- 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.
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).
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.
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.
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.
- 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;|
|Research Assistants:||Liam Felter, Englewood|
|Sophia Frohna, Chicago|
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