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
"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
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
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
Loat declined to comment.