The steadily growing market for floating rate notes is on pace to see its most active year since before the financial downturn, as issuers turn to the product for a better alternative to variable rate demand obligations, and investor demand continues to grow.
Before the financial crisis, FRN issuance topped $25 billion in a year, before dropping to the $2 billion range following 2007.
In the past few years, however, issuance has gradually increased and is expected to continue gaining steam this year. Currently, the total outstanding FRN market is close to $45 billion, with nearly 70% comprised of high quality FRNs — mostly AAA and AA ratings — according to data from Citi. Municipal strategists at Citi estimate that FRN issuance could reach $10 billion by the end of the year.
In a recent report, the Citi strategists attributed two main reasons to the sudden interest in FRNs: higher investor demand and shrinking issuer access to the variable rate demand note market.
"In general, there tends to be more demand for floating debt when investors expect high rates," according to the report, authored by Mikhail Foux, Vikram Rai, and George Friedlander. "As of now, the potential for high rates is probably one of the main concerns for all fixed income investors."
They added that the product provides investors the opportunity to employ their capital, rather than seek defensive products, hedging, or simply to sit on cash.
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.
While some investors turn to FRNs as protection from a possible rise in interest rates, issuers aren't necessarily betting against them.
"What you're seeing on the issuer's side is that most in the municipal market have a desire to take on some part of their debt portfolio with variable rate exposure," said Kyle Pulling, head of short-term trading in JPMorgan's public finance group.
FRNs offer issuers an alternative to other floating rate products when they have already decided to keep some portion of floating rate debt in their portfolio. Issuers can compare the spread over SIFMA or LIBOR that they can get with a FRN with what it would cost to take out some other kind of traditional liquidity facility.
Other reasons for the increase in investor demand are the positive improvements in the FRN market in past years, which have allowed investors to gain more confidence in the product. Some of these developments include a compression of spreads, lengthening of duration, and a greater variety of issuers coming to market, Pulling said.
The New Jersey Turnpike Authority is one of the newest and most recent issuers to the FRN market, with a $646 million deal that Citi priced on April 16. The agency had previously sold floaters in private placements, but this was its first public offering.
Donna Manuelli, the Turnpike's chief financial officer, said the deal was four to five times over-subscribed, which allowed them to tighten the spreads during the sale. The bonds have maturities in 2017, 2018, 2022, 2023, and 2024, with spreads ranging from 48 to 68 basis points over SIFMA.
"The FRNs were the lowest cost alternative to address the need to replace our terminating liquidity facility with Portigon and refund taxable FRNs that were issued last year," Manuelli said.
She added that the benefits of offering FRNs are that no credit facility is required, so the interest rate will not depend on the credit risk of a liquidity provider.
Replacing the VRDO Market
Issuers with a need for variable-rate borrowing have been turning to floating-rate notes to achieve debt structure that, for the past few decades, had been provided primarily through auction-rate securities or variable-rate demand obligations.
Auction-rate securities are long-term debt obligations with an interest rate that is reset regularly, usually every two weeks, at an auction where the securities change hands. A VRDO is also a long-term loan with an interest rate that resets regularly, but 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.
While these products had largely satisfied investor demand for short-term and variable-rate municipal debt, the structures had also involved considerable remarketing risk and reliance on third party liquidity providers. Following the financial crisis, many of these risks associated with the products were highlighted.
As a result, issuers like Connecticut and New York City, in addition to the New Jersey Turnpike, have turned to FRNs as a better alternative to VRDNs.
"Traditional variable rate demand bonds require a remarketing agent and a bank liquidity facility resulting in bank credit risk, bank renewal risk, and the attendant annual bank and remarketing fees," said Sarah Sanders, assistant treasurer for Connecticut. "None of these are required for FRNs."
Connecticut's most recent FRN financing was part of a $400 million general obligation bond sale in March this year. Around $224 million of the bonds were offered as floating rate notes, with interest paid based on a spread to SIFMA. The sale cost the state 0.88% in total interest.
Sanders said the deal was received very well in the market, with customer orders totaling more than five times the amount of available floating rate notes during the institutional order period.
"This demand allowed the state to tighten spreads to some of the lowest spreads of any sale of its kind in the nation," Sanders said.
Other reasons why the state has used this method of borrowing has been to diversify the types of bonds offered to the market, which maximizes investor demand and bond pricing performance, as well as to help diversify the state's large debt portfolio, Sanders said.
New York City is another issuer that has chosen FRNs as an alternative to VRDBs. The city came to market earlier this year to convert some of its bonds that were already outstanding in floating rate VRDB mode. The city remarketed them as $248 million of floaters in February.
Carol Kostik, NYC's deputy comptroller for public finance, said the city wanted to keep the bonds in floating rate mode so they did a comparison between VRDBs and FRNs and found that FRNs were a more economical cost of funds within the floating rate world.
"The FRNs worked for us in that transaction," Kostik said. "They were economical, we felt comfortable that the floating rate compared to the fixed rate we would have paid if we fixed them out provided good savings, and that the FRNs provided us with savings over VRDBs, with an acceptable level of risk."
The reasons why the FRNs were more cost-effective, she said, were that the FRN market has grown, spreads to SIFMA have come down, the buyer base has a stronger appreciation of the product, and they have gotten more comfortable with the type of step coupon that NYC uses in the FRNs.
A New Structure
The "step-up" coupon that Kostik referred to is a fairly new development in the FRN market.
Prior to the financial downturn, FRNs were usually structured with a straight maturity or hard put, where the issuer would be required to repurchase its bonds or remarket them at the end of a given time period.
Now, most FRNs have a soft-put structure. If bonds are not successfully remarketed at the end of a mandatory tender period, it will not constitute an event of default like it would in a straight maturity or hard put structure. Instead, at the end of the period, which is called the "step-up" date, the interest rate will significantly increase in order to encourage the issuer to seek some type of refinancing or refunding.
"We've seen the market become more comfortable with this kind of structure," Kostik said.
NYC had done a few private placement and direct loans with FRNs, but February's deal was the first to the public. Before the soft-put structure was available, NYC could not offer FRNs because the city is not permitted to sell bonds with any sort of put that does not have a bank credit facility behind it.
Another improvement to the structure of FRNs has been a shortening of maturities. FRNs had typically been very long-dated bonds prior to 2008, with around 20- or 30-year maturities. Now they often have maturities somewhere between one and seven years.
"Investors have gotten much more comfortable because of these shorter put features or maturities which give them comfort that the duration is unlikely to go out 30 years," said Paul Palmeri, managing director and head of public finance at JPMorgan.
As a result, the past four years have seen the amount of investors in the FRN market expand dramatically. When the market started off, Palmeri said he saw only a handful of investors participating, but now there are around 25 to 30 different investors in the market.
Most of these investors are short-duration and ultra-short bond funds, as well as intermediate and long-bond funds, some money managers, some insurance companies, and most recently, some retail investors, he said.
In fact, JPMorgan priced a deal for the New York Metropolitan Transportation Authority in which the first retail order period for floaters was held. In November, the MTA held a retail pricing for $360 million of Series 2012G FRNs, followed by an institutional sale. The notes were priced as two through five year soft-puts at 67% of one-month LIBOR.
Compression of Spreads
As the market has grown and the investor base has increased, spreads have come down significantly on FRNs in the past few years. Palmeri said that from 2010 to 2013, spreads have come in almost 70%.
Take, for example, the New Jersey Economic Development Authority. In January 2011 it sold $67 million of school facilities construction FRNs maturing in 2018 at a 180-basis-point spread over SIFMA. When they brought another FRN issue to market in September 2012, the agency sold $120 million of notes maturing in 2017 at 90 basis points over SIFMA.
"The compression of spread has made the product more compelling for issuers to participate," Palmeri said.
In addition to the New Jersey EDA and Connecticut, some of the more frequent issuers in the market in recent years include the Commonwealth of Massachusetts and the Pennsylvania Turnpike Authority. These issuers alone have brought more than 60 FRN deals to market. Connecticut alone has issued $1.1 billion of floating rate notes in five different transactions since 2011.
More Issuers, More Liquidity
"When investors see that issuers are able to continually have market access and come to market, it certainly gives them a lot of comfort that there's liquidity in this product," Pulling said, adding that a growing secondary market has also boosted confidence.
The post-financial crisis emergence of FRNs kicked off with a $538 million deal issued by Massachusetts in 2009.
The commonwealth used the proceeds to refund a $562.7 million VRDO supported by a standby purchase agreement from Citibank, which was converted into a synthetic fixed rate through a swap. The floaters priced at an average spread of 25 basis points over the SIFMA swap rate, and saved the state 65 basis points compared with finding a new liquidity facility for the VRDOs.
After that, more issuers began coming to market with FRN deals, with issuance surging in 2012. According to Citi's data, nearly $7 billion of FRNs were issued in 2012, compared to approximately $4 billion in 2011, and $2.5 billion in 2010.
New York's MTA is another issuer that has been increasing its participation in the market. Prior to the $360 million deal in November, the agency brought $400 million of floating rate notes a few months earlier in March.
Ahead of the sale, MTA financing director Patrick McCoy said that the agency actively pursues the lowest possible costs for borrowing, and that FRNs provide the agency with additional flexibility.
"The markets have changed," he told The Bond Buyer before the sale. "The floating-rate note product is a fairly new development that we believe is an important vehicle for the MTA to participate in the short market."
Part of the move away from VRDOs began following the introduction of new regulations under Basel III, which require banks to have higher minimum liquidity coverage ratios. This ensures that banks have adequate stocks of high-quality liquid assets.
The higher minimum will put upward pressure on the pricing of letters of credit and standby purchase agreements that support most VRDNs.
Since the initial proposal, regulations have been changed to a lower minimum LCR, which lessens the blow a bit. Citi strategists noted that the recent Basel III changes may have the potential to slow down the shrinkage of the VRDO market.
Still, they believe the FRN market will continue gaining steam as it responds to stronger investor demand.