The late U.S. economist Thorstein Veblen once said that necessity is the mother of invention. Perhaps if he had been a municipal analyst, he would have said that a flat yield curve is the father of new products in the marketplace.
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In the last six months, a product called a "percentage of London Interbank Offered Rate note" -- or Libor bond -- has been devoured by traditional short-term muni desks as well as tender-option bond programs and foreign buyers, all looking for yield that they can no longer receive by investing in longer-term bonds.
"Where these things really work well, and where we've used them, is in shorter-term portfolios," said Phil Condon, head of municipal bond portfolio management for DWS Scudder, who manages $9 billion of municipal debt. "These things just look more attractive than other short-term products -- they have more pop than anything else out there."
According to Municipal Market Data, a one-month MIG-1 rated note yielded 3.82% Tuesday and a 30-year triple-A general obligation bond yielded 4.21%, a difference of 39 basis points. On June 30, 2005, a one-month note yielded 2.45% and a triple-A 30-year GO bond yielded 4.26%, a difference of 181 basis points. The risk premium of holding on to a bond for 30 years has diminished greatly, providing incentive to stay in the short-term arena until the relatively flat muni yield curve steepens.
Now, enter a municipal marketplace where it has become commonplace to see a crossover buyer peruse offerings looking for yield. Libor is a widely used index for corporate financial transactions and it opens the doors to many buyers who know it well.
A Libor bond tends to be structured as 67% of the three-month Libor rate, plus a basis point spread. The note will have a maturity, say 20 years, but the coupon will be pegged to the Libor three-month rate. The basis point spread is chosen, usually to match the yield out to what the 20-year bond would have yielded, give or take a few basis points taking into account the credit.
For example, on Tuesday JPMorgan priced $421 million of insured toll road senior-lien bonds for Harris County, Tex., of which $145 million were 67% of Libor plus a 67 basis point spread maturing in 2035. The three-month Libor that day was at 5.36%, and 67% of that is roughly 3.59%. Add 67 basis points to that and you have a yield of 4.26%. The insured yield curve on Tuesday had a 28-year bond yielding 4.32%.
Short-term desks have been a big buyer of these products as they are providing more yield than other short-term products. The Securities Industry and Financial Markets Association municipal swap index that is used as a weekly floater for muni desks yielded 3.85% in its May 16 reset. Even though it is a shorter instrument with little duration risk, the Harris County Libor bond yielded 4.26%.
"You basically have a long-term maturity that is supposed to behave like a short-term instrument," said Paul Disdier, director of the municipal securities division at Dreyfus Corp. "You are capturing the returns of the long end of the market with less volatility, but if the basis relationships change, then so could this product."
That basis relationship change is the one between municipals to taxables, as the product is based on the taxable Libor index. The SIFMA floating rate is the tax-exempt near-equivalent to Libor. While the relationship between the two hinges on a variety of factors, a key one is the highest tax bracket and expectations of changes to tax rates in the future.
In theory, the SIFMA rate should equal the Libor rate multiplied by one minus the highest marginal U.S. tax rate for individual investors. Assuming that 35% is the highest rate, then 65% of Libor should equal the SIFMA rate. It does not usually, because there are many other factors that weigh into this calculation. However, it is where Libor bonds gets their 67% of the index, as market expectations have used this instead of 65%.
Now, the owner of the Libor bond is getting a guaranteed 67% of Libor, but, if the highest tax bracket were to increase to 40%, the market would expect the percentage of Libor to decrease to 60%, making the holder of the Libor bond very happy as they hold a higher percentage of an index that will always yield more than any tax-exempt counterpart. With Democrats in control of Congress, some market participants believe that taxes will increase in the future.
"If you are an investor who is convinced that taxes are going to be rising, then this is a very attractive fixed-income investment because you are locking into a lower tax bracket," Condon said.
Aside from taxes, each index can move in various directions due to supply and demand reasons or any other factor that can influence a market, and if one becomes more attractive on a relative basis, that product will not be as lucrative, and buyers will simply look elsewhere.
Another major user of these products are tender-option bond programs. In a TOB trade a tax-exempt security is deposited into a grantor trust. Then floating-rate certificates are sold to municipal money market funds, usually at the SIFMA swap rate, and the trust will in turn receive a fixed rate. Then the executor of the grantor trust must hedge the transaction in order to lock in a spread. This move will lower the spread, but minimize risk. After this, leverage occurs, making it more profitable.
For example, $10 million of bonds are purchased and placed in the grantor trust. Then the trust sells $10 million of floating rates to money market funds and will put up $1 million in collateral as the money market funds must mark to market and have a certain amount put aside. In this transaction, floating rates are sold linked to the SIFMA, say at a 3.50%. The money market funds will then pay a 5% fixed rate for the bonds, which goes to the trust. This gives 150 basis points of spread, but there are a variety of upfront costs that reduce it.
Then a hedge must be done, because if the SIFMA rate were to suddenly rise, the TOB would be losing money fast. There are many hedges that can be done -- a common one is to place a swap out on the duration of the curve, meaning this swap trade stands to profit if the SIFMA rate jumps. This greatly lowers the spread, but the TOB can leverage the trade several times to increase profits.
What happens with Libor bonds is that the dealer has gone ahead and done a swap with the issuer, and thus the grantor trust is already receiving a floating rate, and one that is set to a very lower duration, typically three months. In this case, the TOB does not have the same hedging costs because the TOB has a match between the borrowing leg, the Libor bond from the issuer, and the payout leg, the floating rate from the money market fund. With less hedging costs, the TOB is more profitable.
"The sell side found a willing market from TOBs and overseas buyers that already have everything keyed to Libor," said Jon Schotz, chief investment officer for Saybrook Capital. "By selling a product linked to Libor plus a spread that has a short-term rate and therefore short duration, the hedging costs are reduced and this makes it more profitable for a TOB trade."
While Libor bonds are now being bought up by a variety of buyers, it is clearly a result of a flat yield curve. There are a variety of risks to be looked at when analyzing the product -- duration risk and credit risk, but also tax risk and basis risk. Buyers of the bonds agree that if the yield curve were to steepen, this product could very well disappear.
"This just may be a creature of the current curve, and when it steepens out, nobody will buy it anymore," said Matt Fabian, senior research analyst at Municipal Market Advisers. "In another six months, if things change, they could be history." (c) 2007 The Bond Buyer and SourceMedia, Inc. All rights reserved. http://www.bondbuyer.com http://www.sourcemedia.com
