In an effort to be more transparent, Moody’s Investors Service will be issuing separate press releases when it changes the ratings on bonds that act as collateral for floating-rate certificates, known as tender-option bonds.
The agency said there has been no change to the rating methodology of TOBs, but that steps are being taken to be more transparent as regulatory bodies scrutinize the municipal market.
“It is now our policy to do press releases for all rating changes,” said Lisa Washburn, team managing director of municipal structured products. “While the majority of portfolio managers know why the TOB rating is changing, press releases will offer additional transparency so all investors will know that something in their portfolio changed, and why.”
A TOB is a puttable, tax-exempt, short-term floating-rate certificate typically backed by long-term collateral held in a trust.
The certificates are usually sponsored by a bank, which establishes a trust to issue the certificates. The bank sponsor is responsible for purchasing the certificates back from investors if they exercise the tender, or put, option.
The collateral is typically owned by a hedge fund, which earns a carry spread in the transaction: it collects the interest on the long-term collateral, pays out the short-term coupon rate on the floating certificate, and earns the spread between the two. Those gains can be enhanced with leverage.
The TOB’s rating is therefore derived from the strength of the bank sponsor and the value of the underlying collateral.
“TOBs pass through the ratings of the underlying bonds that they hold in trust, so what happens is that if a rating action is taken on an underlying bond, then we will take the affected TOBs and change those ratings,” Washburn said. “Typically it’s a day later because we don’t get advance notice of rating changes.”
On days when there are multiple rating changes, Moody’s said it will group them together in one press release.
Jeff Previdi, senior analyst at Standard & Poor’s, said his department issues a separate release on each affected bond rather than merging them together for a single press release.
“It’s pretty high volume on these things,” he said. “Typically, we just move the rating and put out a short release — but we don’t do a comprehensive report like that.”
Mary Jane Ziga, senior director at Fitch Ratings, said her group issues a press release on affected TOBs on an irregular basis whenever a number of rating changes have occurred.
“This is a very sophisticated market, people know what’s going on,” she said. “There is no orphan holding a TOB anywhere in the world. Everyone knows about it when it happens, as soon as it happens.”
Tender-option bonds were originally created in the late 1980s as a way to address the dearth of short-term paper in the market.
In the 2000s, the market for TOBs grew rapidly as firms used increasing amounts of leverage to earn the carry spread. By 2007, the volume of TOBs was estimated by market participants to be more than $200 billion, or about 8% of the municipal market.
When the financial crisis occurred, many TOB structures collapsed. Collateral backed by the bond insurers was downgraded, interest rates became unpredictable, and floating certificate-holders exercised their put options en masse.
More recently, programs with lower degrees of leverage have been creeping back into the market. At the beginning of the second quarter, market players estimated tender-option bond volume to be around $80 billion.
