As part of its $650 million bond offering sold earlier this week, New Yorks Metropolitan Transportation Authority for the first time sold bonds with step-up coupons an uncommon feature in the tax-exempt market, according to market participants.
Step-up coupons where the coupon increases on certain dates if the bonds are not called are often used in the taxable market, but are seldom used in the tax-exempt market.
The $71.5 million in step-up coupon bonds were a proprietary product of Merrill Lynch & Co. and were sold directly to its retail customers on Monday. The balance of the deal was offered through the syndicate of underwriters.
Patrick McCoy, finance director at the MTA, said the step-up coupon feature was a product structured to New York retail investors who have been strong supporters of MTA bonds. He said the step-up bonds enabled the MTA to have a diversified mix of products that was appealing to both retail and institutional investors. It was a way to put slightly different types of bonds into the market, he said.
The MTA is one of the biggest issuers in the municipal market and is expected to issue $2.84 billion in bonds this year.
David Stephens, director in charge of new products in the municipal derivatives group at Merrill Lynch, said the sale allowed the MTA to reduce its dependence on institutional investors. In addition, the higher coupons attracted retail investors to the longer end of the curve maturities investors are usually reluctant to buy into. The bulk of retail investors prefer maturities within the 10-year range.
The step-up bonds have a nominal fixed maturity of 2026, but the coupon increases at set dates if the bonds are not called. Retail investors will collect a coupon of 3.4% from closing to Nov.15, 2010. If the bonds are not called by the MTA, the coupon steps up to 4% from then until November 2015. The coupon then jumps to a 5% coupon until November 2021. If they are still not called, the bonds will step up to a 6% coupon until maturity in November 2026.
Stephens said the stepped coupons were used to address retail investors concerns about the potential for interest rate hikes. The muni step structure gives them a higher coupon that translates into protection against rising interest rates, Stephens said.
By comparison, the yield on a five-year serial bond, which was also sold as part of the $650 million deal earlier this week, yielded 2.9% 50 basis points lower than the yield during the first five years of the step-up coupon bonds which were sold at par to yield 3.4%.
At the same time, the step-up coupon bonds are beneficial for the MTA because if rates stay where they are, the Authority has a five-year call option, Stephens said. Most long-term bonds have a 10-year call option.
Ambac Assurance Corp. and MBIA Insurance Corp insured the $650 million dollar deal. MBIA also insured the step-up portion. As part of the deal, the MTA also sold $82 million in traditional fixed-rate single coupon retail orders.
Another large issuer also used step-up coupon bonds last year. In May New York City sold $44 million in municipal step-up coupon bonds as part of a $650 million tax-exempt bond offering. UBS Financial Services Inc. was lead manager on the deal, while Merrill marketed the $44 million in step-up coupon bonds.
In a taxable deal, Dallas on Jan. 19 sold $75 million in series 2005C step-up coupon bonds as part of a $545 million taxable general obligation bond deal for pension plans. Those step-up bonds were insured by MBIA. Citigroup Global Markets Inc. served as underwriter.
Wayne Placide, senior vice president at First Southwest Co., the financial adviser on the taxable pension fund deal, said Dallas used the step-up feature because it had to meet certain cash flow requirements and has a mandate to issue only bonds that are callable.
The bonds, which carry a coupon of 5.25%, are callable at par after five years. In 2009 the coupon steps up to 5.5%, 6% in 2013, 6.75% in 2016, and 8% in 2020.
Placide noted that the strategy was prudent because the issuer was able invest the proceeds from the taxable bonds in the stock market to realize arbitrage. That would not be permitted in the tax-exempt market. It was an attractive feature to add to the bonds in an environment where they were competing with other types of taxable securities, such as treasuries and corporates, Placide said.
