TOB Growth Reveals New Players in the Trade

Tender option bond programs expanded more than twice as fast during the first half of 2007 as they did during the same period last year, according to data compiled from Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s. The three rating agencies rated a combined 3,326 new trusts during the first half of the year, as compared to 1,626 new trusts during the opening half of 2006. Market sources estimate that TOBs have now ballooned into a $180 billion to $200 billion market. While the number of programs run by hedge funds and domestic and foreign-based banks has increased, the market’s biggest programs have also added on by the billions. “The most notable growth in demand for the TOB has come from the municipal hedge fund community, who have attracted more assets in the last couple of years — particularly as some of them have crossed over to having a three-year track record,” said Eric Vandercar, an executive director at Morgan Stanley. Investors tend to invest more freely once they see that a hedge fund has been successful for three years or so, he added. After posting double-digit tax-exempt returns in many cases, these funds have started to build up more assets under management, Vandercar said. Several new programs have launched recently at banks, too, driving the sector’s total asset volume up, sources said. DEPFA Bank PLC and RBC Capital Markets LLC are among the newer programs. Dexia , the European bank that owns Financial Security Assurance Inc., is ramping up a program, too. Meanwhile, Merrill Lynch & Co.’s program, which several sources called the industry’s largest remarketer of TOBs, has grown significantly in the last six months, managing director Jim Nacos said. Merrill’s main program has been around since the early 1990s, though Nacos would not say how large it is now. New interest in TOB programs also stems from an increase in flows to municipal money market funds among the most common buyers of TOB floaters. Further demand has come from investors lured by the relative credit safety of munis’ and the tax-exempt yield curves, which remain steeper than nearly any other in the fixed-income world, Nacos said. At its core, the TOB strategy is a municipal carry-trade. An investor or group of investors, designed as a trust or partnership, purchases long-dated bonds and funds the purchase by selling short-term certificates, or “floaters.” As long as long-term yields are higher than short-term yields, the investor pockets the spread between them. Individual programs’ strategies vary, including whether they take a short- or long-term outlook on the market or how they hedge the investment. Based on figures reported yesterday, there were 71 basis points of spread between the average yields on two-year and 30-year high grade municipal bonds . The spread between these maturities was 27 basis points in the Treasury market. One year ago, these spreads sat at 84 basis points in the muni market and zero in Treasuries.An uptick in June in interest rates across fixed-income asset classes steepened municipal yield curves, after a long period of flattening. This change, in turn, has made the carry-trade on TOB programs larger. The advent of a new class of floating-rate notes in the municipal market has also fueled the creation of new TOB trusts. While the concept has been around for years in other fixed-income markets, issuers began in earnest this year selling long-term variable-rate bonds with coupons based on the London Interbank Offered Rate. TOB programs have taken to buying large blocks of them partly because they make the programs’ hedges more seamless. This confluence of factors has drastically increased the number of trusts showing up at the rating agencies each week to get rated. Vandercar said that in the two weeks before the July 4 holiday, Morgan Stanley’s program established 68 new trusts — $1.6 billion of new floaters. As more TOB players have entered the market, competition for suitable residual bonds has tightened the spreads that trusts can earn in the trade. While they started out putting long-dated triple-A and double-A bonds in their trusts, firms have begun hunting for higher yielding bonds to widen the spread. DEPFA’s program, created about six months ago, looks at capital appreciation bonds, housing bonds, tobacco bonds, and other types of revenue bonds to try and bump up the yields it can get from the trusts’ underlying bonds, said David Burke, the managing director who runs the program. He said the program already has grown to about $1 billion. Alternative minimum tax bonds have also been a good source of yield for the long term piece, Nacos said. “The spread between an AMT and non-AMT securities further out on the yield curve — at 10 years, 20 years, 30 years — tends to be wider than the differential between a tender option bond floater for an AMT and a non-AMT bond,” he said. Zero-coupon bonds also have been popular with TOB programs. Thomson Financial data on Wednesday showed that 30-year zeros yielded eight basis points more than the standard 30-year munis.Using zeroes requires a special structure, though, because the bonds don’t generate any cash flow from offering until maturity. To circumvent this problem, programs have devised ways to issue floaters that represent the accretion of tax-exempt interest on the zero, according to Al Sawyers, a partner at Orrick, Herrington & Sutcliffe LLP. While the idea has been in the market for several years now, interest in them has picked up recently, Sawyers said. Other exotic ideas for new trusts have included variable-rate bonds and triple-A slices of the market’s first collateralized debt obligation. Some sources said they’ve seen more trusts with multiple credits in them, a concept known as a pooled trust. Merrill’s program is known for having used pooled trusts, according to Jeff Previdi, director at Standard & Poor’s. Burke, echoing the thoughts of several other sources, said pooled trusts still have not quite caught on en masse. “Most of the investors, in our experience, really prefer single credits because of the different tax jurisdictions and how they sell their funds on to investors,” Burke said. “At least on that side, for the time being, the market is more on single-credit, single-state, or single-name trusts.”While the rating agencies’ numbers suggest that the TOB market is growing dramatically, Vandercar said reports of newly created trusts can be deceiving. “While a lot of volume has been created, one should not make the assumption that it’s all been reflected in an increase in supply,” he said. There are also trusts being unwound at any given time.He agreed, however, that creation of trusts has far outstripped the rate unwindings. Vandercar said the Morgan Stanley program also has been growing at a rapid pace. Morgan Stanley added 210% more new floaters by total par to it program during the first half of 2007 than it did during the same period of last year, Vandercar said. The program operates largely for outside clients, rather than for the firm’s proprietary book, and now includes about $20 billion of floaters. Vandercar and other market sources said they expect the TOB market to continue its rapid expansion.It would likely take a drop-off in municipal primary market volume or the shock of a new tax regime to stunt the growth, sources said. If the muni yield curve continues to steepen, then the trade stands to become even more popular, Nacos said. The growth certainly has caught the eyes of financial advisers, who have noted the extra demand for long maturities that TOBs provide. The first half of 2006 has seen issuers extending large blocks of their deals to 30 years and longer, partly in response to demand from TOB programs.“That is part and parcel of trying to get the lowest risk-adjusted cost for you client,” said Bob Rich, managing director at Public Financial Management Inc. “I focus on the market more broadly, but there are influences in the market that the TOB programs have.” He said that when it comes to selling bonds for his issuer clients — fixed- or variable-rate — he considers the effects TOBs along with other market forces. With more TOB programs competing for similar credits to put into new trusts, many will consider cranking up the leverage on their programs, said Ying Chen Li, a municipal strategist at JPMorgan who follows the TOB market. “Now it’s clearly harder to make that kind of return because of the flattened curve,” he said, referring to a trend that was reversed in June. “So, one thing the investor has to do is increase the leverage. But, it goes without saying, that if you are a hedge fund, you cannot do very much about that. If you are in a bank, you can go with a very high leverage without a problem.”This suggests that, even though munis are considered by many as a safe bet, stakes on the TOB trade might be rising. “This program used to be called the duration-zero trade — no interest risk, no credit risk, nothing,” Ying Chen said. “But now, if you want to maintain the same kind of total return, you have to take a little bit more risk.”