Tender-Option Bond Trusts Drive Muni Holdings

The amount of outstanding tax-exempt debt grew to $2.466 trillion in the first quarter of 2007, but certain categories of bondholders, namely brokers and dealers and money market funds, are growing much faster than others as a result of tender-option bond trusts. Data released by the Federal Reserve as part of its quarterly flow of funds report last week shows that while traditional households are the largest muni holders with $876 billion of bonds in the first quarter, they are growing at a slower pace than other areas. It appears that TOBs as well as the changing demographics of the United States are driving the change. The $2.466 trillion total outstanding debt of state and local entities is an increase of $61.3 billion over the fourth quarter of 2006, and up $211.3 billion over the same period last year. The amount of outstanding municipal bonds debt has grown every year since 1996, in large part because of demands on local and state governments to provide services and facilities to residents.“The answer for so much debt issuance is that we need the infrastructure,” said Paul Disdier, director of the municipal securities division at Dreyfus Corp. “States are in good shapes in terms of tax revenues right now, but the long term picture is that the needs of America are growing.”Disdier also pointed out that new issuers have also entered tax-exempt space. This includes charter schools and new health care entities, for example, that have not traditionally been in the market. The household sector — traditional buy-and-hold investors — continues to be by far the largest holder of muni bonds. This is more than double the next class of investors, money market funds, which own $388.3 billion in debt. Rounding the top four categories of owners are mutual funds and property and casualty insurers with $359.4 billion and $338.3 billion, respectively. These types of owners collectively account for 79.6% of all holders of tax-exempt debt. The data this quarter as compared to previous quarters and prior years illustrates the changing marketplace. Buy-and-hold investors’ holdings grew 1.3% from the last quarter of 2006 and in the last year ownership in that segment has grown 6.8%, or $55.9 billion. This is not nearly as fast as some of the other categories of bondholders. There are a variety of reasons for the slower pace at which household ownership has grown, but Rick Calhoun, vice president of sales at Crews & Associates, points to the growth of institutions that want to actively manage people’s money.“A lot of individual households will look at a money manager alternative instead of locking into a bond for 10 or 15 years, which lately you have to do to get the yields you want, when instead you can have your portfolio actively managed,” Calhoun said. “Institutions don’t want to sell someone some bonds, they want to get a person’s entire portfolio and his entire net worth under management.”Broker-dealers’ holdings are up to $54.1 billion, a rise of 6.3% from the previous quarter and a staggering 52.2%, or $18.5 billion, from last year, according to the data. This growth can largely be attributed to the popularity of TOBs, which many brokers dealers are a part of. “The brokers and dealers are holding more tax-exempt bonds because of the growth of the tender option bond programs that are continuing to put on a carry trade by buying at the long end of the curve and funding their purchases in the short end,” said Ross Berger, head of credit for the proprietary tax-exempt portfolio at Wells Fargo Bank. “They are executing this trade for their own accounts and for customer accounts.”Wednesday’s Municipal Market Data triple-A scale pegged a 30-year bond at 4.52% yield and the Securities Industry and Financial Markets Association’s 7-day floating rate now sits at 3.74%. A profitable spread of 78 basis points exists between these yield points, which the TOB exploits. “These portfolios will continue to apply this trade as long as there is steepness in the curve, relative value of municipal bonds relative to other asset classes and if their hedges can continue to effectively neutralize duration risk of their long-dated bonds,” Berger added.Money market funds also grew their holdings with a 4.9% increase in the quarter and a 11.8%, or $41.1 billion increase in the year. This is also largely a result of TOBs. Part of the TOB process involves the grantor trust selling floating-rate certificates to municipal money market funds, usually at the SIFMA swap rate, and the trust will in turn receive a fixed rate.“Municipal money market funds have been huge recipients of assets in particular because we have seen a lot of growth in synthetic supply, which is the tender option bond market,” said Pam Tynan, a principal and senior portfolio manager at Vanguard Group. “That has provided an enormous amount of supply in the short-end of the yield curve. Things have changed from where they were a couple of years ago.” The final area that experienced faster growth is that of mutual funds. These pooled investments posted an increase of 4.4% this quarter and 11.8%, or $37.9 billion, on the year to total $359.4 billion. To explain this many participants look to the aging U.S. population.“People are looking for stability of income,” Disdier said. “Aging baby boomers are getting ready to retire and when that happens, people will shift from equities to investments with predictable streams of incomes and that means tax-exempt bonds in many cases.”With this ongoing trend, municipal mutual funds are gaining in popularity as a tax-free investment and this area looks to continue to grow faster than other sectors of buyers. Investors have consistly poured money into muni mutual funds for a year, according to data from the Investment Company Institute.