Early this year, the municipal floating-rate note was fast emerging as a potent tool for local governments to maintain some variable-rate component in their debt profiles.
Then, its emergence slowed.
Some municipalities with a need for variable-rate borrowing in the first few months of the year turned to floating-rate notes to achieve the debt structure formerly provided through auction-rate securities or variable-rate demand obligations.
A small flurry of FRN deals from names like Massachusetts, Louisiana, and the District of Columbia in the first half seemed to be setting the stage for the product to become a favored means of restructuring VRDO facilities.
Issuance of the product has slowed since the summer, and, other than student-loan securitization pools, FRN deals have been very sparse the past few months.
But some market participants have said they expect this market to grow as more issuers face expirations on liquidity facilities and cannot get good pricing on renewals.
The ARS market is mothballed and bank guarantees remain scarce and expensive, leaving traditional means for municipal variable-rate borrowing either stressed or moribund.
One banker in New York expressed confidence that the FRN market will grow next year, though it may not soon expand to the size of what the ARS or VRDO markets were in their respective heydays.
“There’s going to be a lot more of these,” said Chris Alwine, head of municipal operations at Vanguard, the mutual fund behemoth. “Our expectation is that more of these will be issued simply because the cost of the facilities that are attached to VRDOs has gone up.”
FRNs are municipal obligations with interest rates resetting regularly, often monthly or quarterly. The rates are derived from a benchmark rate — typically either the Securities Industry and Financial Markets Association seven-day swap rate or the one- or three-month London Interbank Offered Rate — plus a fixed spread negotiated at issuance.
Take as an illustration the South Carolina Public Service Authority, better known as Santee Cooper.
The state-owned electric and water utility normally floats commercial paper for interim financing on its capital plan.
In July, Santee Cooper took a different course, selling a $234.9 million issue of one-year floating-rate notes underwritten by Goldman, Sachs & Co. and Bank of America Merrill Lynch.
The utility, in a statement, said the FRNs represented the “least-cost financing option for raising short-term capital.”
The taxable notes pay monthly interest at a rate of one-month Libor plus 25 basis points. The securities offer no put option.
Unlike ARS, floating-rate notes do not rely on continuing demand in the secondary market. And unlike most VRDOs, they do not require support from a bank, a crucial impetus for the flood of issuance this year and what market experts believe is the potential for issuance in the future.
“The big advantage is that it eliminates what had become pretty costly liquidity facilities, and also eliminates the renewal risk for those bank facilities,” said Howard Cure, director of municipal research at Evercore Wealth Management.
Nine months into the year, municipal governments have shattered the record for sales of bonds with floating rates based on a reference index, according to Thomson Reuters. Municipalities in 2010 have sold 27 floating-rate debt deals worth $6 billion through the end of September. The record for annual issuance until now was $2.52 billion, in 1999.
According to a Bank of America Merrill Lynch estimate, there are now about $40 billion of outstanding muni FRNs, still dominated mainly by student loan debt and prepaid gas deals.
Some market participants have said the lower-for-longer interest rate landscape that took shape in the spring likely slowed issuance. Investors are most likely to buy a floating-rate note if they think interest rates are going to rise.
One finance official for a frequent issuer said he believes the only reason governments are not bringing more FRNs to market is the extraordinarily low borrowing costs issuers can realize in the fixed-rate bond market. Record-low tax-exempts fixed rates provide less impetus for issuers to consider floating-rate products.
A triple-A rated borrower floating 10-year debt at 2.5%, based on the Municipal Market Data scale, can often “fix out” of VRDOs and save money at the same time. Some issuers reportedly have been able to save money by refunding VRDOs with fixed-rate bonds even after accounting for swap termination fees.
Not all have that luxury.
Massachusetts in March came to market with a possibly seminal $538.1 million floating-rate note based off the SIFMA swap rate.
The deal was a way of coping with a portfolio of deep-out-of-the-money swaps and a banking sector increasingly skittish about guaranteeing municipal debt.
Understanding Massachusetts’ dilemma requires an exploration of the plumbing and history of variable-rate muni financing. Municipal governments over the past few decades have relied primarily on two products for variable-rate borrowing, both of which have become anywhere from burdensome to inaccessible.
First to fall apart was the auction-rate security, which is long-term debt with an interest rate resetting regularly, perhaps every two weeks, at an auction where the securities change hands.
Municipalities sold $185.88 billion of ARS from 2004 to 2008, according to Thomson Reuters, and by some reckonings the market grew to more than $200 billion at its zenith that final year.
In February 2008 the market froze. Auctions came and went with no bidders, saddling some municipalities with high penalty rates and investors with illiquid paper. The travails imposed on both municipalities and investors from the crisis prompted an exodus from the ARS market, which is now frozen solid. This exodus in turn enabled a massive wave of issuance in another product: the variable-rate demand obligation.
A VRDO is also a long-term loan with an interest rate that resets regularly. Instead of setting rates at an auction, the VRDO’s rate is reset by a remarketing agent, who determines the rate necessary to clear the market.
In order to be eligible for ownership by money market funds — among the largest investors in short-term markets — VRDOs feature a put option enabling the investor to sell the debt back to the municipality.
Because few governments have the financial wherewithal to repurchase their own debt at the investor’s option, VRDOs typically carry a letter of credit or standby bond purchase agreement from a bank, promising to buy the debt from the investor exercising the put option, if nobody else will.
Municipalities sold $302.4 billion of puttable VRDOs from 2004 to 2008. According to an RBC Capital Markets estimate, the VRDO market hit its apex at more than $500 billion in 2008.
Many issuers that used these structures now face two problems.
BANK LIQUIDITY EVAPORATES
When a JPMorgan Chase letter of credit on Louisiana’s $200 million VRDO approached expiration in May, the state sought bids for a renewal with a different bank. It wasn’t just that the state didn’t like the bids it was getting.
“To be quite truthful, we weren’t getting any,” said Whitman Kling, director of the Louisiana bond commission.
Variable-rate demand obligations suffer from reliance on a banking sector whose ability or willingness to extend credit to municipalities is vastly diminished.
A VRDO might have a maturity in 20 or 30 years, and a bank liquidity facility expiring in two or three. That necessitates a renewal of the facilities every few years — a process that has gotten much tougher.
The financial crisis decimated banks’ ratings and disqualified many from writing credible guarantees on municipal debt. A gaggle of banks have exited the muni guarantee business the past two years, voluntarily or otherwise.
Last year five banks — JPMorgan, US Bank, Wells Fargo Bank, SunTrust Bank, and Bank of America — wrote 65% of the new letters of credit issued to municipalities.
The top five banks in the standby bond purchase agreement market wrote nearly 80% of new business last year, led by Royal Bank of Canada.
The lack of competition in the market has now been compounded by potentially looming regulatory burdens imposed by Basel III, which would force banks to hold higher-quality capital and set more liquid assets aside to guarantee municipal debt.
The upshot is that bank liquidity for VRDOs is more expensive. Before the crisis, these facilities reportedly often cost just five to 15 basis points.
Double-A rated Massachusetts would have had to pay roughly 90 basis points to renew or replace a liquidity facility that expired in March, based on information in a press release from the treasurer’s office.
Since there was a ton of issuance three years ago, and since the typical credit facility on a VRDO has a term of three years, an enormous wave of facilities is expiring this year and next — roughly $200 billion, according to a Standard & Poor’s estimate.
Because VRDOs are puttable, the expiration of a liquidity facility would leave a an issuer vulnerable to investors demanding immediate repayment.
That poses the need for issuers that can’t renew their bank facilities at reasonable prices, or find new ones, to find some way to refinance their VRDOs — and soon.
SWAP TERMINATION PAYMENTS
The good news for these issuers is that with an incredible wave of cash washing over the bond market in the past 18 months, fixed-rate borrowing costs are extremely low. Some issuers can sell fixed-rate bonds to refund their variable-rate facilities, often saving money.
The bad news is that many issuers have out-of-the-money swaps associated with their VRDOs, and the cost of fixing them out would also include the cost of terminating the swap.
Many issuers used VRDOs to achieve lower fixed-rate borrowing costs. They achieved this by selling VRDOs and then entering into a swap with a bank, under which the municipality paid a fixed rate and received a floating rate. The fixed rate paid on the swap was the municipality’s effective borrowing cost. The floating rate received went to pay the VRDO holders.
Many issuers found the “synthetic” fixed rate established through the VRDO and swap was lower than what they would have paid on a fixed-rate bond.
It turns out the lower cost came with a price.
No governmental entity illustrates this better than the Bethlehem Area School District in Pennsylvania, which oversees 15,000 students, two high schools, four middle schools, 16 elementary schools, and a swap portfolio that’s $19.1 million in the red.
In 2005, Bethlehem structured a $55 million VRDO, supported by an standby bond purchase agreement from Dexia Credit. The district created a synthetic fixed rate on its VRDO by entering into a swap with Morgan Stanley.
Under the contract, the district would pay Morgan a fixed rate of 3.9%, and the bank would pay the district a floating rate based on Libor. The floating-rate payments would be funneled to the VRDO holders, while the 3.9% fixed rate would be the district’s effective borrowing cost.
The impending expiration of Dexia’s SBPA in January this year prompted the district to consider refunding the VRDO.
With one-month Libor not far from zero, the Bethlehem district’s swap is extremely valuable to Morgan Stanley, which is receiving 3.9% annually in exchange for a handful of basis points.
If the district were to sell fixed-rate bonds to refund the facility, it would still have to honor the fixed payments on its swap — which would be about $1.7 million annually, based on the terms of the fixed and floating rates.
Terminating the swap would have cost about $7 million, based on fair value.
Floating-rate notes formed part of the solution.
As a piece of a larger deal, the district sold $30 million in 20-year FRNs to refund a portion of the VRDO, pricing at 150 basis points over the SIFMA rate.
The key to the FRN portion of the deal was it did not have to pay to cancel the swap. It left its swap intact and applied it toward a synthetic fixed rate on the note.
The district still pays a swap-enabled synthetic fixed rate on a variable-rate bond. The difference is now it doesn’t have to stay in touch with its bank to make sure it can renew its liquidity facilities every few years.
Louisiana tells a similar story, converting its $200 million VRDO in June to an FRN bearing SIFMA plus 75 basis basis points, sidestepping the termination of swaps.
THE CASE OF MASSACHUSETTS
Of Massachusetts’ $3.8 billion in variable-rate debt at the end of fiscal 2009, $3.5 billion was synthetically fixed, mostly with swaps valued at negative $325.7 million. The state in 2005 floated a $562.7 million VRDO supported by an SBPA from Citibank and converted into a synthetic fixed rate through a swap.
The VRDO was scheduled to mature Feb. 1, 2028. The SBPA was scheduled to expire March 15, 2010, at — as the official statement put it — 5 p.m. Boston time.
Citi has not sold an SBPA in several years, and bank liquidity would have been costly for the state to buy. Compounding matters, the swap the state entered promised to pay fixed rates of as high as 4% until 2028, while receiving the SIFMA swap rate, which is currently less than 0.3%.
The swap counterparty — also Citi — was entitled to a sizeable fee to terminate that deal. As of the end of fiscal 2009, the swap’s value to Citi was $31 million.
Was there any way to refund the VRDO facility without having to pay Citi $31 million to terminate the swap?
In a deal led by Morgan Stanley, Massachusetts in March sold $538 million in FRNs, using the proceeds to refund the VRDO. The floaters priced at an average spread of 25 basis points over the SIFMA swap rate. The swap remains outstanding and the state essentially continues to pay a synthetic fixed rate by relating the floating-rate portion of the swap with the payments on the FRN.
In a press release after the sale, the state treasurer said it saved 65 basis points compared with finding a new liquidity facility on the refunded VRDOs. The state claims it not only saved $7.5 million by paying less on the floaters than it would have paid the banks, but it also pared its vulnerability to the risk of depending on banks.
Moody’s Investors Service called the refunding a “credit positive” — despite an identical amount of debt outstanding — because of the relief of “bank counterparty risk” and “liquidity replacement risk.”
These solutions might not be for everyone.
Louisiana’s Kling points out that since investors have demonstrated demand for these products mostly for short periods, the FRN is not a long-term solution.
Just as the necessity of renewing a bank facility every few years poses a risk to the issuer, keeping a swap outstanding and continually rolling over floating-rate products opens the possibility of a failed rollover, requiring a swap termination payment.
“At the end of that three-to-five year period you’re in the position of having to pay off the debt, as well as any associated swap payments, or you have to go through a refinancing structure again,” Kling said. “That’s the downside to doing it. This is an intermediate relief mechanism.”
Another notable SIFMA-based floater this year came from the District of Columbia. In 2008, the city came to market with a big, complex deal that, among other elements, included a $125.8 million VRDO supported by a letter of credit from Bank of America. The VRDO was slated to expire June 1, 2034, while the LOC was slated to expire May 21, 2011.
The city in March sold $126.7 million of FRNs, with half maturing this year and yielding SIFMA plus two basis points, and the other half maturing next year and yielding SIFMA plus 18 basis points. It used the proceeds to refund the VRDO.
The deal was also underwritten by Morgan Stanley, which after Bank of America is the second-most active underwriter of FRNs this year, with $2.36 billion in deals for a 39.2% market share. JPMorgan is third, with an 8.8% market share.
“What we’re seeing right now is significant interest from issuers looking for alternatives to bank liquidity given the number of facilities that are coming up for renewal in 2011,” Paul Palmeri, a managing director in JPMorgan’s public finance group, said in an e-mail.
“Given that there is a reduced number of liquidity providers in the market, coupled with the future potential impact of Basel III, issuers are looking at floating-rate notes as an alternative to traditional VRDBs,” he said. “We’re in a unique position to assist issuers as these liquidity facilities come up for renewal, either in the form of traditional credit products or other capital markets solutions such as FRNs.”