Bank backstops for municipals
There is a very interesting class of municipals that you may not know about.
They are called “variable rate demand obligations” (VRDOs).
Moody’s estimates the market size at about $380 billion or 13% of the $3 trillion municipal market.
Moody’s issued a report today saying that this class of munis is finding its sea legs. This is good news for muniland. The health status of VRDOs was a big concern for market participants and Moody’s is cautiously optimistic.
VRDO’s are bonds issued with longer maturities (up to 30 years) that you can put back to the trustee or tender agent with a little notice.
The interest rate on the VRDO is usually reset weekly and generally is slightly better than a money market rate.
VRDOs require a bank or lending facility to stand in as a backstop in case investors want to put their VRDOs back to the tender agent. And issuers pay for this guarantee.
So they are long term bonds that pay interest at short term rates.
This can be a big boon for issuers.
When interest rates are low, as they are now, the issuer pays very low rates.
But the tide can turn and issuers can face a massive spike in their weekly interest rate bill.
This happened in 2008 and helped create the financial crisis.
Here is an example from EMMA:
- Issuer: NY City Municipal Finance Water Authority
- CUSIP: 64972FPP5
- Issue size: $50,000,000
- Unit size $100,000.
- Maturity Date: 06/15/2033
- Interest rate for May 9th, 2011: 0.04%
You can see the trade activity for this NYC Water VRDO here. It’s a little hard to make sense of.
Moody’s said a review of 277 [VRDO] expirations in the first quarter of 2011 affecting bonds it rates found that about 85 percent of the facilities’ expiration dates were extended by the bank provider or a facility was obtained from a new provider.
Most of the remaining issuers refunded the debt or redeemed the bonds using their own liquidity, while only two issuers had their facilities expire without an alternative in place, according to the rating agency.
“Although issuers with weaker credit may have fewer options, the first quarter’s track record indicates that the orderly resolution of bank facility expirations is likely to continue through the expiration bubble over the balance of the year,” Moody’s said.
Many states, cities, schools, hospitals and other municipal bond issuers were trapped a few years ago in a frozen auction-rate market when they could not obtain or afford the facilities to refund that debt into a variable-rate mode.
Another significant hurdle in muniland is being overcome.
We are not entirely out of the woods but the winds are blowing in the right direction.