The following article is reprinted from the Quarter 1, 2007 issue
of On the Edge, the Interactive Data Fixed Income Analytics Quarterly newsletter.

Municipal Markets

Teri Geske
Senior Vice President, Product Development

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The municipal market has become an increasingly important area of focus for BondEdge, as a growing number of our clients manage portfolios that include municipal securities and need analytics that can support these efforts. This is partly attributable to the growth in the wealth management industry but is also driven by the increasingly sophisticated demands of investors who hold municipals and now require more comprehensive reporting, index comparisons and performance analyses than in years past. In addition to the muni reporting, simulation and attribution capabilities already available in BondEdge, version 5.5 (available beginning January 31, 2007) offers a number of new muni-related features. We are also pleased to confirm that we will be providing Lehman Muni indices constructed from constituent-level information in the first quarter of 2007.

In this article we take a look at some of the trends in the municipal market over the past 15 years. As shown in the chart below, the market has grown significantly over this time. There does appear to be some cyclicality in the issuance pattern, but the long-term trend is clearly upward.

Long-term debt issuance exceeded $400 billion in 2005, compared to $128 billion in 1990, for a cumulative average growth rate of over 12%:

Security Characteristics

Unlike the taxable credit market, the majority of municipal bonds are callable, as it is critical for states and municipalities to retain maximum flexibility with respect to their borrowings relative to sources of revenue (tax receipts, etc.) and infrastructure development plans.

This characteristic of the muni market highlights the importance of having robust analytics for managing portfolios of municipal securities. Muni managers have often relied on the rather simplistic measure of duration-to-worst, which although easy to compute, understates true duration in a low-rate environment and overstates true duration in a rising rate environment. In contrast, option-adjusted durations and convexities in BondEdge give an accurate assessment of a portfolio's interest rate sensitivity and are particularly important in this market where callability is ever-present. Furthermore, the "muni duration beta" feature in BondEdge allows managers of blended (taxable and tax-exempt) portfolios to intelligently combine the durations of their muni and taxable holdings to reflect the relationship between interest rate shifts in the tax-exempt and taxable markets.

Another important aspect of the muni market is the popularity of variable-rate demand notes (VRDNs) whose coupons are set by auction every N number of weeks (typically every 4 or 5 weeks, but sometimes as often as weekly). Since the holders of these notes can put them back to the remarketing agent at each auction date, the price of a VRDN tends to stay very close to par and its duration is thus quite small – about the time to its next reset date. However, since the coupon rate is reset based on some externally observable index (as with FRNs in the taxable market with coupon formulas based on LIBOR or some other market index), we cannot calculate or predict a VRDN's future coupon rate. In BondEdge, VRDNs are modeled in the Money Market model, with a secondary sector = VRDN. This automatically assigns a fictitious index of "AUCT" (for "Auction") in the security's coupon formula and allows BondEdge to treat the security as a floater for analytical purposes, resulting in a very short duration. With version 5.5, we are expanding the choice of reset frequencies in the Money Market-VRDN model.

Investor Base

The Bond Market Association (now known as SIFMA) estimates there are over 2 million municipal issues in investors' hands. Individuals, i.e., the sum of Households (which includes bank trust departments) and mutual funds (including closed end funds and money market funds) comprise more than 70% of the investor base. Property and casualty insurance companies are the next largest set of investors at around 13%. The remaining investors are banks and corporations. Some investors are crossover, or arbitrage, investors who buy munis when they are particularly attractive relative to other fixed-income asset classes.

Given the large number of municipal issues it is important to have a comprehensive source of securities data. BondEdge clients can automatically access complete descriptive data from the municipal securities database maintained by our sister company, FT Interactive Data, including call schedules, pre-refunding data, credit ratings and other pertinent information, as well as daily prices on these securities. For clients who prefer to use JJ Kenny data, we have a link to that data source as well, or you can bring in your own data from a proprietary source, if desired.

We hope this review of the Municipal securities market has been useful. If you have any questions about the features in BondEdge for managing portfolios or are interested in subscribing to the Lehman Muni Index data, please contact your Interactive Data Fixed Income Analytics Representative.