Background

Tender Option Bond (TOB) programs were created by large US banks in the 1980s to efficiently finance their proprietary tax exempt municipal bond investments.  As their proprietary programs grew, some banks developed third party programs in the late 1990s for large institutional investors.  In the 2000s, dealers aggressively marketed TOBs to 3rd party investors, including hedge funds.  Dealers required minimal haircuts and funds were leveraged up to 90%.  In the 2007-2008 financial crisis, hedge funds struggled when both their bonds and their hedges simultaneously sold off – triggering collateral calls causing them to collapse.  Post crisis, the 3rd party TOB market is smaller and significantly less leveraged than pre crisis.

What is a TOB?

  • TOB programs were developed to efficiently fund some of the fair market value of a longer dated municipal bond at short-term tax-exempt rates.

  • TOBs are economically similar to structured repos, the funding vehicle typically used by investors in taxable securities.  However, repo generally provides poor execution for tax-exempt investors, as the borrowing cost is a taxable rate and is typically not tax deductible.  (Interest expense relating to the acquisition of municipal bonds is disallowed by Section 265 of the U.S. Tax Code.)

  • TOB programs involve the deposit of a single bond, or a few bonds of the same principal credit, into a trust that is considered a partnership for tax purposes.

  • The bonds support two trust certificates:

    • A short term Floater Certificate  -  also known as a tender option bond, typically w/a 7-day tender option

    • A Residual Interest Certificate

 

TOB Termination Events

 

Floater and Residual investors both share in the economics of the underlying bonds.  The use of leverage can increase returns as well as magnify losses.  Residual investors maintain the majority of the exposure to the underlying bond and have the risk of losing TOB financing if a Tender Option Termination Event (TOTE) or a Mandatory Tender Event (MTE) occurs.  Floater investors are entitled to Gain Share but have the risk of TOTEs.

TENDER OPTION TERMINATION EVENTS (TOTE)

Floater holders lose their right to tender to the Liquidity Provider if any of the following events known as Tender Option Termination Events (TOTEs) occur.  Upon the occurrence of a TOTE, Floater and Residual investors will receive their pro-rata share of the underlying bonds if the bond’s market value isn't sufficient to redeem the par balances of the certificates. 

Act of bankruptcy of the Underlying Issuer and or Obligor

Default or Failure of Payment of Principal or Interest by the Underlying Issuer

Ratings Downgrades - Underlying bonds are downgraded below investment grade (Baa3/BBB-)

Event of Taxability - Underlying Bonds are deemed taxable

TOB Trusts can be unwound for a number of reasons with short notice.  Some MTEs are at the Residual investor’s discretion while others are at the Liquidity Provider’s.

Residual Investor Exercises Call Option - Residual investors can call the Floaters for Par plus Gain Share in order to withdraw the underlying bonds upon 5 business days notice.

Trust Maturity Date / Gain Share Determination Date - In order to maintain an equity partnership, Floater investors must have the ability to capture Gain Share prior to the underlying bond’s price to worst date known as the Gain Share Determination Date. Residual holders have the option to pay the Gain Share into the Trust in order to keep the Trust outstanding.  Otherwise, the Remarketing Agent will sell the underlying bonds and dissolve the partnership.

Bond Ratings Downgrade - The Liquidity Provider has the right to cause a mandatory tender and termination of the Trust if the underlying bond’s ratings fall below an established minimum ratings threshold, typically Aa3 / AA-.

Failed Remarketing of the Floater Certificates - If the Remarketing Agent is unable to sell tendered Floaters during the notice period, typically 5 business days, the Liquidity Provider can instruct the Remarketing Agent to sell the underlying bonds and redeem the Floater and Residual certificates with bond proceeds.

Overcollateralization Breach - The underlying bond value in relation to the Trust’s Floater balance, must stay above a predefined minimum value.  If breached, the Liquidity Provider will instruct the Remarketing Agent to sell the underlying bonds and redeem the Floater and Residual certificates with bond proceeds.

Trust Liquidity Expiration Date - The Trust’s liquidity facilities are typically structured to be 1 year terms.  The Liquidity Provider has the option to not extend the facility a month before the scheduled expiration date.

MANDATORY TENDER EVENTS (MTE)

Glossary of Financial Terms 

 

Tender Option

Contractual right of the Floater holder to tender (sell/put) the security back to the TOB Trust to exit the transaction and receive their principal at Par + accrued interest.  The tender is assured by a Liquidity Facility provided by a money center bank. 

Liquidity Facility

Contractual agreement in trust program documents requiring a large money center bank to honor tenders and purchase Floaters from holders with 5 business days notice at Par + accrued interest.  This commitment qualifies the Floaters as Money Market Fund eligible. 

SIFMA

The Weekly Municipal Swap index, comprised of 7-day high-grade tax-exempt VRDO reset rates reported to the Municipal Securities Rule Making Board (MSRB) SHORT reporting system.  Index calculated on actual/actual basis and published every Wednesday by 4p ET.

Leverage

Expressed as a percentage to indicate how much of a purchase price is financed.  65% Leverage means that for a $100 purchase price, $65 was borrowed.

Modified Duration  

The price sensitivity of a bond.  It measures the percentage change in price of a bond for a 1.00% change in interest rates.

Non-Recourse

A type of borrowing where the lender is only secured by the assets within the transaction.  There are no additional guarantees or recourse required by the borrower.

Repo

The abbreviated term for a repurchase agreement, which is the sale of a security with an agreement to repurchase the same security back at a higher price at a later date.  This is a form a borrowing to purchase assets.  To assure financial ability to repurchase, the seller is required to post collateral to protect the buyer.

Haircut

Expressed as a percentage and used to discount the value of any posted collateral.  A 10% haircut means that an asset worth $100 would only be valued at $90 if posted as security in a transaction.