LOS ANGELES -- Bonds sold in March for a start-up toll road in Orange County, Calif., have performed well, but may face a more skittish market in coming months as project-related litigation moves closer to resolution, according to a new J.P. Morgan Securities Inc. report.

"We continue to believe that the economic outlook for Orange County and the willingness of residents to use the toll road will have a far more important long-term impact on the bonds than litigation," said the J.P. Morgan credit update on $1.1 billion of bonds issued by the San Joaquin Hills Transportation Corridor Agency.

Nevertheless, the direction of litigation and status of construction also "will influence the trading patterns of these bonds over the next few years," and it appears "the critical period for litigation may be ahead," the report says.

A temporary injunction granted last month could block construction on a part of the tollway, though the action is not expected to affect the overall construction schedule, the report notes. Other groups may also seek similar injunctions on a broader scale.

Robert H. Muller, managing director of J.P. Morgan's municipal bond research, prepared the update for the firm's Aug. 6 Municipal Market Monitor.

The $1.1 billion senior and junior lien bond financing drew widespread attention when it was brought to market in early March.

Bond proceeds are targeted to finance the toll road, with toll revenues providing primary security for the debt. The lack of a track record, plus potential construction risk, presented a challenge for municipal analysts and portfolio managers alike.

The bonds were rated by only one rating agency, Fitch Investors Service, which assigned a BBB to the transaction.

Despite the complex nature of the credit, prices on the bonds generally held up well in the three months following the sale, the report observed. The 5% San Joaquin bonds due in 2033 and the 6.75% bonds due in 2032 "performed quite well in the second quarter of this year," and finished in the top 20% of bonds in the J.P. Morgan database when ranked by total return.

In an interview yesterday, Muller attributed this performance to both market and credit-specific factors.

Market demand for high-yield paper has remained strong, he noted, and has resulted in a tightened interest-rate spread between higher-and lower-rated bonds. The toll road project itself also has benefited from a "quiet" period, marked by generally favorable construction progress and litigation decisions, Muller said.

In the near future, however, "it appears unlikely San Joaquin bonds will duplicate their second-quarter performance," he wrote.

Credit spreads are already tight, leaving less room for prices on lower-grade bonds to improve relative to higher-rated debt, the report says. But Muller also believes there is "some potential for unfavorable news" in connection with the project itself, largely tied to litigation developments and economic forecasts.

In late July, for example, Muller observed that a superior court judge granted the temporary injunction -- pending a trial hearing -- that effectively blocks construction on a small part of the 15-mile tollway near the University of California-Irvine. Two environmental groups have challenged the university system's decision to sell land for toll road right-of-way, alleging that certain development and environmental processes were violated.

This segment of the toll road "is not critical to initial phases of the project," Muller wrote, and it questionable whether the court challenge will eventually succeed.

But the imposition of the injunction still represents "the first adverse court action suffered by the agency," and occurred at a time when environmentalists and other groups "have stepped up efforts to seek injunctions delaying the start of construction," the report says.

The transportation corridor agency expects some opposition groups to seek injunctions blocking construction of the entire road, in a case directed at the U.S. Department of Transportation, according to the report.

Agency officials might fight such an injunction request vigorously, or possibly seek an expedited trial on grounds they have a strong case, the report says.

All this activity might lead to a resolution of principal legal concerns over the next six months to a year, and a favorable result for the agency could reassure investors, Muller wrote. In the meantime, though, publicity over the litigation might dampen some investor enthusiasm.

The Orange County economy may be of equal if not greater concern to bondholders, Muller wrote, because certain economic trends are lagging projections that were incorporated into a feasibility study for the toll road.

Accordingly, J.P. Morgan believes toll receipts may fall short of so-called base case projections by as much as 4% to 8%.

"Ultimately, however, the sizable coverage cushion from anticipated toll receipts alone, together with investment earnings, should still provide for coverage in excess of 1.3 times on the senior lien bonds during the key initial years following opening," the report says.

Last week, the agency also announced that it is contemplating a crossover refunding of certain senior lien bonds, Muller wrote, but at this point "it is difficult to ascertain what effect, if any, would accrue" to investors from such a move.

A finance official at the agency could not be reached for comment yesterday about matters discussed in the J.P. Morgan report.

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