August 2017 Muni Market Review – An Introduction to VRDO’s
Munis continue to be a top performing assets class year-to-date, and there are so many good things going on in muniland. That being said, we are seeing storm clouds developing on the near horizon and take time this month to let you know our concerns.
Never fear, we still have investment ideas and a place to wait out and see what happens. In this month’s credit review, we provide you an introduction to the variable rate demand obligation (VRDO) market. This is where you can earn roughly 26% of the max muni curve income, while taking no price risk.
Muni Market Review:
The municipal market continues to outperform its taxable equivalents and, year-to-date the BAM muni index is showing a 4.8% total return versus 2.83% for US Government Bonds. We do feel this trend may be coming to an end over the next 30 to 90 days and are being defensive with our investment strategies. Highlights of muni performance are as follows:
- Tax-exempt yield curve has steepened, with yields dropping from 67 to 36 bps. Taxable yield curve has changed from 22 to 24 bps.
- Year-to-date date, 2017 issuance is lagging 2016’s record levels by 14% with refunding off 25%.
- Credit default spreads remain virtually unchanged and there has been some positive news this year on “problem states” like Illinois and New Jersey.
Why do we think this could change in the next 30 to 90 days?
- Issuance should increase, especially from an increase in refunding deals. Lower interest rates and the reopening of the SLUGS window should cause an increase in refunding issuance.
- Tax reform seems to now be in focus in DC. We do not think munis will be impacted from the potential reforms, but it could raise the prospects for uncertainty given the recent history of the current administration.
- FOMC and its plans to announce how it will proceed to reduce its balance sheet. We are uncertain how the market will react, especially if it is more aggressive than what many are thinking.
- Supply and demand technicals in the muni market are turning seasonally negative for the market. The preliminary numbers shows that demand will be only 80% of forecasted issuance. We believe that issuance will be greater than the forecast and that the number could be closer to 60%.
Market News & Credit Update:
- The State of New Jersey bond rating was changed to a stable outlook instead of negative by S&P. S&P cited that the new proposed budget for the State allocated funds to meet half of the pension obligation versus the third it met last year. So let me get this right, they are paying half of the bill instead of a third of the bill, and that is considered an improvement in credit quality?
- The recent news that Libor will be phased out will have an impact on the municipal market. The recent emergence of floating rate notes has created an investment vehicle in munis that is priced off the Libor market. We are not sure how this will be changed, but something will need to be done by the end of 2021 to reprice these securities.
- Illinois is planning to issue $6 billion in bonds in the near future. The State has seen a strong market performance in its bonds year-to-date (7.33% Barclays Bloomberg Index). The Governor feels now is the time to tap the market for this record amount.
Why Not Cash? An Introduction to the Variable Rate Demand Obligation Market:
We have recently been recommending investors put their cash in 7-day variable rate demand obligations (VRDO), and have invested up to $25 million for 15 different accounts over the last 30 days.
Why, you may ask? Quite simply, we feel munis are a bit overvalued and do not represent good long-term value at this time and, as we laid out in the market review, we have concerns with the market’s performance in the next 30 to 90 days. This coupled with long-term munis trading at a 3% yield, and seven-day money market eligible security trading at 80 bps, staying out of the market is not too “expensive”. You can still receive 27% of the max muni curve’s income while taking virtually no market price risk. Now would you like to learn more about these VRDO’s?
Introduction:
Variable Rate Demand Obligations (VRDO’s) are debt instruments that allow issuers to receive financing at short-term borrowing rates. They make up roughly 75% of the US municipal money market, and appeal to investors looking for a safe, short-term liquid investment that has a floating interest rate. They are 2A-7 money market fund eligible, which means the following:
- Low market price volatility – Investment term is 7 days, or the length of the variable rate reset frequency (could also be daily or monthly). This means bonds reset in price each week to par.
- Principal protection is top tier credit quality – In most cases the put option is guaranteed by a third party high credit quality financial firm (mainly banks). These firms must meet with the credit quality requirement of the money market funds. There are some support facilities that also require investors to analyze the issuer credit quality.
- Diversification easy to achieve – Remarketed by numerous firms, liquidity supported by numerous banks and VRDO’s issued by many different types of municipal entities.
Variable Rate:
Bonds pay out a floating rate coupon that typically resets every seven days, according to a stated index. Some reset daily and there are a few that reset monthly. The rate is based off the Securities Industry and Financial Markets Association (SIFMA) Index. This index is set each Wednesday afternoon for first accrual day on Thursday. The level is determined by supply and demand of tax-exempt cash and one month Libor.
Depending on the underlying issuer, the actual rate earned could be plus or minus basis points from the stated index (at this moment roughly +/- 10 bps.) Items that determine this spread are the following:
- State of issuance. High tax states like California could earn less than the index.
- Tax status – Bonds subject to AMT will earn more than the index.
- Underlying credit quality. A bond with an “AAA” rating will trade with less spread to the index than a bond with an “A” rating.
- The type of liquidity support. LOC will price at a lower spread, a self-liquidity program will price at a wider spread.
Interest is usually paid on a monthly basis and minimum investment par amount is $100,000.
Demand/Put Option:
Bonds are putable back to the remarketing agent for par with a seven day notice. The broker who has remarketed the floater needs to be notified of the request and the trade will be booked for redemption seven days from the date the request is made. For example, if the investor exercised the put option on Thursday, proceeds will be paid out, plus accrued interest the following Thursday.
If this put option is not executed by the remarketing agent, an event of default has occurred. The bank providing the liquidity and/or the issuer has not met a required financial obligation. This makes VRDO’s much different from “auction rate securities” that failed in 2008/2009.
Liquidity Support:
Par value upon notice is backed by a third party financial party. There are several types of support, but the objective of it is that the bank will provide the investors principal upon demand using its full financial resources to meet this obligation. These third party financial firms must be A-rated or higher, and have short-term ratings in the highest two categories.
The three most common types of liquidity support are:
- Letter of Credit (LOC) – The strongest support available. The financial firm has put this obligation on par with its own debt and underlying issuer credit quality is not a big factor.
- Stand By Purchase Agreement (SPA) – The financial backing is there to provide support if the issuer cannot do so. If payment is not made by the issuer, the issuer has defaulted, the SPA then takes over. The underlying issuer’s credit quality is under consideration, but the bank remains the main credit risk.
- Self- Liquidity – This is very rare, and liquidity is fully dependent on the issuer. There is no financial firm providing liquidity. If the issuer defaults, there are no other sources of funds to repay the obligations. The underlying credit quality of the issuer is all that matters. MainLine does not invest in these types of VRDO’s.
Conclusion:
Let’s get you out of that cash, and ready to buy munis if the opportunity presents itself. In the meantime, you can earn decent tax-exempt income with no price risk. Call us about VRDO’s.