Tender option bond programs, which have taken the municipal market by storm in recent years, are enthusiastically shopping TOB pools, whereby a variety of different bonds are held under management. The structure, or “pool,” has presented problems for money market funds who have become some of the largest buyers of TOB product. Discussions at the 13th annual Institute for International Research’s Money Fund Forum, held earlier this week in New York, indicate pools may be gaining in market acceptance. TOBs and hedge funds have been enthusiastically discussing pools for about a year now. Money market portfolio managers, however, have been reluctant to invest in them because they are difficult to analyze in terms of Securities and Exchange Commission Rule 2a-7. “A lot of these pools are very difficult to look at,” said Joseph Irace, a portfolio manager at Dreyfus Corp. who spoke at the conference. Rule 2a-7 governs the types of securities that money market funds can hold and regulates a number of factors, including credit quality, duration, monitoring ability for bonds held, and diversification. Before buying from TOB programs, portfolio managers must ensure that the product meets 2a-7 requirements. Most TOB programs now in existence are single asset trusts, meaning they hold a chunk of bonds in the same issuance. It could be from one maturity or from a strip of maturities, but all bonds must have the same credit rating and the same dates for coupon payments, said Lisa Washburn, managing director at Moody’s Investors Service. A pooled tender option bond program, on the other hand, involves placing non-uniform bonds into a TOB trust. This structure gives TOBs added flexibility and a place to put smaller blocks of bonds while keeping liquidity. The bonds in the pool could differ by issuer, credit rating, home state, or any number of other factors. And when they do, it makes it that much more difficult for portfolio managers and their staffs to evaluate the overall trust. One speaker at the conference explained by saying that if a pool is made up of 100 bonds, each accounting for one percent of the trust, all 100 bonds must be evaluated for compliance with rule 2a-7. This has been a significant barrier to entry for the structure, despite enthusiasm from TOB managers and hedge funds. “I think the residual holder would like to see the growth of these pools, but it’s imperative that they get the floater holders on board because they need them to purchase” the other side of the transaction, Washburn said. “For the money funds, there is not a whole lot of upside,” said Pam Tynan, principal portfolio manager at Vanguard Group. “Unless for some reason they would get an attractive yield as a result of this structure.” However, some firms are warming to the pools and have bought product from trusts holding bonds in the same state, because the issue of tax-exemption is at least clear. “The main thing is taxation,” Irace said. “It’s mainly a fund accounting issue with us,” Tynan saidOthers at the conference expressed worries about credit events that could knock an issuer’s rating below the 2a-7 threshold. In such a case, it is crucial to know how the pool would react, Washburn said. In such case, so-called open end pools would allow TOB managers to move bonds in and out of their trusts, without having to decrease the size of the trust. This, in turn, would make it more difficult for portfolio managers to specifically monitor the bonds held in the trust. It is these open, more flexible pools that are now gaining traction in the market, Washburn said. Despite the difficulties faced by portfolio managers trying to evaluate these pools, a significant number of pools already exist. In fact, they may account for as much as 10 percent of all TOB programs, according to Nicholas Rabiecki, senior portfolio manager at JPMorgan Asset Management, who spoke in an interview at the conference. Rabiecki said he is currently evaluating pools to see how they might work for his funds, and said he would not be surprised if they eventually make up half of the market.
