Municipal bond-backed collateralized debt obligations are expected to take off, with the first such deals hitting the market by the end of the third quarter, according to industry sources.

"We have heard from a number of people that are looking to do deals," said Henry Albulescu, of Standard & Poor's CDO group.

Fitch and Moody's Investors Service have also confirmed that there is significant interest in this market (see ASR 3/5/2001).

Last week S&P held a teleconference to discuss the rating agency's methodology on muni-backed CDOs. According to S&P, the muni market is as large as $1.2 trillion, compared to the high-yield market, which is closer to $600 billion.

S&P anticipates CDOs potentially adding substantial liquidity to the muni market. Skeptics, however, point to the lack of "juice," or arbitrage opportunity in the tax-free market, since much of it is insured and highly rated, and spreads tend to be compressed, sources said.

About 98% of the market is rated single-A or above, according to Thomson Financial.

Still, arbitrage is less of a concern to institutions looking to optimize their balance sheets for regulatory capital relief, or to adjust risk exposures.

One of the complexities in structuring these deals is tax issues. For example, would the notes issued by a CDO backed by tax-free debt be tax-free as well? According to S&P, issues like this one are being solved. As it stands, muni CDOs look like they'll be issued to muni investors in the tax exempt market, at least initially.

"You can put tax exempt bonds into a CDO structure, and if you structure the ownership of the CDO properly, you can maintain tax exemption," said Colleen Woodell, of the municipal ratings group at S&P.

S&P also previewed its criteria in last week's issue of Credit Week, where the agency addressed topics such as municipal bond default rates, recovery assumptions, and concentration risk, all of which are unique to each industry sourced by a CDO, the article noted.

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