CHICAGO - Market participants should understand the intricacies of tender-option bondprograms, even if they are not directly involved in them, because they are having anincreasingly huge effect on trading and pricing in the municipal market, Nat Singer, asenior managing director at Bear, Stearns & Co. told analysts at a meeting hereWednesday.
These programs are "influencing buy and sell decisions in the municipal market," Singersaid at a session on secondary market derivatives at the National Federation ofMunicipal Analysts' twentieth annual conference here.
Tender-option bonds are growing in popularity, not only because of the simple economicbenefits they produce, but also because of the huge tax benefits they provide forinvestment banks and other sponsors, said Singer, who estimated the tender option bondmarket is at least $50 billion to $75 billion right now.
"There are tender-option bond accounts on a significant number of deals being done rightnow," he told the analysts at the meeting.
Singer, who heads Bear, Stearns & Co.'s Municipal Derivative Products Group and managesthe firm's tender-option bond program, said that while the typical tender-option bondprogram makes a few million dollars per year in revenue for the dealer or other sponsor,it also provides more than ten times that amount in tax benefits for that sponsor.
"That's why tender-option bonds are so big right now," he said.
Tender-option bonds are created in the secondary market by investment banks, commercialbanks, hedge funds, insurance companies, and mutual funds. The sponsors of such programsbuy long-term bonds that typically are fixed rate, and put them into trusts to createboth putable short-term notes and residual interest. The putable notes are backed by thefixed-rate bonds. The residual interest is effectively an inverse floater. The putableshort-term notes are usually sold to money market funds. The sponsors keep the residualinterest.
But the sponsors of the programs, the residual interest holders, typically enter intointerest rate swaps to hedge the floating rate risk of their residual interest.
The disparities that exist between the yield curves for the municipal bond cash marketand the swap market create tremendous opportunity for arbitrage earnings, Singer said.
Singer detailed several scenarios that would lead arbitrageurs to sweep into themunicipal bond market and become big buyers of long-term, fixed-rate bonds, which theywould then use to create tender-option bonds.
The spread between the cash and swap markets is "the biggest factor driving the market,"he said. "The steeper the yield curve, the better" for creating tender-option bonds, hesaid.
Market participants need to know where the spreads are between the cash and swapmarkets, he said, because when arbitrageurs begin buying bonds for tender-option bondprograms, they buy big. They typically buy the bonds in minimum amounts of $10 million.They sweep up the supply of bonds, increasing prices and lowering yields.
Singer used a chart to explain how tender-option bonds produce economic benefits. If adealer or other sponsor is receiving 5% on long-term, fixed-rate bonds, but is paying4.6% in fixed rates in the swap, and at the same time is receiving a 1.15% floating ratefrom the swap but is paying 1.25% on the floating-rate notes, there is a 30-basis-pointgain overall to the sponsor. If the sponsor subtracts 20 basis points for expenses, hehas a net gain of 10 basis points.
Singer used the same chart to explain the tax benefits. The 5% fixed rate the deal orother sponsor receives on the bonds and the 1.25% floating rate he pays on the notes aretax-exempt. The 4.6% fixed rate he pays and the 1.15% he receives from the floating ratein the swap are taxable. Those rates, combined with 20 basis points in taxable expenses,produce tax-exempt income of 3.75%, the taxable equivalent of which is 6.25%. If thetaxable costs are 3.65%, on a tax-adjusted basis, the dealer nets a tax benefit of 260basis points. This translates into billions of dollars of tax benefits on a multimilliontender-option bond program.
Stevie Conlon, an attorney in Arlington Heights, Ill., who was also on the panel, talkedabout the tax and other legal issues in connection with such products. He said thesponsors entering into these transactions must show there are economic benefits and thatthe transactions are not being done simply for tax benefits.
Conlon said also that these transactions must be structured so that the owner of thefloating-rate notes retains a portion of the benefits and burdens of the underlyingfixed-rate bonds.
