Overview of Tender Option Bonds
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Overview of Tender Option Bonds (TOBs)
TOBs are synthetically created short-term tax exempt instruments. A TOB sponsor will buy a portfolio of fixed rate, long term municipal bonds with ratings between AA-AAA and combine them with an interest rate swap to create short term tax exempt floating rate bonds. (Please see attachment 1 for a summary of the deal structure).
The tax-exempt status creates a high level of demand particularly from investors who seek tax exempt cash flow as a source of annual income and revenue. The buyers of TOBs are for the most part money market mutual funds. Money market mutual funds are guided by certain regulations as to what type of bonds they can have in their portfolio. Specifically, the underlying municipal bonds must be rated at least AA-. The maximum maturity of the municipal bonds is thirteen months and the average weighted maturity of a money market funds tax exempt bond portfolio must be no longer than 50 days. This compares to typical maturities of municipal bonds of five to fifteen years. The money fund maturity guidelines combined with a strong demand for tax exempt instruments creates a very active and deep market for these synthetically created short-term tax-exempt securities. The approximate size of the TOB market is $70Bn.
With respect to the underlying quality of the municipal bond, TOB sponsors (including Merrill Lynch) generally mandate that the TOB program can not carry any bonds in inventory related to the TOB program with ratings below AA- because the protection of principal is important to the investors.
Tender Option Features
In order to truly simulate the characteristics of a short-term tax-exempt security, the TOB sponsor has to provide a way for investors to liquidate their investment at par value. This is accomplished by giving the investor the right to tender (or put) the security to the remarketing agent at par value plus accrued interest at regular intervals. These intervals are based on investor demand (Merrills program generally sets them at one week).
On put days, the investor has the choice to either tender the TOB or to roll them over at a reset tax-exempt rate. The investors are required to give the TOB sponsor one week notification prior to a put in the case of weekly TOBs and same day notification (prior to 10:00am) for daily TOBs. The risk that the TOBs might be put by the investors and might not be immediately remarketed by the remarketing agent is the reason why the liquidity bank is needed.
Other Features of TOBs
In order for the investors to benefit from the tax-exempt status of the synthetic bond, the TOBs must have a feature that establishes the investor as the legal owner of the underlying municipal bond. This is achieved by the investor bearing the default risk of the issuer on the underlying municipal bond. Specifically, if the issuer of the underlying municipal bond defaults, the investor loses the right to put the bonds to the liquidity bank and the liquidity facility is automatically reduced by the amount of the bonds in default.
Interest Rate Swap
As indicated above, the sponsor (MLCS in Merrills case) creates a TOB through the combination of a long-term municipal bond and an interest rate swap. The swap functions as a hedge to protect the sponsor against the possibility of short term tax-exempt rates increasing relative to the fixed coupons on the underlying municipal bonds.
The sponsor enters into a swap where it pays a fixed rate which is below the coupon of the underlying municipal bond (generally 100+bps under) and it receives a floating short term rate. The sponsor pays out the floating short-term rate from the swap to the TOB investors (plus an additional amount in the range of 10bps). Out of the spread on the transaction (the difference between the fixed rate on the municipal bond and the fixed rate on the swap, i.e.; the 100+bps noted above) the sponsor pays the fees to the liquidity bank and the trustee. The balance after these expenses is paid out to the RITES holders (historically about 30bps-50bps).
RITES
“RITES” stands for Residual Interest Tax Exempt Security. When the TOB originator establishes the trust for the TOB program, it creates the Tender Option Bond which receives the floating rate of return. It also creates RITES which are entitled to the spread between the interest on the municipal bond and the fixed rate on the swap (a.k.a residual interest). It is common for the RITES to be 100% owned by the sponsor of the TOB program (as is the case with MLCS) because this is where the profits/spreads are made on structuring the TOBs. It is important to note that only the tender option bonds (TOBs) are backed by the liquidity facility. RITES are not covered.
Role of the Liquidity Bank
In the event that the TOBs are tendered by the investor and cannot be remarketed by the remarketing agent there will be a drawing on the liquidity facility under the terms of the Standby Purchase Agreement (SPA) which is signed between the trustee and the liquidity bank. The proceeds of such a drawing would be used to pay out the TOB investor. (In the event of a successful remarketing, it is the proceeds of that remarketing that would pay out the redeeming TOB investor.) In the event of a drawing, the liquidity bank becomes the owner of the TOB and will be paid interest at a rate of cost of funds plus 50bps. This interest amount will be paid for via the coupon on the underlying municipal bond. The sponsor (Merrill Lynch Capital Services under Merrills program) is obligated to make up any short-fall if the coupon on the bond does not equal the banks cost of funds plus 50bps.
If there is a drawing on the liquidity facility and the bank holds the bonds, the sponsor is obligated, under the Reimbursement Agreement , to remarket the bonds on a best efforts basis to pay out the bank. If a successful remarketing cannot be achieved, the sponsor is obligated to buy back the TOBs from the liquidity bank at par no later than one year after the drawing on the liquidity facility. The reason for the one year buy-back, rather than a shorter period, is for balance sheet purposes. Namely, if the buy-back period was less than one year, then the client would have to carry those bonds on its balance sheet as a liability during the period even though the liquidity bank held the bonds.
An important right provided to the liquidity bank under the reimbursement agreement states that after holding the TOBs