TOBs, and Why Munis Are a Must for Long-Term Holders

by: Accrued Interest

What is a TOB? A tender option bond (from now on TOB) is the municipal bond market's answer to the classic borrow short and invest long. As with many types of leveraged strategies, this one has been getting hit very hard in 2007. It also has some disturbing parallels with the SIV problem which has rocked the money markets.

What exactly is it?

First, here is what a TOB is. You start out with a long-term tax-exempt municipal bond, usually highly rated. Let's say you buy it at par with a 4.5% coupon. 30-year tax-exempt munis are widely available at that price right now.

Then you sell senior notes to some other investor with your long-term muni pledged as collateral. The amount is somewhat less than the value of the collateral pledged. The senior notes have the same maturity as your pledged collateral, but the interest rate floats every seven days. Typically the floating rate is set by a dealer firm (called the "remarketing agent") based on whatever rate will clear the market. The senior note holders also get a put option, also called a tender option. The senior note holders can put their bonds back to the issuer at par at any time with settlement on the next reset date.

If you are familiar with municipal floaters, you know this is a very common structure. It goes by the name VRDO (Variable Rate Demand Obligation) or VRDN (N=Note) or VRDB (B=Bond). It is used by normal issuers who want variable rate debt as well as TOBs. The idea that the bonds would always be puttable at par probably sounds funny to some readers, so think about it this way: It is really just like a revolving CP program where the issuer retains the same amount outstanding all the time. While technically in a CP program, the old CP matures with proceeds from the new CP, as long as the capital markets are fully operational, the CP issuer effectively just resets his interest rate.

So back to the TOB. You remember the size of the senior issue was less than the size of the collateral pledged, which leaves us with some residual. That is sold to junior note holders, who in essence have leveraged exposure to the original municipal bond.

These programs can be structured as single name deals, where a single long-term muni has been pledged vs. a single senior VRDO. Or it can be structured where there is a pool of long-term munis pledged against a larger senior VRDO. From a pure safety perspective, the senior holders would obviously prefer the pool, but there are legitimate tax concerns about the pooling structure. Legally, in order for the tax-exempt status of a bond to pass through any kind of structured product, the credit risk of the municipal has to be retained by the investor. Thus the senior/subordinate structure of the TOB can get sticky, especially if it is pooled. Some tax attorneys argue that when you pool this kind of program, the senior holders are not actually taking risk on all the municipals in the pool, since it's usually the case that several could default without senior holders getting hurt. This senior/subordinate concept is not unlike a CDO structure in terms of how the senior notes are protected.

VRDOs are normally backed by some sort of credit enhancement, which is different than the classic bond insurance. In the case of a VRDO, the backing is normally from a bank, which can come in various forms: a letter of credit, a stand-by purchase agreement, or just a liquidity facility. All of these have similar functions for the investor: it ensures that, if investors want to put their bonds back, then someone with capital is there to buy them.

The junior notes are most likely held by a hedge fund. There are many hedge funds for which this is their only strategy, and they spend most of their day creating these TOB structures. Since the junior notes have considerable interest rate risk, the hedge fund generally cooks up some means of hedging this risk. Unfortunately, the world of municipal derivatives is pretty murky, so often the hedge fund winds up using LIBOR swaps or some such as its hedge. This introduces the risk that taxable bond rates move differently than municipal bond rates.

In addition, long-term municipal bonds are usually callable by the issuer starting in the 10th year. The option risk inherent in the municipal makes hedging with non-callable taxable instruments like swaps a real challenge.

TOBs are generally created using AAA municipals as collateral. This has to do with the desires of both the senior and junior note holders. The senior holders, usually money markets, generally want very highly rated securities. Ratings agencies will generally rate the TOB senior piece the same as the underlying collateral. The hedge fund buying the junior piece also wants to avoid credit problems. The arbitrage of a TOB is all about the slope between short-term and long-term bonds. Introducing credit risk merely complicates an essentially simple arbitrage.

Now here is where the problems start...

Current Troubles

Up until now, finding AAA-rated long-term munis was easy, because so many munis were insured by AAA-rated monolines (I believe around 40% of all municipal issues are insured). But now we're in a world where that AAA rating is imperiled. This has caused the municipal bond market to decouple from the taxable bond market, perhaps not entirely, but to some degree. Whereas, historically, municipals tend to trade around 80% of Treasury rates, currently the number is above 90%. Long-term municipals are widely available at, or slightly above, the 30-year Treasury rate.

This means two things for TOBs. First, money market funds are increasingly unwilling to hold short-term TOB debt. Makes sense right? If you were running a muni money market fund, and you could get out of any TOB debt at par right now, wouldn't you? You know that there is a decent chance some of the TOB bonds are about to be downgraded. You also know that the guy across the hall who ran your prime money market fund just got fired over the whole SIV thing. I'd dump those TOB bonds as fast as I could.

Second, the TOB hedge fund's hedge position isn't working. Municipal yields are not moving with taxable yields and this is creating big losses for the TOB. And we know what happens when hedge funds take losses: investors start pulling out. So you've seen TOB programs having to force liquidate bonds.

Bad news. TOBs represent 8% of the total municipal bonds market, or about $200 billion. The muni market isn't known for its liquidity, so if you have a large number of bonds being dumped on the secondary market, the whole market cheapens up. This is exacerbating any credit concerns market participants might be having.

Parallels with SIVs

The parallel with the SIV problem is hard to miss. Money market participants eschew the debt. The vehicle can't roll over, winds up liquidating into an illiquid market and exacerbates an already tenuous credit environment.

The good news is that unlike SIVs, the credit quality of municipals remains very strong. While SIVs were involved in the CDO and sub-prime markets, where there has been unquestionable and material deterioration, municipals don't really have this problem. Property tax collections may wane a bit, but the odds of this rising to a level where any cash flow to bond holders is ultimately impaired is remote. The only real problem in munis are the bond insurers. Even if one or more bond insurers were to disappear, the downgrade in most municipals would be from AAA to AA or A. Not good, but not the end of the world.

The bad news is that the bank credit enhancers may wind up owning the TOB bonds. See, if the hedge fund which is operating the TOB program can't make good on the short-term debt, perhaps because it can't liquidate all its long-term bonds and hedges at less than 100%, the bank will probably wind up possessing the underlying bonds. Again, this won't turn out like the SIV problem, where bank sponsors of SIVs are taking bonds onto their balance sheets at steep discounts. But still, cash-strapped banks are likely to just blow out the muni positions, creating more of a supply problem in the long-end of the muni curve.

Sell my Munis? Sell my muni money market?

I'm surprised to find you squeamish, monsieur, that is not your reputation. I think munis are a screaming buy for long-term holders. You are rarely going to get the chance to buy long-term munis at prices about equal to Treasuries. That isn't to say this is the absolute bottom, but I think as we finally resolve the bond insurer issue (one way or another) municipal buyers will come back in. Remember, there is no good substitute for municipals. They are the only tax-free game in town.