The turbulence blowing global financial markets askew has not slowed the creation of tender-option bond trusts, according to new data compiled from the major credit rating agencies.
While the continual creation and rating of new trusts does not always mean the overall muni TOB market is expanding, it does offer a glimpse of how the programs have collapsed, changed, and sometimes shifted their positions in recent months.
During the third quarter, Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s rated 2,147 new trusts for muni TOB programs — more than double the 758 trusts they rated in the third quarter of 2006.
Through the first two months of the fourth quarter, the rating agencies said they have rated another 1,184 trusts, which is already more than the 1,032 rated during the entire final quarter of last year.
The numbers do not necessarily signal growth in the $180 billion to $200 billion TOB market, said Jeff Previdi, director at Standard & Poor’s. Programs like Citi’s have sometimes taken trusts out of one program, only to change them slightly and put them into another program run by the same firm.
“So total TOB [volume] outstanding doesn’t increase, but it looks on our sheets like there has been a market explosion,” Previdi said.
This type of repositioning is not uncommon in the TOB market, as investors that own the residual bonds want to make sure they are selling floaters through the program they think will be best able to generate profit for them.
“You’re certainly going to see residual owners react to the availability of liquidity by moving trusts from one program to another,” said McDermott Will & Emery LLP partner John Lutz, who does legal work in the TOB market. But Lutz said there has certainly been more shifting of late.
Tender-option bond programs are created to take advantage of the difference between short-term and long-term municipal yields. At its root, the concept involves selling short-maturity securities, or floaters, at low short-term rates to pay for buying long-maturity bonds with higher yields.
The health of tender-option bond programs, both a major buyer of long-term bonds and a main seller of short-term floaters, now has ramifications for the broader municipal market.
TOB programs typically hedge their investments through taxable instruments, such as Treasuries or securities pegged to the London Interbank Offered Rate. As the recent global credit and liquidity crises have rippled through markets, the historic relationships between tax-exempt indexes and these taxable benchmarks have been shaken.
“Just as in August, munis have sharply underperformed Treasuries in recent weeks, pushing yields as a percentage of Treasuries up to new highs for this cycle and close to all-time highs,” said Citi managing director George Friedlander, in a monthly report to clients published Friday. He said 10-year, high-grade munis now yield 90% of Treasuries — up from an average of 80% during the nine months before August’s troubles — and that munis now yield roughly 100% of Treasuries on the long end.
Such tight muni-taxable spreads signal that TOB programs’ hedges could be costing them far more than they first intended, sapping their returns.
Unlike August, concern over the strength of the triple-A-rate bonds insurers is now also being factored into the market. The three rating agencies are reviewing bond insurance companies to decide if a recent wave of structured-finance downgrades merits a downgrade in one or more of the insurers’ ratings, too.
TOB program managers, along with money-market funds, the largest purchasers of TOB floaters, have approached rating agencies to see how different TOB trusts would be rated if an insurer of the underlying bonds is downgraded. Many programs are changing their trust contracts to make sure that investors do not lose their tender option if the bonds’ insurer is downgraded.
Insurer doubts also have dried up liquidity, sources said. While traders in the cash muni market have begun focusing more on the bonds’ underlying credit ratings, nontraditional market players like the TOB programs sometimes bristle at this prospect.
“That is all very well for those that want to spend all that time analyzing muni credits and get paid for it,” said one muni hedge fund manager. “But the bottom line is that it will affect liquidity in the market place.”
With returns down at many municipal TOB programs, sources said the hedge funds involved in TOB programs could start seeing investor redemptions.
Many hedge funds honor redemptions on a quarterly basis, and Dec. 31 is the next time these redemptions will take affect.
“The Dec. 31 redemption date will be very interesting,” said portfolio manager Evan Rourke of MD Sass. “For some people, August was a tough month, and their investors may have filed notice for redemption as a result. If this happens on a large basis there is the potential that this will put pressure on the market.”
Unlike mutual funds, when a hedge fund gets a redemption notice, there is usually a waiting period of about 60 days and then the investor can only leave at certain points in time, usually at the end of a quarter. Investors who wanted out in August are going to be able to exit at the end of this month.
This waiting period will mitigate the impact of redemptions because it allows portfolio managers to deliver and sell bonds slowly, so as not to weaken the market dramatically, said one institutional TOB manager.
Further complicating the situation, some liquidity providers have arrangements with programs that allows the provider to cancel its relationship with the program if the related fund’s net asset value falls below a certain level. Dropping 15% in one month or 25% in a quarter is often enough to trigger such out-clauses.
“The fourth quarter was rough for a lot of us,” one manager said. “I guarantee you that some trusts blew through the trigger level. But most times you will see a trust just putting up more collateral because no broker wants to be the one to cancel a trust.”
