Yield-Rise Bet Spurs Most Floating Sales Since ’09: Muni Credit
U.S. states and cities are on pace to sell the most floating-rate bonds without bank credit support in four years as they respond to demand from investors betting interest rates will rise.
Connecticut, Massachusetts and South Carolina’s student- loan finance agency are among borrowers that have offered $2.5 billion of such debt this year, compared with $817 million in the first quarter of 2012, data compiled by Bloomberg show. New York City sold $248 million last month, its first publicly offered issue of the debt. Nationwide, sales reached about $7.9 billion in 2012, the most since at least 2009.
“More accounts now are buying them, because from their perspective it’s a way to say that you’re effectively building in an interest-rate hedge,” said Lyle Fitterer, a managing director in Menomonee Falls, Wisconsin, at Wells Capital Management. The company owns about $3 billion of the debt across its funds, he said.
With the U.S. jobless rate at a four-year low and the Dow Jones Industrial Average setting a record high this month, bondholders are using floating-rate securities to protect against higher interest rates as the economy gains strength. Two-year Treasury yields will probably be almost double the current level of 0.25 percent in a year, according to the median forecast of 53 analysts in a Bloomberg survey.
Floating-rate notes were introduced in the $3.7 trillion municipal market following the credit crisis that struck in 2007, when the market for adjustable-rate debt such as auction- rate securities collapsed. Yields on auction-rates surged when Wall Street banks stopped stepping in to buy the debt at periodic auctions.
At the same time, local governments had to draw on bank credit facilities to support other variable-rate debt.
To avoid the cost of such credit lines, municipalities have turned to floating-rate notes. These securities don’t require a bank backstop because investors don’t have the option of periodically selling the notes at par plus accrued interest.
“The creation of publicly offered FRNs that enable clients to access the short end of the curve is really a natural evolution to those events of the last five years,” said Chris Hamel, head of muni finance in New York at RBC Capital Markets LLC.
States and localities have issued about $22 billion of tax- exempt, floating-rate notes since 2009, or 1.4 percent of munis sold, according to Bloomberg data.
The J. Paul Getty Trust in Los Angeles, whose museum features Van Gogh’s “Irises,” plans to issue $163 million of the notes this week. The securities will pay a variable rate tied to the Securities Industry and Financial Markets Association seven-day swap index, which was 0.12 percent on March 13, the highest this year. The index tracks floating-rate bonds that are high-grade and tax-exempt.
In part, the deal will convert so-called variable-rate demand bonds, or VRDBs, backstopped by a portion of the trust’s investments and two external credit lines, Patricia Woodworth, the trust’s chief financial officer, said in an interview.
One reason Getty wanted to sell floating- rather than fixed-rate debt is because the trust had hedged the VRDBs with interest-rate swaps. The trust would have had to pay $150 million to cancel the swaps if it replaced the VRDBs with fixed- rate debt, Woodworth said.
It’s also cheaper to issue floating-rate notes than pay for the credit lines on the VRDBs, she said.
The floating-rate notes that top-rated Getty is selling include a so-called soft put, which gives the trust a year to refinance them if it’s unable to buy them back from investors on the April 1, 2016, mandatory tender date. The trust will have to pay interest rates as high as 9 percent on the debt if the put is triggered.
“We don’t expect to take it beyond the soft-put date,” Woodworth said. “We fully expect to roll them on that date.”
As investors clamor for such notes and more dealers trade them, providing more liquidity, prices have risen, making them less attractive, Fitterer said.
More than 20 percent of the assets in Wells’s ultra-short and short-term muni funds are floating-rate, he said.
New Jersey Economic Development Authority floating-rate notes maturing in February 2018, and rated A+ by Standard & Poor’s, traded at about 104 cents on the dollar March 21, Bloomberg data show. That’s up from par when they were issued in January 2011.
Investors are better off buying fixed-rate bonds if they yield more than floating-rate notes on a fixed-equivalent basis, Fitterer said.
New York City last month sold floating-rate notes as part of a $1.3 billion general-obligation issue.
The notes replaced variable-rate debt on which bank facilities were expiring, said Carol Kostik, deputy comptroller for public finance.
The city sold a $100 million block of floating-rate notes maturing in 2025 at the SIFMA rate plus 0.55 percentage point, which equals 0.66 percent. That compares with a 2.49 percent yield on fixed-rate bonds maturing that year.
If the city doesn’t redeem the floating-rate notes or convert them to a different interest-rate mode on or before April 2, 2018, it must pay a higher rate, Kostik said.
“We’re saving money today and then we’ve got room for rates to rise before we start losing money on that trade,” Kostik said.
The floating-rate securities also help the city, which sold $11 billion of fixed-rate bonds last year, diversify its investor base.
“It’s important to have other pockets of demand,” Kostik said.
The municipal market starts this week facing an issuance lull. Local governments and agencies led by Northeast Ohio Regional Sewer District are set to offer about $4 billion of debt this holiday-shortened week, the slowest period since the start of the year. Sifma recommends that the U.S. bond market shut March 29 to observe Good Friday.
The slowdown may bolster munis as benchmark yields have been above those on Treasuries for eight straight days, the longest span since October, Bloomberg data show.
Investors pulled about $261 million from muni mutual funds last week, the biggest withdrawal this year, Lipper US Fund Flows data show. Munis tend to lose value in March as investors sell to raise cash for tax payments before the April 15 filing deadline.
At 2.01 percent, yields on benchmark 10-year munis are close to an 11-month high and compare with 1.93 percent on federal securities, Bloomberg data show.
The ratio of the two interest rates is about 104 percent, compared with an average of about 92 percent since 2001. As that percentage rises, local bonds become cheaper relative to Treasuries.
Even with the move higher in the percentage, “ratios could continue to increase, due to tax-selling” and demand for Treasuries, Citigroup Inc. analysts wrote in a March 22 report.
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