Derivatives volume continues to

decline along with the drop in overall

new issues, but some fundamental

factors are making the slump even

more pronounced than the overall


For one, municipal bonds have

recently outperformed taxable

securities. Most municipal swaps are still

priced off the taxable yield curve, so

the rates available to issuers on swaps

have not kept pace with rates on

ordinary bonds.

"It's bit harder to get some

savings when the muni market is

galloping and the [Treasury] market is

hobbling," one swaps professional said.

On recent deals, "we haven't beaten

fixed-rate bonds."

Some of last year's most popular

structures are now out of the money.

"It's tough to get a synthetic

fixedrate deal done. Things that worked

last year don't work this year,"

another derivatives professional said.

Also, volatility rose in the second

quarter, according to analysts at J.P.

Morgan Securities Inc. Higher

volatility means higher prices for options

and hedging products like interest

rate caps, floors, and collars.

Annualized yield volatility on the

Bond Buyer Revenue Bond Index hit

14.51% for the second quarter, up

from 12.53% in the first quarter of

1994, and 7.89% in the second

quarter of last year, the firm said in its

weekly Municipal Market Monitor.

The higher volatility pushed up the

price of some derivatives despite

relatively little change in the underlying

rates. While short-term rates posted

big declines, related derivatives did

not keep pace.

For example, one dealer's price of a

two-year interest rate cap on the J.J.

Kenny high-grade index with a strike

price of 4.00% was 154 basis points in

May when the index was at 3.08%.

At the end of last month, the index

has declined to 2.72%, a

36-basis-point drop, but the price of the cap

dropped only 18 basis points to 138.

Another dealer priced a two-year,

4.00% cap on the Public Securities

Association's municipal swap index

at 108 basis points in April when the

index was at 3.24%. By the end of

May, the index had fallen to 2.87%

but the price of the cap rose to 127


One issuer, the M-S-R Public

Power Agency in California, took

advantage of the higher volatility during the

quarter to sell an option on a swap.

The option runs for two and a half

years and nets the agency $2.5

million if the buyer does not exercise it.

Trading in the municipal futures

contract cooled a bit over the past

week. Open interest in the September

contract peaked last Thursday at

26,618 and closed at 26,372 by the

end of trading Friday. That was still

well above the previous week's close

of 24,805 contracts.

Texas may use a derivative

structure on a portion of a note offering

expected later this summer. The state

has $1.4 billion of notes maturing at

the end of its fiscal year on Aug. 31.

State officials plan to sell between

$1 billion and $1.5 billion of notes for

fiscal year 1995.

Last year, several issuers that sold

notes competitively allowed bidders

to choose a fixed rate or a swap-based

synthetic fixed-rate structure. New

York City completed the first

competitive sale in October, when

Goldman, Sachs & Co. won $250 million

out of a $650 million note offering

with a swap-based structure.

Last July, California used a similar

swap-based structure on a portion of

its $2 billion negotiated note sale.

Smith Barney Inc. has hired

Martion Loat to head the firm's push into

derivatives. In March, Loat left

Merrill Lynch & Co. where he most

recently headed the firm's foreign

currency department.

Loat replaces Alan Marks, who was

promoted to head of global risk

management in May.

So far, Smith Barney has not acted

as a principal in municipal

derivatives deals. The firm has arranged

swaps for issuers with AIG Financial

Products, a subsidiary of the

triple-A-rated insurance company American

International Group. Smith Barney

also manages the sale of bonds

associated with the AIG swap


The firm intends to become a

bigger player in all markets, including

derivatives, firm officials said.

Eventually, they said, the firm will act as a

principal and may develop a

separately capitalized, triple-A-rated

swap subsidiary.

Loat declined to comment.

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