With standard interest rate swaps now becoming firmly established in the municipal market, Wall Street is encouraging issuers to try derivatives based on more esoteric swaps.

Until now, the tax-exempt swap market has been dominated by transactions that exchange a series of fixed-rate interest payments for a series of floating-rate payments.

But now Wall Street is planning to serve up a host of new tax-exempt, embedded-swap products based on credit spreads, yield curve spreads, and even the difference between taxable and tax-exempt rates.

This week, for example, Lehman Brothers sold $11 million of a Virginia issuer's tax-exempt bonds with an embedded swap based on the 10-year constant maturity Treasury rate, a taxable market rate. And Merrill Lynch & Co. considered adding an embedded swap product, based on the spread between short-term taxable and tax-exempt rates, to the $1.1 billion Puerto Rico Transportation and Highway Authority issue priced Wednesday. In the end, however, the deal was sold without the new product because the legal work could not be completed in time.

Institutional investors with specific requests are driving the market, derivatives professionals say. These investors want new products both to hedge risks in their existing portfolios and to make bets on a variety of interest rate spreads.

Embedded swap products allow investors to take such positions and still receive tax-free income. Often, the positions could be duplicated in the taxable swaps or futures markets, but any earnings would be taxable.

"In tax-exempt funds, I think one of the primary goals is to provide income in a tax-exempt format," said David Johnson, a portfolio manager at Van Kampen Merritt. "So the ability to embed various portfolio structures into a tax-exempt structure is beneficial."

Issuers have been able to save 10 to 40 basis points by issuing variable rate debt and then entering a fixed-rate to floating-rate swap to lock in a synthetic fixed-rate. Similar savings could be gained with the new embedded swap products, according to derivatives professionals.

Issuers take a cautious but optimistic view of the new embedded products.

"We're willing to do new products but only after we study them thoroughly," said John Haupert, treasurer of the Port Authority of New York and New Jersey. The Port Authority has issued bonds with standard swaps embedded, but officials have not seriously evaluated more esoteric swaps yet, he said.

"The level of complexity is important. We have a limited amount of time for review. We may pass on a very complicated proposal even if it would save us 10 basis points," Haupert said.

A number of derivatives professionals said they had proposed new types of embedded swap products to New York City for its upcoming deal, which is expected to be priced on July 20.

"We hope to lower the city's borrowing costs by bringing a broader range of buyers to the market," said one professional who had submitted a proposal.

The city received 11 different derivatives proposals, including some new embedded swap products, according to Roger Anderson, the city's bureau chief for debt sales. Anderson said city officials are still evaluating the proposals.

Issuers have executed other types of swaps, including foreign currency swaps by New York City and the Kentucky Development Finance Authority, that exchange interest payments denominated in dollars for payments denominated in yen. But the issuers did not pass through to investors the changing interest payments based on the swaps.

On Wednesday, Lehman Brothers sold $11.2 million of a $43.7 million refunding issue for the Industrial Development Authority of the City of Winchester, Va., with an embedded swap based on a 10-year, taxable rate.

For the first five years the 22-year bonds are outstanding, they will pay investors a portion of the 10-year constant maturity Treasury rate minus a fixed spread of 1.45%. Interest is paid twice a year, based on the CMT rate at the time the interest is calculated.

After five years, the noncallable bonds convert to a fixed 5.50% rate. The issuer will enter an offsetting swap with Lehman Brothers, locking a synthetic fixed rate of 5.50%, a savings of 10 to 15 basis points over conventional noncallable bonds, according to bankers involved with the transaction.

The CMT rate is released by the Federal Reserve once a week and is based on an interpolated yield for a theoretical bond due 10 years from that specific date. The interpolation is based on bid-side quotations on actively traded Treasuries provided to the Fed by five major dealers in the government securities market.

The bonds are not based on the actively traded benchmark, or "on-the-run," 10-year Treasury note. The benchmark is generally only replaced four times a year, when the Treasury sells new 10-year notes. For the rest of the year, the benchmark note's maturity is not exactly 10 years, but slightly less.

According to Lehman Brothers, the new bond, called a CMT Step Up Recovery Floater, or SURF, allows investors to profit from rising intermediate-term rates, especially if taxable rates rise faster than tax-exempt rates.

At present, the rate on similar maturity municipal bonds is 91% of the 20-year constant maturity Treasury rate, according to Lehman Brothers.

"That's historically high, and we're expecting tax rates to rise. The ratio should definitely decrease," said one portfolio manager who is looking for ways to profit from the decrease. Although he was not offered the SURF bond, "I'd consider it. It could be the most efficient play, depending on the pricing," the manager said.

The total return on the SURF bond will dramatically outperform that of a conventional bond if rates rise, even if the spread between tax-exempt and taxable rates stays the same, according to Lehman's models. If rates decline and the spread is constant, the conventional bond performs better, but by a smaller margin. And as the spread widens, the SURF bond's total return will receive an additional boost.

According to the firm's models, the SURF bond would be less volatile than a similar ordinary bond. Within a variety of scenarios, with long-term interest rates rising or falling by up to 200 basis points, a conventional bond's return would vary between 24% up and 9% down. In the same scenarios, the SURF bond varies only between 11% up and 2% up. If interest rates were to drop even further, the SURF would have a negative total return.

Also this week, Merrill Lynch considered an embedded swap-based derivative for the $1.1 billion Puerto Rico Building Authority issue. The derivative would have allowed investors to profit if tax exempt rates outperformed taxable rates.

Merrill's new product would have paid investors a fixed rate plus the difference between two measures of short-term rates: the Public Securities Association Municipal Swap Index and the London Interbank Offered Rate.

If yields in the tax-exempt market fall relative to yields in the taxable market, the derivative will pay a higher rate of interest.

The authority would have entered an interest rate swap with Merrill Lynch to lock in a synthetic fixed rate. Merrill would pay the authority the Libor rate, and the authority would pay Merrill the PSA rate.

But Merrill was unable to complete the necessary legal evaluations in time to include the new product, a source on the deal said. The work should be completed within a few weeks and Merrill expects to bring the structure to market on another deal shortly thereafter, the source said.

Portfolio managers said they often make special requests for embedded swap products, but frequently they are not satisfied with the structure or pricing of the products.

"I have asked for security with an embedded spread many times, but after the [firms] get back to me with a concrete product, the price is not appealing," one portfolio manager said.

And in some cases, as the Port Authority's Haupert points out, the issuer is unable to commit the time required to evaluate a complex, new product.

As a further incentive to add new derivatives, the municipal market has attracted a host of nontraditional investors in recent months who believe that the tax-exempt market will outperform the taxable market, Wall Street officials noted.

Currently, such investors can buy futures based on the MOB or the MUT spread, which measure the difference between yields in the municipal and treasury markets.

But none of those strategies would provide tax-free income. The Merrill product, by contrast, would pay fully tax-free interest.

New York City considered another type of unusual embedded swap product in April. Bankers Trust proposed a structure that would have paid investors a fixed rate plus a floating rate based on the difference between long-term and short-term rates in the tax-exempt market.

But market demand was inadequate and the Bankers Trust proposal was scrapped, officials on that deal said at the time.

New York is expected to come to market later this month. Wall Street derivatives professionals submitted proposals for the issue to city officials last Friday.

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