Key Takeaways
- Bank-sponsored, tax-exempt tender option bond (TOB) trusts surged in 2023 as the SIFMA Municipal Swap Index remained roughly 35% lower than SOFR, on average.
- As of September 2023, a third of our rated TOB portfolio is made up of bank-sponsored TOB trusts, of which almost 80% are tax-exempt TOBs.
- Year-to-date new municipal bond issuance is down 9% from last year, adding pressure to TOB issuance.
- We believe banks will continue to seek tax-exempt TOB financing as the strategy fits into their overall balance sheet strategies.
Although the cost of financing has increased along with interest rates, tax-exempt financing (reflected by the Securities Industry and Financial Markets Assn. [SIFMA] Municipal Swap Index) has remained attractive relative to taxable financing (reflected by the Secured Overnight Financing Rate [SOFR]). This has led to an increase in tax-exempt, bank-sponsored, tender option bond (TOB) trusts.
A typical TOB trust issues a residual note and a separate note with a floating rate (called a "floater"), which resets periodically depending on its mode. In general, the interest rate on a tax-exempt floater will reset based on the SIFMA Swap Index, which measures short-term, tax-exempt rates. Meanwhile, the interest rate on the taxable floater will reset based on SOFR. Chart 1 shows an historical comparison of the SOFR and SIFMA rates over the past five years.
Chart 1
Bank-Sponsored Issuance
Taxable bank-sponsored issuance exploded in 2020 as interest rates were cut to near zero percent in the wake of the COVID-19 pandemic. Chart 1 shows that for two years following the onset of the pandemic, there was virtually no difference in taxable and tax-exempt rates. As interest rates began to rise in 2022, however, tax-exempt financing once again became an attractive alternative for banks. Historically, tax-exempt rates have been about 30% lower than those of taxable rates. Year-to-date in 2023, tax-exempt bank-sponsored issuance has exceeded that of 2022 in terms of both par amount and the number of new trusts (see chart 2).
Chart 2
Volker Rule And Covered Funds
Tax-exempt, bank-sponsored TOB trusts (commonly referred to as 3a-7 trusts) are an alternative financing vehicle that banks may use to finance municipal bonds. The term "3a-7" refers to Rule 3a-7 under the Investment Company Act of 1940, which excludes issuers of asset-backed securities (ABS) from the definition of an investment company upon satisfying certain conditions. More importantly, it also exempts trusts from the definition of covered funds, which banks are prevented from sponsoring under the Volker Rule.
Some banks also use taxable TOB trusts, which, rather than being structured as partnerships, are set up as wholly owned subsidiaries. This is accomplished by issuing the floater component as debt and the residual receipt as equity. Because the sponsor traditionally retains full ownership of the residual receipt, the TOB trust qualifies as a wholly owned subsidiary of the sponsor, which provides an alternative exemption to the definition of a covered fund.
Expanding Balance Sheet And Leverage
Banks are motivated to use the TOB trust structure because it expands their balance sheets. To this end, banks will often maximize leverage to finance and securitize as much of their municipal bond portfolios as possible. This strategy differs from that of fund-sponsored trusts, which are more concerned with the risks associated with additional portfolio leverage. Fund-sponsored trusts make up roughly two-thirds of portfolios, with the remaining third being bank-sponsored (see chart 3). Almost 80% of bank-sponsored TOB trusts are tax-exempt.
Chart 3
An additional requirement of 3a-7 exemption is that the issuer--in this case the trust--may not issue redeemable securities. Although the SEC has not ruled on how long the security must remain non-redeemable, this condition has led banks to use tax-exempt TOB financing for longer positions (typically up to a year). This is another substantial difference from fund-sponsored TOB trusts, as well as taxable bank-sponsored trusts, which may be collapsed in much shorter times from original issuance. Chart 4 breaks out the relative shares of bank-sponsored portfolios by banks.
Chart 4
Looking Ahead: Balancing Headwinds Against Opportunities
Although interest rates alone do not necessarily explain the recent shift to tax-exempt financing, they represent a significant driver as demonstrated in the data above. As we discussed in our earlier piece this year (see "2023 Mid-Year Review: Tender Option Bond Issuance Continued Despite Headwinds," published Aug. 7, 2023), we believe the reduced municipal supply dampens the overall supply of new TOBs, including bank-sponsored bonds. Additionally, U.S. banks have tightened lending standards across all loan types amid softening economic conditions, which may have impacts on TOB financing as well (see "U.S. Banks Webinar 2Q 2023: An Uphill Climb As Funding Costs Rise," published Aug. 23, 2023). We believe banks will continue to seek tax-exempt TOB financing as it fits into their overall balance sheet strategy.
Related Research
- 2023 Mid-Year Review: Tender Option Bond Issuance Continued Despite Headwinds, Aug. 3, 2023
- U.S. Banks Webinar 2Q 2023: An Uphill Climb As Funding Costs Rise, Aug. 23, 2023
This report does not constitute a rating action.
| Primary Credit Analyst: | Joshua C Saunders, Chicago + 1 (312) 233 7059; joshua.saunders@spglobal.com |
| Research Assistants: | Liam Felter, Englewood |
| Sophia Frohna, Chicago |
No content (including ratings, credit-related analyses and data, valuations, model, software, or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced, or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees, or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness, or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED, OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.
Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses, and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment, and experience of the user, its management, employees, advisors, and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.
To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw, or suspend such acknowledgement at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal, or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.
S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain nonpublic information received in connection with each analytical process.
S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.spglobal.com/ratings (free of charge), and www.ratingsdirect.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.spglobal.com/usratingsfees.