Municipal bonds are expected for the first time to appear in collateralized debt obligations later this year, according to originators and lawyers. Several aspects of the public finance bond market make it attractive for inclusion in CDOs, and are causing structurers to explore using muni-only deals or transactions with large muni buckets now. While some bonds, particularly subordinate asset-backeds, can be difficult to source, the triple-B muni market is vast and offers enough suitable collateral, according to one structurer. "There is a readily accessible pool of assets and there are a lot of people who understand the credits and would be in a position to manage them," said Bill Gray, a partner in structured finance at McKee Nelson.
Yet munis are not a perfect fit for CDOs, mainly because they traditionally carry low yields that are attractive only on a tax-advantaged basis. Therefore, the main challenge in creating a CDO backed by munis is to preserve the tax-free status of the liabilities, according to several participants. Also, bankers tend to prefer yieldy assets and the thin spreads on munis could make it difficult to structure a CDO that would offer attractive enough returns for investors throughout the capital structure. "If underlying munis offer 3-3.5%, the senior liabilities can't do much better than that and how much juice is there left for the mezz and equity," asked one skeptical originator. Gray added: "All the elements are on the table, except the spread."