, registering 52.4% in February.
A reading below 50% indicates the manufacturing economy is generally declining; a reading above 50% means it is generally expanding.
But municipals failed to move as high as Treasuries because supply and the uncertain outcome of tomorrow's jobs report stifled activity.
The approximately $11 billion of cash expected to flow into the hands of municipal bond investors from October 1 coupon payments and redemptions had virtually no impact on the market yesterday, traders and analysts said.
Some dealers estimated that investors might put cash from the redemptions to work as early as this session. Others said it could take up to two weeks to for the cash to funnel into the market.
In addition, any market movements due to the cash inflow may be difficult to determine because the activity may be skewed by reaction to today's employment report, dealers added.
Many market players have argued that any tax-exempt rally would be limited by an influx of more supply, as issuers race to borrow at the lower interest rates.
"The Treasury rally helped new deals move along, but any improvement will bring more deals and that will keep the lid on it," said the head of a major Wall Street-based trading desk. "It's going to take something very significant to get us to the point where supply isn't a problem."
Recently, crossover buyers have queued up to purchase short and intermediate securities, which are attractive to the Treasury market.
But investors have been selective about long-term rates, even though the long end also remains attractive to Treasuries.
"If we can get more investment flowing in, we could make progress," said the director of municipal analytics at a major Wall Street firm who asked not to be named.
"Most managers sound like they're concerned about getting into the market, but they say they're fully invested."
Some market players argue the largest deals have been priced. And once $1.4 billion of North Carolina Eastern Municipal Power Agency bonds are sold, they noted, the market will have worked its way through enough supply to participate in a potential rally.
"The North Carolina deal is costing the market 20 basis points," Joe Dean, vice president and managing director at Shearson Lehman Advisors, said. "Relative to taxables, we're still too cheap. There's more than enough money in the system. And if that deal goes, we'll have a riot on our hands."
The North Carolina deal was tentatively priced on Sept.22., but was pulled from the sales block later in the day, due to market conditions.
A North Carolina finance official said yesterday meetings about the deal between the state and the power authority were ongoing.
Market sources said there was rumor on the Street that the issue could be priced next week.
Other players acknowledge that the market could make short-lived gains when supply eases. But they insist interest rates are attractive enough to issuers that the ensuing flood of new deals would overpower a rally.
"Even if the North Carolina deal gets done well, at these interest rate levels, we should see issuers come back in," said Peter J.D. Gordon, owner of Peter J.D. Gordon Inc. "We're seeing more crossover buying in the 10-year and under range, but issuance will continue to keep a cap on the market."
Traders reported moderate activity throughout the session as players positioned themselves for today's jobs report.
Some blocks of bonds in the $5 million to $10 million range were said to have changed hands, including $10 million Northern California Power 5 1/2s of 2023. The bonds were said to have traded to a permanent investor and were offered at 6.18%.
In follow-through business, Lehman Brothers, senior manager for $261 million City and County of Denver, Colo., special facilities airport revenue bonds for the United Airlines project, freed the issue from syndicate restrictions.
Paine Webber Inc. released $446 million Puerto Rico Electric Power Authority bonds from syndicate restrictions. In late action, the maximum term bonds, the 6 1/4s of 2017, were quoted at 97 3/8-bid to yield 6.463%, compared to the original 6.494% reoffering yield.
In late secondary trading, the authority's AMT 6 7/8s of 2032 were quoted at 7.20%, less 1/8 to the net. They were originally priced to yield 7.20%.
In secondary dollar bond trading, prices were unchanged to up as much as 1/2 point in spots.