S&P Global Ratings is providing a recap of rated tender option bond (TOB) activity in the first half of 2023.
New Issuance
TOB issuance continued to surge during the first three months of 2023, largely due to rising interest rates. While issuers added more underlying bonds and issued more TOB certificates to existing trusts during this period (i.e., add-on activity), issuance experienced a steep drop off in the beginning of the second quarter. We attribute this to several factors, including the spread compression between long- and short-term yields, and the lower volume of municipal (muni) bond issuance. TOB issuance volume stabilized somewhat in the second half of the second quarter, along with the stabilization of the banking sector.
The most active liquidity providers for the first half of 2023 were JPM, Barclays, and BAML, accounting for 33.6%, 19.7%, and 11.9%, respectively, of the total issuance volume.
Chart 1A
Chart 1B
Rating Surveillance: Rating Actions Signal Asset Stabilization
We took 247 rating actions in the first half of 2023 (see chart 2). Upgrades accounted for 84.2% of rating actions taken year-to-date through June 2023, up from 72.3% as of the comparable period in 2022, primarily due to improved credit conditions of the underlying securities and the related public finance sectors (i.e., state and local government, health care, and housing) and the Barclays Bank PLC rating upgrade. Meanwhile, downgrades accounted for 14.2% of rating actions as of June 2023, primarily due to downgrades in the health care sector. Ratings placed on CreditWatch with negative implications accounted for 0.8% of the ratings actions taken through June. During the same period, these ratings were subsequently removed from CreditWatch with negative implications.
Chart 2
In May 2023, S&P Global Ratings raised the issuer credit rating on Barclays Bank PLC to 'A+' from 'A' (see "Barclays PLC Upgraded to 'BBB+' on Business Diversification and Resilient Performance; Outlook Stable," published May 19, 2023). As a result, we raised ratings on 90 Barclays Bank PLC-supported TOBs. The banks serving as TOB liquidity providers currently all have stable rating outlooks.
First-Half 2023 TOB Trends
First-half 2023 TOB trends include:
- Restructuring of existing debt continues into 2023;
- Rising costs of portfolio leverage; and
- Municipal bond issuance remains low.
We discuss these trends in further detail below.
Restructuring of existing debt continues into 2023
Restructuring of existing TOB trusts, which dominated new issue in the second half of 2022, continued into the first half of 2023. As interest rates have dramatically risen over the past 12 months, TOB sponsors have been terminating older low-yield trusts and creating new ones with higher maximum rates to maintain levered positions. However, actual par amount has increased over time due to add-on activity to the existing trusts.
Table 1
| Tender option bond universe | ||
|---|---|---|
| 2022 | 2023 | |
| Total tender option bond trusts (no.) | 1,619 | 1,453 |
| Total tender option bond ratings (no.) | 3,166 | 2,753 |
| Total par (bil. $) | 36.17 | 38.75 |
Rising costs of portfolio leverage
Since the first federal funds rate hike in March 2022, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index has experienced unprecedented volatility. This is largely due to the interplay of supply and demand in the short-term tax-exempt market, which does not benefit from floors provided by third parties (e.g., federal repo program). This market dynamic has led to a see-saw effect with the index rising by 187 basis points (bps) in early February and falling by 93 bps in early April. However, when averaging the index to eliminate weekly volatility, it remains between 65% and 68% of equivalent taxable rates, which is slightly below the typical benchmark of 70%.
Chart 3
The flat yield curve has led to a reduction in leveraged returns in the TOB market. Long-dated municipal bonds, which are typically repackaged into TOBs, have experienced stagnating and, in some instances, falling yields. Coupled with a higher cost of short-term financing, the spread between long-term muni yield and SIFMA has become compressed, reducing the overall attractiveness for new issuance in the market.
Municipal bond issuance remains low
Municipal bond issuance has remained low into 2023, continuing the trend from 2022. Year-to-date primary market issuance is down approximately $27 billion to $192 billion, from $219 billion in 2022, according to the Municipal Securities Rulemaking Board). Rising financing costs and a historically high balance of rainy-day funds have given municipalities the financial flexibility to avoid costly financing in the bond market. This in turn has added supply pressure to the TOB industry, resulting in less issuance to securitize.
Chart 4
TOB Issuance Expected
We believe the current macroeconomic environment continues to put downward pressure on debt issuance (see "U.S. Public Finance 2023 Midyear Outlook," published July 18, 2023), and we expect TOB issuance to remain muted in the second half of 2023. Although our base-case macroeconomic outlook no longer includes a recession, depending on how quickly the yield curve returns to normal, the spread between long- and short-term financing will remain compressed, disadvantaging leveraged funds. Compounding the situation is the expectation of another Fed rate hike later this year, which will put upward pressure on short-term yields.
Our credit condition outlooks across the municipal market are stable, with exceptions in health care and mass transit, for which they are negative, and higher education, for which it is mixed. Approximately half of the TOB portfolio consists of bonds in these three sectors. In the case of financial institutions, the TOB industry is largely supported by global-systemically important banks. Although these suffered some credit deterioration, they remain stable (see "U.S. Banking Sector Risk Should Remain Manageable While Headwinds Persist For Certain Banks," published May 15, 2023). On March 31, 2023, S&P Global Ratings revised the outlooks on four large U.S. Banks, including Bank of America Corp. and JPMorgan Chase & Co., two of the largest banks supporting the TOB industry, to stable from positive (see "Outlooks on Four Large U.S. Banks Revised To Stable From Positive On Uncertain Operating Conditions; Ratings Affirmed," published March 31, 2023).
Related Research
- U.S. Public Finance 2023 Midyear Outlook, July 18, 2023
- U.S. Banking Sector Risk Should Remain Manageable While Headwinds Persist For Certain Banks, May 16, 2023
- Outlooks On Four Large U.S. Banks Revised To Stable From Positive On Uncertain Operating Conditions; Ratings Affirmed, March 31, 2023
This report does not constitute a rating action.
| Primary Credit Analysts: | Joshua C Saunders, Chicago + 1 (312) 233 7059; joshua.saunders@spglobal.com |
| Mindy Xu, New York + 1 (212) 438 2879; mindy.xu@spglobal.com | |
| James Ho, New York + 1 (212) 438 1306; james.ho@spglobal.com | |
| Research Assistant: | Sophia Frohna, Chicago |
| Research Contributor: | Manash Mazumdar, CRISIL Global Analytical Center, an S&P affiliate, Mumbai |
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