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.

It was Cumberland’s opinion that these instruments offered outstanding value, not only because of the high tax-exempt rate (compare 6% to the 1.5-2% offered by short US Treasury bills) but also because most (not all) floaters offered provisions to buyers which allowed a grace period to put the bonds back to the liquidity provider in case of downgrades below a certain level.  That level is important since it is the point at which the liquidity provider is able to terminate its liquidity agreement.

In states other than California, AMBAC and MBIA VRDN rates stayed high but started to subsequently decline as large numbers of nontraditional buyers found their way to this market.  New buyers included foreign buyers and US state and local governments that did not need the tax exemption.  They found the nominal level of rates very compelling; so did some charitable and nonprofit accounts as well.

In early June, both MBIA and AMBAC saw themselves downgraded by Moody’s and Standard & Poor’s.  AMBAC was downgraded to AA3 by Moody’s and to AA by S&P.  The rates on BATA’s floaters shot up from 2.9% to 6%.  The weekly resets since have yielded 9%, 7%, 8%, 8%.  Cumberland’s clients were invested at the 9% level and continue to hold them.

In the case of this BATA credit, we know that a downgrade by TWO rating agencies to below an AA3 (Moody’s), AA- (S&P), or AA- (Fitch) for 90 consecutive days will allow Dexia to issue a 30-day notice of termination.  Upon receipt of the notice a mandatory redemption will be made.  This means that there is a grace period AND, in this case, the bonds would be called because of the downgrade.  So far, the downgrade has not   been below the specified level.   

It should also be noted that all floaters DIFFER in terms of liquidity and termination provisions.  It is this complexity and confusion which has additionally caused these rates to stay high on what we consider extremely high-grade credits.

Of course, from the issuers’ standpoint these high rates are hitting them at the worst possible time: during an economic slowdown.  Issuers had planned for rates to approximate short-term Muni rates and that clearly is not what happened here.  The hole that is being driven into municipal budgets by these high short-term rates is having what we call a “common sense” effect.  Issuers are taking action to redeem these securities.

In the case of BATA, we now know the endgame.  BATA announced this week that it will convert a total of $1.9 billion in various insured variable-rate demand obligations to uninsured obligations with new liquidity facilities.  It will also be refunding $510 million in auction-rate bonds which have also been at much higher than normal rates.

Cumberland’s course of action will be to look for other short-term VRDNs once these have been redeemed.  We would expect other issuers to continue this practice (which has been ongoing the last 4 months) as they seek to replace the higher-yielding VRDN and auction product with either a new short-term product or with bond issues into the longer-maturity end of the market at a fixed rate. While that longer-term bonding out is done, this new issue volume will keep pressure on the long-maturity spectrum of the Muni market.

Meanwhile, we recognize that the ability to average 7%-8% tax-free (10.75% to 12.3% (taxable equivalent yields BEFORE taking into account any state tax exemption benefits) is as compelling a short-term opportunity as we have seen in a generation.  We will continue to take advantage of them.

David Kotok added note and disclosure: Cumberland has numerous separate accounts using this VRDN investment style; the clients are of all types; the largest institutional portfolio currently is $300 million.   These VRDN securities are often smaller sized issues and often need to be allocated among clients because there are not enough to fill all open positions.  Individual research on each issue is necessary in order to be sure that Cumberland’s internal specifications and requirements are met.  There is a special Cumberland staff segment dedicated to that purpose.  Retail and individual investors who try to do this on their owned are warned to take time and exercise great care so that they fully understand the terms and conditions of each offering prior to investing.

cumber map
Cumberland AdvisorsĀ® is registered with the SEC under the Investment Advisers Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in the states where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services. Please feel free to forward our commentaries (with proper attribution) to others who may be interested. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed.