Tax-free Bond Opportunity: A VRDN Case Study

Author: John Mousseau, Post Date: July 20, 2008

Since early in 2008 there has been much congestion and volatility in the short-term tax-exempt bond market.  This has been due to the failure of the short-term auction-rate market, specifically the backup in yields in the variable-rate demand-note (VRDN) market caused by market aversion to downgraded insurers, the abject failure of auction markets of student loans and closed-end preferred shares’ failure to clear.

Clearly the high rates on floaters and auctions have put financial pressure on municipal issuers who have done nothing wrong on their own except be hurt by the fallout from the downgrading of the bond insurers.

Let’s take a look at one bond which we have recently owned in Cumberland accounts.

The Bay Area Toll Authority (BATA) in California is eleven years old and was created in 1997 by the California state legislature to fund and administer the seven state-owned toll bridges in the San Francisco Bay Area.  BATA is rated AA3 by Moody’s and AA by Standard and Poor’s and has an entire portfolio of $2.4 billion in variable-rate debt, both auctions and floaters.

Last fall they issued VRDNs.  The issue we reference was a $500mm issue, and this particular nominal maturity was $50mm.  The bonds came with AMBAC insurance – then AAA rated by both Moody’s and Standard & Poor’s.  The bonds have a nominal maturity of 2047 but were issued as weekly floaters.  The weekly “put” feature was secured by a Standby Purchase Agreement from Dexia (a Belgian-based European bank specializing in public finance internationally), which gave the bonds a VMIG1 short-term rating (Moody’s highest short-term rating).

The reason that BATA, like many large infrastructure issuers, issued variable-rate debt is that it allowed them to offer long-term maturities but also enjoy the benefits of the traditionally steep tax-exempt municipal yield curve, where short-term rates are usually much lower than long-term rates.

The initial weekly rate was 3.23% last October and stayed roughly between 3.5% and 3.0% until year end.  To compare this: if BATA had issued long-term bonds instead, the interest cost to BATA would have been a yield of roughly 4.50%-4.80% for long, high-quality California debt.

The rates stayed low in the beginning of 2008, dropping to nearly 2% in late January.  This certainly correlates with the rest of the short-term market, where rates were falling in concert with the Federal Reserve moves of lowering all short-term interest rates to battle the freeze-up in liquidity which had gripped all financial markets.

February, 2008 saw most money market funds (where VRDNs are a staple item) “put” almost all floaters – FGIC, CIFG & XLCA-insured because of downgrades;  AMBAC & MBIA-insured bonds because of the threat of downgrades.  These funds did not want to take a chance of having downgrades appear in their portfolios for legal as well as marketing reasons.  Thus, the interest rates on all floaters shot up in February as the dealers’ only recourse (since the bonds trade at par) was to offer higher and higher rates. 

On Feb 28 the weekly reset rates on BATA floaters shot up to 6% from 2.75%.  Because of the great demand for California paper in general, and short-term California paper in  particular, these rates soon started to work their way back down.  At that time AMBAC & MBIA, unlike some of the other insurers, were not yet downgraded.

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