Some tender-option bond programs have been unwinding because of changing market conditions in 2006, putting more long-dated muni bonds back into the market during the past six weeks.
In recent years, TOBs have become a growing presence in the municipal market. They are typically set up as trusts that allow users to pay a low interest rate to borrow funds by selling short-term notes, with proceeds then used to purchase longer-term bonds to earn higher yields. But certain trends have diminished the profitability of the trade, leading TOBs to sell some of their bonds, or unwind.
“TOB unwinds are running at twice the rate of new TOB origination over the last few months,” said Pavan Wadhwa, a managing director and head of tax-exempt finance at J.P. Morgan Securities Inc. in New York. “The first reason obviously is the flattening of the curve, the second reason is the richness of the muni market, and the third and much smaller reason is the ‘max rate’ considerations.”
The term “max rate” refers to the rate paid out to the short-term noteholders, which cannot be higher than the yield earned on the long-term bonds in the trust, because TOBs cannot have more tax-exempt funds flowing out of their trusts than they are bringing into them.
The short-term rates are usually determined by the Bond Market Association municipal swap index. While short-term municipal rates have yet to surpass those on the long end, as they have in the Treasury market, some TOB users have become concerned that they could.
However, other factors have already been at work suppressing the profitability of the trade.
As short-term rates have risen, the spread between 30-year and one-year triple-A rated general obligation bonds has narrowed to 105 basis points, as of Wednesday, from more than 160 in November, according to Municipal Market Data. With higher short-term rates to pay out, TOBs are not able to keep as much of the long-term bond yields they earn.
Meanwhile, 10-year triple-A GO bonds traded at 73.30% of the 10-year London Interbank Offered Rate on Wednesday, compared with more than 78.50% in October, according to MMD. Ten-year triple-A GOs traded at 81.67% of 10-year Treasury notes on Wednesday, which was down from more than 86.80% in November. Some market participants, fearing a large-scale sell-off, have been uneasy about the proliferation of TOBs, hedge funds, and crossover buyers in the municipal bond market.
“Non-traditional buyers of munis are becoming an ever-growing presence, which is not only the TOBs, but [arbitrage] accounts, and they tend to move en masse,” said Rick LaCoff, senior vice president at Payden & Rygel Investment Council in Los Angeles. “There are some bad implications, obviously, because it would be a large volume of bonds coming back into the market at a time when the market is probably not prepared to digest that.”
| John Hallacy |
According to John Hallacy, a managing director at Merrill, Lynch & Co. in New York, their presence introduces a “danger that when the rate environment changes, the market stands to lose some interest.”Tom Doe, president of Municipal Market Advisors, a research firm in Concord, Mass., said: “We certainly have seen in the first two months that people that are in the trade have been less active.”
However, it may be a little premature to start envisioning TOB programs’ rapid flight from the muni market, according to market analysts.
“Even though the curve is relatively flat, they are still making money on these programs,” LaCoff said.
“There is still a considerable way to go before they have to start unwinding all of them,” he added. “I think for the muni curve to get completely flat, there is going to have to be a lot more pressure put on the front end of the curve. We just don’t envision that at the moment.”
But trouble could arise if long-term rates remain range-bound and the Federal Reserve continues to raise the federal funds rate. “Let’s say we are here next year at tax time and the funds rate is at 5.5% or even 6.0% — then that is going to be a huge problem, obviously,” Wadhwa said.
At that point, LaCoff said, portfolio managers would likely want to position their funds with curve-steepening trades or get outright short in duration because there would likely be a lack of paper on the very short end of the curve and increased supply on the back end of the curve.
While it is difficult for market analysts to track the overall amount of money invested in municipal TOBs, J.P. Morgan is estimating that the level is currently in the neighborhood of $110 billion and will likely increase only marginally by year-end, Wadhwa said. Other market participants estimate the current total at as much as $150 billion and predict that the level could rise above the $200 billion mark if the yield curve steepens dramatically in 2006.
Unwound TOB money has not gone very far and is not likely to stay away for very long, according to analysts. Many of them have been dumping funds into tax-exempt money market funds, Wadhwa said. “Obviously, they don’t want to let it just hang around,” he said.
“A lot of the players are folks that have committed a certain amount of capital to the muni market and will play in that particular market itself,” Wadhwa added. Money market funds are “a great place to put the money to work for the short term while you wait for the muni market to cheapen up.”
In the meantime, property and casualty insurers, mutual funds, retail buyers, and other investors who maintain a “buy and hold” strategy have become very active in the muni secondary market and have likely soaked up a lot of the excess paper sold by the programs, he added.
The additional supply comes at a time that muni bond issuance has been running very low. Through Tuesday, $48.87 billion in deals have come to market in 2006, compared to $63.86 billion through the same period last year, according to Thomson Financial data. The last time issuance was lower at this point in the year was in 2002, when $48.20 billion was sold. Approximately $358.74 billion was issued in the 2002 calendar year.
Going forward, the slope of the curve, the availability of new issues, and the growing competition for the same products between TOBs and muni bond hedge funds are the three main components that will determine whether alternative accounts continue to buy muni bonds, Doe said.
“What if municipal issuance for the year, instead of maintaining a level, drops below $300 billion?” Doe asked. “There are now more arguments for that low-end projection than anything else.”
“Let’s say there is $280 billion and you have 30 TOBs as opposed to 10 a few years ago and everything else is unchanged,” Doe said. “Should issuance be as light as it is, the competition can contribute to the reduced incentive in the strategy. That demand component would drive down the long end and flatten the curve out further, and how much can you really grow then?”
“Last year there was plenty of product and there weren’t nearly as many people in the trade,” Doe said. “I estimate the number of people that are pursuing the strategy has grown 30% in the last 12 months.”
Other market analysts agreed that supply will be critical in determining the direction TOBs take.
“There has been strong bidding for longer paper just because there is an absence of supply out there,” said Matt Fabian, a senior research analyst with UBS Securities LLC in New York. “That is a major factor in the flatness of the curve. Once the curve re-steepens to a more typical level, then the TOBs will be back.”
The steepness of the curve will also be dependent on how the Federal Reserve adjusts the federal funds rate, because tightening monetary policy pushes up the short end of the curve, he added.
“Our expectation is that the Fed is going to stop raising rates in March and that they will possibly begin to cut rates as soon as November, and that should drive short rates down and improve the carry trade,” Fabian said.
Still, some market participants feel that even in the market’s current state, TOB players remain interested in muni bonds.
“People keep talking about [how] when the curve flattens, it won’t be good for munis,” said Ying-Chen Li, co-director of research and a municipal derivatives strategist at Merrill. “But in terms of the curves the munis may actually be relatively steeper,” Li said. “What these buyers are looking for is what is called the relative steepness of the muni curve, and right now all of the taxable curves are inverted.”
“Compared to last October the total return for the trade would be reduced by a total of about 1.0%,” Li said. “The total return for this trade is very big and so if it is reduced by 1.0%, it is still very big.”
According to some, the possibility exists that even if the Fed continues to raise rates and the municipal yield curve flattens further, TOB participation may persist in the market.
“TOBs are not wimpy buyers and they are used to some volatility,” Hallacy said.
“As a matter of fact, they are probably used to a lot more volatility than you find in munis, period,” he said.
“They don’t flinch too easily.”
