Tender-Option Bonds

Taxable TOBs Take The Stage

A new strain of tender-option bonds is geared toward taxable investors who want the advantages of Build America Bonds without committing to a long maturity.

A small number of banks have rolled out this new product in recent weeks, which is known as a taxable tender-option bond. Like their tax-exempt brethren, taxable TOBs offer short-term, puttable, floating-rate certificates created in the secondary market, but BABs serve as their collateral instead of long-term tax-exempt debt.

Nearly $120 billion of BABs have been issued since Congress created them in February 2009. The average maturity on BABs is 29 years, according to Bloomberg LP, whereas short-term notes are issued with a maturity of 13 months or less. TOB maturities tend to be less than 25 days, according to market participants.

The three rating agencies have rated four taxable TOB deals so far totaling $68 million. Some deals have also been unrated, so market participants estimate the overall volume to be closer to $100 million.

Two of the known deals were sponsored by Morgan Stanley. Another was by Bank of America Merrill Lynch, and one was by JPMorgan.

Buyers of the floating-rate certificates include Blackrock, a New York-based money manager. Calls to Nuveen Investments, which purchase tax-exempt TOBs and mentions taxable TOBs in research notes, were not returned by press time. The banks and rating agencies would not disclose which investors owned the underlying assets.

Richard Kolman, head of municipal securities at U.S. Bancorp Investments Inc., said short-term debt backed by BABs is “a natural market to develop” with definite potential. But, he said, it’s too early to say how successful it will be.

“Absolutely there’s potential — no question about it,” Kolman said of pairing of BABs with TOBs. “It’s just about timing. Today is a little more about putting your toe in the water, and tomorrow is about putting your foot in.”

The first TOB structures were created in the late 1980s, to maintain the underlying asset’s tax-exempt status and pass it on tax-exempt interest to the investor purchasing the floating-rate certificate. This allowed some investors to borrow money at short-term, tax-exempt rates in order to finance the purchase of longer-term muni bonds.

With taxable TOBs, there’s no tax-exemption to maintain, yet the structure remains attractive, said Peter Hayes, managing director and head of the municipal bonds group at BlackRock.

“The tender-option bond structure was always viewed as a good structure,” he said. “If you look at the dislocation in 2008, tender-option bonds actually held up quite well. There was some dislocation from the underlying collateral, but that was really related to the downgrade of the monolines” that insured the underlying bonds.

Jeff Previdi, a senior analyst at Standard & Poor’s, said the term “taxable TOBs” caught on for marketing purposes and simplicity. But in some respects, the products are akin to asset-backed securities, he said. The distinction is that municipal debt is the underlying asset instead of a credit card receivable, auto loan, or other securitized asset.

“It’s being done with the players of the TOB, so the idea is that, conceptually, it functions like a TOB. But it’s taxable, so the structure is different,” he added.

Last month Previdi helped analyze and rate $16 million of taxable TOBs using BABs issued by the San Francisco Public Utilities Commission Office Project as the long-term asset.

The difference between taxable and tax-exempt TOBs is merely the tax status, but otherwise the two are “nearly identical,” said Lisa Washburn, team managing director of municipal structured products at Moody’s Investors Service.

In mid-June, Washburn helped rate a $20 million deal using BABs issued by Oregon’s Department of Administrative Services as the underlying asset.

Regardless of tax status, a TOB offers investors a floating-rate certificate, the value and rating of which are derived from long-term bonds held in a trust. That trust is usually established through a partnership between a hedge fund, which owns the collateral, and a bank, which serves as a liquidity provider enabling holders of the floating-certificates to exercise a put option that the securities offer.

TOBs were introduced to meet a growing demand in the late 1980s among tax-exempt money market funds for high-quality, short-term paper. The TOB market grew swiftly during the 2000s and volume of the floating-rate certificates equaled more than $200 billion in 2007 — about 8% of the entire muni market, according to market participants.

Now, taxable money market funds and mutual funds are the ones that “cannot find enough short-term product,” said Eric Vandercar, manager of municipal funding and liquidity at Morgan Stanley. He helped orchestrate the bank’s first taxable TOB deal on May 13.

Vandercar declined to name which funds had purchased the notes, but said at least four money fund managers are authorized to buy them and have expressed interest.

“The demand is absolutely there for weekly paper,” he said. “We were able to bring $20 million and $30 million deals to them, and they were saying, 'Can we see $200 million deals and bigger?’”

BlackRock’s Hayes said money fund managers find the puttable option especially attractive in light of recent amendments by the Securities and Exchange Commission. In the 2a-7 rules, which govern money market funds, the SEC in May said funds would be required “to maintain a portion of their portfolios in instruments that can be readily converted to cash.”

Hayes said money market funds now have a greater need for daily and seven-day notes.

“The taxable market that’s existed really hasn’t had a structure like that — where the taxable money market funds had the option to put a security or not put a security,” he said. “This vehicle fills that void … and it also helps gives them greater control over their own liquidity.”

Among hedge funds, the incentive for creating TOBs rests in their ability to earn a carry spread on a steep yield curve — that is, to borrow cash at a low floating rate and collect on a higher fixed yield.

Comparing triple-A BABs with double-A corporate debt reveals how attractive the carry spread can be. Triple-A BABs with a one-year maturity have an average yield of 0.80%, which is 29 basis points lower than the double-A corporate average, according to data from BMO Capital Markets. Conversely, triple-A BABs with a 30-year term have an average yield of 5.59%, which is 42 basis points higher than double-A corporates.

Put another way, the term spread between one-year and 30-year maturities is 479 basis points among triple-A BABs versus 408 basis points among double-A corporates.

That extra spread is crucial to hedge funds, which can exploit that spread with additional borrowing, or leverage. Among tax-exempt TOBs it was common to use 10 times or more leverage before the credit crisis, but investors have been less keen to take on that kind of risk more recently.

The less inviting yield curve in the corporate market is one reason why TOB-like structures are rare in the broader taxable bond market. Instead, leveraged investors tend to use repurchase agreements to similar effect.

In a repurchase transaction, the borrower will give a counterparty some bonds to hold as collateral in exchange for cash. In a typical scenario, the counterparty receives the cash back later and earns a fee by lending at a taxable fixed rate. If anything goes wrong and the borrower is unable to return the cash, the lender can liquidate the collateral. The repurchase market that exists in the municipal world is small in comparison to other markets.

Chris Holmes and Alex Roever, municipal strategists at JPMorgan, wrote in a recent report that the sheer number of issuers in the muni market has made it difficult for a repurchase market to emerge. In addition, the relatively small issue size per Cusip hurts liquidity, as does the high percentage of non-institutional investors.

The absence of an adequate repurchase market for BABs means taxable TOBs could become a viable funding option, Holmes said in an interview.

“One of the reasons why these TOB structures have come up on the taxable space is because the repo market hasn’t developed as much as it could have,” he said. “And since the market for tax-exempt TOBs is already developed, it seemed like a natural extension to use TOBs for leveraging purposes in the taxable space as well.”

Taxable TOBs could also serve to expand the investor base of the municipal market, which is the reason BABs were created.

“In order to broaden the market for Build America Bonds, it is key to be able to provide a menu of services, including funding,” Vandercar said. “As the market becomes more aware of the available alternatives, the efficiency and the economics of being able to fund Build America Bonds using TOB-like structures and repo should bring more demand and more liquidity into the marketplace.”

Anecdotal evidence suggests that BABs have already been successful in opening the muni market to crossover buyers, pension funds, foreign investors, and sovereign funds.

Despite that diversity, Vandercar finds one thing in common: they all purchase with real money.

He said there has been “virtually no retail” and few hedge funds employing leverage in their purchases.

“We expect this will change, given growth of attractive and diverse funding choices,” Vandercar said.

For now, taxable TOBs remain in their infancy. Only a handful of deals have been completed, but market participants agree that the market has the potential for

rapid development.

“That’s the interesting part of these — the potential,” Hayes said. “There’s a lot of pent-up demand for this. I think if there were more deals in the market, you’d continue to see them oversubscribed, at least for the foreseeable future.”

Mary Jane Ziga, senior director at Fitch Ratings, said the potential is dependent on the uncertain future of the BAB market. Efforts to extend the BAB program beyond 2010 were tabled last month when Senate Democrats were unable to garner enough votes to pass the American Jobs and Closing Tax Loopholes Act.

“We’ve heard about taxable TOBs for several months,” said Ziga, who in mid-May participated in the rating of $16 million of taxable TOBs. “Given the fact that the extension of BAB authorization is in doubt, I don’t find the fact that so few deals have come to market all that surprising.”

Despite those legislative hurdles, the program is widely anticipated to be extended.

If it is, Ziga said the same funds that purchase tax-exempt TOBs may be interested in taxable TOBs, given their familiarity with the structure.

That would help taxable TOBs become a permanent fixture in the muni market. It’s not clear, however, that they will ever be as influential as tax-exempt TOBs once were in placing downward pressure on the long-end of the municipal yield curve, thereby lowering borrowing costs for state and local governments.

“Any real impact on the supply-demand imbalance and flattening pressure on the taxable yield curve — as we have seen traditional TOBs have on the tax-exempt curve — is at best years away,” Vandercar said. “And probably only theoretical, given the overall size of the taxable markets.”

Holmes and Roever said it is difficult to see how BABs would ever yield less than their corporate peers. They said the “weaker transparency and liquidity” for municipal debt implies a fair value for BABs that is 15 to 20 basis points higher than corporates.

“It’s probably fair to view yields on ­corporate bonds with similar maturity and credit characteristics as a practical yield floor for taxable munis,” they wrote in a research note.


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