Aside from tax status, there is one key distinction between tax-exempt and taxable TOBs.
With tax-exempt TOBs, the relationship between the holders of the floating-rate certificates and the owners of the underlying assets must be structured as a “form-equity partnership” for legal purposes in order for the certificates to maintain the tax-exempt status.
That means the floater-holders must have a stake in the value of the underlying collateral, which exposes them to positive and negative risks. In market parlance, that stake is called the “gain share,” meaning that if the underlying equity rises or falls, the floating certificates in the transaction rise or fall accordingly.
Holders of the floating certificates are also exposed to reinvestment and interest rate risks, commonly called tender-option termination events, or TOTEs. These are events in which the put option on the securities can be terminated and the certificate holder becomes stuck with the paper.
TOTEs can include a severe downgrade, a default on the underlying collateral, the issuer declaring bankruptcy, or the payments on the underlying bonds losing their tax-exempt status.
While for taxable TOBs preserving the tax-exempt status is not a concern, other termination events may still be applicable.
When Morgan Stanley structured its first taxable TOB in mid-May, the bank created the program as “form-debt” instead of a form-equity partnership.
This distinction allowed it to eliminate gain share and the accompanying TOTE risks altogether. Instead, it offered an unconditional put on the floating certificates.
Eric Vandercar, Morgan Stanley’s manager of municipal funding and liquidity, said the unconditional put was more valuable to the investor than any added exposure for a liquidity provider or liquidity bank. That makes the taxable TOB more marketable, he said.
“The noteholder would not lose their tender right,” Vandercar said. “Even if the underlying bond were to default, get downgraded below investment grade, or become bankrupt.”
Eliminating TOTE risks “sweetens the deal and makes them more attractive,” said Peter Hayes, head of the municipal bond group at BlackRock, an investment management firm that has purchased taxable TOBs.
“An unconditional put is much stronger and much easier to monitor than a conditional put, without a doubt,” Hayes added.
The distinction shouldn’t be exaggerated, however, given how distant those risks are.
Vandercar said a tender-option termination event has never occurred in the 3,000 or so tax-exempt transactions he has participated in over the past two decades. The reason why it is so unlikely is that the asset backing a TOB must be rated double-A or higher, usually by at least two rating agencies. If the asset begins to deteriorate, Vandercar said, the holder of the certificates is likely to exercise the put option long before it falls below investment grade, let alone defaults.
Jeff Previdi, senior analyst at Standard & Poor’s, said he had never heard of a TOTE actually occurring either, though he couldn’t definitively say that one had not.
