While the rest of the industry spent 1992 toppling volume records, derivatives desks enjoyed their own version of success, busily detaching calls, imbedding caps, and swapping interest rates with issuer heavyweights.

"The ice was broken on the derivatives market in '91, but in '92 it really began to take off," said Peter Shapiro, a manager of municipal derivatives at Citicorp Securities Markets Inc.

New Jersey made one of the year's biggest splashes in late September when the state signed a $1 billion swap and set a new, albeit short-lived, market record. Nine days later California stole the spotlight with a $1.25 billion deal.

The Municipal electric Authority of Georgia last month took credit for another market milestone, becoming the first issuer to strip call options from a bond issue and sell them as separate securities.

In addition, 1992 also saw issuers welcoming imbedded caps onto the derivatives stage, with a July debut on a Southern California Edison Co. revenue bond series underwritten by Goldman, Sachs & Co. The product continued the trend toward building derivatives into new-issue coupons in order to preserve tax exemption, rather than sell them as separate taxable products.

In fact, several derivatives professionals called the growth of the imbedded derivatives market, which began last year with imbedded swaps, one of the most important developments of 1992, laying a foundation for continued evolution next year.

In an imbedded cap deal, variable-rate coupons are designed to pay off in structures tailored to the specific needs of a given investor. The savings to the issuer comes from the investor's willingness to pay above market rates for a product fashioned around the needs of his portfolio.

The products are being marketed as especially usedful to investors who own inverse floaters, which pay higher yields as market rates decline. Now that some market analysts are predicting stable or gradually rising rates, investors exposed to inverse floaters need hedging devices like imbedded caps, which pay higher yields as market rates rise.

"Now investors have [inverse floaters] in their portfolios, and they need to hedge and balance that portfolio and achieve other objectives," said Sheldon L. Sussman, a senior vice president at Lehman Brothers.

Joshua Siegel, a vice president of municipal financial products at First Boston Corp., added, "This was the year when buyers had a much stronger role in terms of dictating what kinds of products came to market."

Citicorp's Shapiro agreed that investors' changing interest rate expectations will feed the market for imbedded products heading into next year.

"In 1993, we still see an appetite on the investor side for products which will either boost yields during this period when yields are unsatisfactorily low or will protect investors' principal from loss if and when interest rates rise," Shapiro said. He said imbedded derivatives offer the best way to achieve either goal.

But whether an issuer uses derivatives will still depend on factors other than pure economics. For example, the frequency with which an issuer comes to market might also play a role, said Richard E. Kolman, a manager in Goldman Sach's underwriting department.

"If you're a one-time issuer, it might not be worth going through all the extensive work educating bond commissioners and others," Kolman said. "Sometimes by the time you get all that done you might have missed the market, and a more traditional financing might have been more cost-effective."

Corporate treasurers, on the other hand, are much more flexible in their ability to make decisions on the use of new derivatives products, he said, which is one reason derivatives products are utilized so much more frequently on the taxable side.

That dynamic is more true for imbedded products than for interest rate swaps, which although still considered exotic by many issuers' standards are becoming standard fare for top market names.

~Validation' for Swaps

This year's massive California and New Jersey swaps, besides breaking market records for the sheer size of the issues, were also noteworthy in terms of the players involved. The use of swaps by two major issuers brought a new aura of legitimacy to the product for issuers who may not yet have made up their minds whether to pursue the technique, market sources said.

"It provided validation in a visible way that these approaches save money, and it showed how a municipal issuer can take advantage of the swap market when it's out-performing the municipal market," said Sussman of Lehman Brothers, which won New Jersey's entire $1 billion swap contract.

Citicorp's Shapiro added that "while it was the case two years ago that discussions of swaps were a rarity, today the typical issuer starts out asking. ~Could I use a swap?'" But while swaps are constantly gaining broader market acceptance and are to some extent better understood by issuers, Shapiro said the market remains "arcane" to most segments of the industry.

The New Jersey and California swaps also generated heated discussion among swap providers on the different way each issuer structured deals.

California gave swap bidders more control over their ultimate costs by allowing them to act as remarketing agents on the underlying bonds. New Jersey, in contrast, sought bidders after already promising Kidder, Peabody & Co. that it would be remarketing agent, responsible for determining the new daily interest rate by reselling the notes put by investors each day.

Many swap providers said they bid more conservatively on the New Jersey deal because of the difference, and a few said they refused to bid at all. Robert Martin, manager of Kidder Peabody's municipal derivatives products operation, said separating the remarketing agent from the swap provider has not affected New Jersey's market performance.

"The numbers simply speak for themselves," Martin said. "As of Nov. 23, the average rate for New Jersey was 2.31% versus the average for California of 2.35%, with virtually identical letters of credit. The floating-rate market doesn't seem to care who the swap provider is."

Still, other market players predict most new swaps will be structured to allow swap providers to also remarket the bonds.

A further indication of the maturity of the swap market is a decline in the bid-asked spread on swap deals, which market sources say have been dropping dramatically on recent deals. The spread used to be as high as 30 basis points, but recently has fallen to between 5 and 10 basis points on a typical swap deal, one source said, adding that the trend indicates a broader range of bids reflective of a maturing market.

The Georgia utility's detachable call deal broke vital new ground for derivatives professionals dreaming of an over-the-counter options market for municipals, several dealers said. First Boston Corp. was senior manager for the issue and acted as a co-agent with J.P. Morgan Securities Inc. on structuring and underwriting the sale of the calls.

Municipal issuers sold almost $2 billion of detachable call options before the Georgia deal, but none of the options have ever been used. The actual stripping of a deal and the selling of options to investors marked a tangible beginning for the option market.

"Now I think it's a real product that people will have to pay attention to," one derivatives professional said. But he added that as the market develops, important disclosure issues would have to be addressed. For example, he said it is currently difficult to determine in the secondary market whether the call on a particular bond is detachable. That information would affect investment decisions regarding the likelihood of a call.

While the Georgia deal captured much of the derivatives market's attention in 1992, other derivative providers continued quietly chugging away in niches they established in years past.

AIG Financial Products Corp., for example, is still one of only a handful of names in the industry providing issuers with swaps whose maturities match the underlying bonds. The company, which has formed a loose alliance with Smith Barney, Harris Upham & Co. to offer municipal issuers with swaps, most recently provided the New Jersey Sports and Exposition Authority with a swap on a $210 million, 32-year issue in November.

The firms' success in providing maturities that long, while most other deals barely reach 10 years, have left many of AIG's competitors baffled. "A lot of us in this market continue to be amazed at the pricing which AIG is offering on these long-dated swaps," one swap provider said. "They seem to be at interest levels which are so much lower than where anyone else would want to do them that some of us believe they're not looking at the right screens."

Rating agency and AIG officials peg the firm's success to its triple-A credit rating, which they say provides enough comfort for municipal counterparties to take such extended exposure to the insurance giant. In addition, AIG is active in many global derivatives markets, some of which offer the company more effective hedges against municipal exposure than are available to other swap providers.

New Players

In addition to the usual players becoming more involved in derivatives products, bond insurers became more active in 1992 as well. Municipal Bond Investors Assurance Corp., for example, entered the derivatives field with a new tender option program that turns long-term bonds into synthetic short-term instruments, which MBIA says are in short supply.

Several market players said any firm that is not currently involved in derivatives will soon be forced to make an effort, or watch market share and profitability decline. That incentive, as well as favorable market trends expected in the coming months, are likely to help 1993 expand on the success stories of this year.

The huge numbers of redemptions coming next year, for example, mean a lot of cash will flow to investors, and that bodes well for further evolution in the derivatives market, said Donald C. Carey, manager of First Boston Corp.'s municipal financial products group.

"When all this cash comes in, it will be possible to do more with derivatives and synthetics, as investors are under the gun looking for better ways to get their returns higher," Carey said. "That's an incentive to issuers to agree to more innovative structures in exchange for savings."

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