The volatility of short-term rates, however, means the variable rate structure isn’t a silver bullet.
Short-term interest rates are on the rise as the U.S. Federal Reserve continues to hike its target rate amid global demand for U.S. Treasuries. Given rock-bottom interest rates across most other advanced economies, coupled with trade war rhetoric, perhaps it’s not so surprising the U.S. yield curve has flattened amid good domestic economic growth. What are fixed income investors seeking to protect portfolios from rising interest rates and the associated falls in bond prices to do?
One option involves investments offering variable instead of fixed coupon payments. While many investors have some familiarity with floating rate bond structures, they believe them to be limited to the corporate high yield market in the form of senior loans. While the variable structure of the interest paid can be attractive, credit risk may still be a real drawback. If the credit risk is acceptable, though, the taxable nature of the income still doesn’t provide a solution for tax-free investors.
Tax-free investors did have a solution prior to the 2008 Financial Crisis. At that time, municipal closed-end funds issued securities called Auction Rate Preferreds (ARPs), which were used to finance the leverage of the funds. The ARPs were marketed to investors in $25,000 par lots and coupon rates that were set by an auction process. Interest payments were effectively set in accordance with market rates, allowing the securities’ coupons to rise and fall with market levels. The structure was advantageous for investors interested in protecting their fixed income portfolio from the potential principal erosion associated with rising rate environments. Unfortunately, like other investments during the Financial Crisis, they failed when banks were unable to support the auction process and investors were stuck with the instruments, which have since fallen into obscurity.
Fast forward 10 years, and we are once again in a rising rate environment that has tax-free investors searching for protection. Unbeknownst to many investors, there is a floating rate municipal structure that has been around for decades that can help with this problem. Variable Rate Demand Obligations (VRDOs) are long-term floating rate securities that include a put feature allowing the securities to be considered short-term. The interest rates of the securities, which are also known as Variable Rate Demand Notes (VRDNs), are indexed to the SIFMA Municipal Swap Index (SIFMA Index) and the securities are priced at par. While VRDOs are priced off a floating index, they are not to be confused with ARPs, as certain features make them very different.
A large distinction is the re-marketing protection that exists on most VRDOs in the form of a letter of credit (LOC), or standby bond purchase agreements (SBPA). A LOC provides for complete credit substitution, which entails credit and liquidity protection for the issuer. If there is a credit event affecting the issuer, the bank providing the LOC will step in and make payments of either interest or principal to the bond holders. An alternative agreement is the SBPA, which provides liquidity or otherwise purchases the bonds in the case of a credit event or failed re-marketing. Under the agreement, the bank does not cover interest or principal payments but simply provides liquidity. These agreements are most often used by high-quality issuers seeking a lower cost alternative to an LOC. From an investor’s standpoint, the key is that protection exists in the case of credit events, or failed re-marketing, to ensure the liquidity of the bonds. In either case, the bank is stuck with the securities, not the investor.
Several other distinctions involve the rate reset period, the par value of the securities and the put/tender features available. As noted, VRDOs are indexed to the SIFMA Index and depending on the stated structure have daily, weekly, or monthly reset rates. Along with the differing reset rates, VRDOs typically trade in larger sizes than ARPs, with minimum denominations of $100,000, making them less accessible than the $25,000 denominations associated with ARPs. The last distinction is the put and tender feature often associated with VRDOs. While the put option is what allows the securities to be considered short-term in nature, often a tender option is attached as well. The tender option provides protection for the issuer in the case that interest rates spike and the financing costs are no longer advantageous. The tender option allows them to call the bonds, effectively retiring the debt, so the issuer can then seek more attractive sources of financing. This allows issuers to conduct long-term borrowing at short-term rates without worrying about a spike in short-term rates that could jeopardize the benefit of doing so.
While the credit and liquidity enhancements make VRDOs attractive in the current rising rate environment, they are not without risks. Like any other municipal bond, there is always credit risk associated with any investment. While the majority of borrowers are high-quality in nature, health care and multi-family housing account for the largest amount of outstanding debt and the states of New York, California, and Texas account for 44% of total outstanding VRDOs as of the fourth quarter of 2017, according to SIFMA Index.
Beyond issuer and sector concentration, another caveat is the way the securities trade. The structure and market tend to be highly inefficient and technically driven. The supply and demand impact on the market can be very pronounced especially at or around tax season. Many money market funds are heavy investors in VRDOs and their inflows and outflows can have a large impact on dealer inventories, which in turn affect the interest rates paid on the bonds. These rates, while attractive in recent times, reset daily and can be quite volatile. In fact, the largest risk that we see with VRDOs is short-term rate volatility, raising the potential for investors to mistime trading around them. But VRDOs are nonetheless a useful tool for muni investors in managing cash reserves as part of a larger portfolio, particularly in a rising rate environment.