Tenders, particularly taxable tenders, grew substantially in 2023
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The muni market saw a large uptick in taxable bond tenders as issuers saw an opportunity to restructure their debt portfolios to unload taxables that have been trading at deep discounts.
Taxable bonds that could be replaced with tax-exempt debt “has been the main target market segment for bond tenders as late (close to 60% of total), especially bonds that were used to advance refund tax-exempt muni bonds in the past several years, and are currently trading at deep discounts to par after rates have sold off 300bp,” according to Barclays PLC.
Tax-exempts can be used to take out taxables, “as original refunded bonds were also tax-exempt,” said Barclays strategists Mikhail Foux, Clare Pickering and Mayur Patel.
Tenders have “rapidly increased in volume and in numbers in the past two years, and this year will be by far the highest tender volume year on record,” Barclays strategists said.
The number of tenders has been growing quickly this year, with Barclays strategists estimating that since 2018, there have been more than $20 billion of bonds tendered.
The trend took hold in 2020 and volume rose above $4 billion in both 2021 and 2022 before surging to more than $14 billion in 2023, they said.
Most of the taxable bonds issuers are targeting were priced during the period of extremely low interest rates during 2020 and 2021, many also have low coupons, and in some cases, lack a 10-year par call, noted Julie Burger, managing director and co-head of the public finance division at Wells Fargo.
The rise in taxable tenders is “purely a function of the fact that taxable issuance was so robust in 2021 and 2022,” according to James Pruskowski, chief investment officer at 16Rock Asset Management.
“Given the burden that tax-exempt has on it with outflows and high ratios and wide spreads, it was a cheaper alternative to issue taxable bonds at high rates to have seamless execution with a broader distribution network of global buyers,” he said.
Now that rates have come down on the tax-exempt side and the curve “has done what it’s done,” he said the economic incentive there for municipalities to refinance debt that they cannot otherwise do in the tax-exempt market after the Tax Cuts and Jobs Act of 2017.
Issuers can “also tender for tax-exempt bonds issued with low coupons that were trading cheap and at deep price discounts,” Barclays strategists noted.
Taking out these bonds might not be as “attractive” as taking out taxable bonds with tax-exempts, but they said “there was still a sizable universe of tax-exempt bonds that had been tendered for (close to 40%).”
For both taxable and tax-exempt tenders, they said new bonds have mostly been tax-exempt.
When tendering, “issuers typically try to save money by taking out bonds with above-market coupons that are not currently callable,” Barclays said.
This is done as
Additionally, Barclays strategists said some issuers under financial stress might want to restructure their debt profile.
The increase in tenders can be attributed in part as they have become an accepted practice in the market, according to Burger.
Market participants first started discussing tenders following the elimination of advanced refundings. At that point, rates were so low that many opted for taxable refundings instead.
“We knew we needed to get a little creative when tax-exempt advanced refunding went away,” she said.
But now the market has seen tenders in almost every state, almost every sector,” she said. “It’s become a normal practice rather than something that you have to spend a lot of time explaining to any given issuer.”
Similar to the Build America Bonds era, the most “sophisticated” municipalities were first to issue tender bonds and take advantage of the program, and then came the rest of the market, the “smaller, less routine issuers,” Pruskowski added.
However, there are some drawbacks to tenders.
Bond tenders present “a bit of a dilemma for investors, as they could negatively affect liquidity of the issue portion that remains outstanding,” according to Barclays strategists.
“For larger CUSIPs, even though liquidity might deteriorate a bit, it should present less of an issue,” they said. “However, for bond sizes in the $300-$500 million range, it might present a more-serious challenge — when the deal size declines below $300 million, the bond would drop out of the Bloomberg Aggregate index, and its spreads will likely widen as a result — currently there is about 25-30 basis points spread differential between index and nonindex bonds, hence the downside in this case could be quite sizable,” they said.
However, “tenders can provide a boost to portfolio returns, especially if the funds can be easily redeployed at market rates elsewhere.”
Andrew Kalotay, president of Andrew Kalotay Associates, though, doesn’t believe tenders will reduce liquidity since “liquidity was bad before and it’s not going to be hurt too much by the tenders,” he said.
To him, the issue with tenders from the perspective of the holders is showing a loss.
Kalotay said he believes that municipalities that advance refunding their tax-exempt debt with taxable bonds saved “much less than by waiting until the call date and refunding then with tax-exempt bonds,” he said.
Now, Kalotay said he believes municipalities want to “reduce the damage” from refunding tax-exempt debt with taxables.
Municipalities, when they have the chance, “want to refund these taxable bonds by tax-exempt bonds because the yield of tax-exempt bonds are always much lower than the yield taxable bonds, and therefore if the taxable bonds are callable, they may call them when it doesn’t make too much sense to call them,” he said.
For example, “if the taxable bonds are refundable with tax-exempt bonds the issuer
So, he said, from the holder’s perspective, “this is suddenly a windfall profit because they are taking away my bond when they normally wouldn’t do it for interest rate reasons,” he said.
However, the “taxable bonds were issued when rates were much lower, and currently, they are trading at a considerable discount,” Kalotay said.
Investors who are not marking to the market, most of which are insurance companies, “would have to recognize large losses, although the tender premium … would somewhat reduce the pain,” he said.
For this reason, tenders have been “remarkably unsuccessful,” he said.
The average tender success rate at just under 30%, though the average could vary widely, ranging from a success rate of over 50% to a low well below 30%, according to Barclays.
One of the main reasons for the low success rate, they said, is because “there is a sizable universe of buy-and-hold investors that have restrictions on selling their bonds prior to maturity.”
Additionally, Barclays strategists noted “some market participants prefer not to take losses on their bond positions that have massively declined in price in the past two years.”
Furthermore, “you have to have the back office infrastructure, and straight-through processing communication to coordinate the tender,” Pruskowski said.
Unlike a call or a prepayment “that just flows through to your holdings and gets processed, the tender requires reading of the documentation, figuring out what the price is, running relative value analysis to make sure the economics make sense, and actually physically going through the tender and then accepting the new CUSIP,” he said.
“It’s a burden for unsophisticated and/or small managers not deeply dedicated to the space,” he said.
However, Burger noted that success rates can vary significantly and even a 30% success rate could be advantageous in the right circumstances.
“Some very large clients have a significant amount of taxable debt that they could look to do a tender on, and so if you’re looking at a billion dollars of bonds, even 30% is a pretty significant transaction and can be a nice pick up on savings and optionality,” Burger said.
Market participants were split on whether taxable tender activity would increase in 2024.
Pruskowski believes tenders will slow down next year.
“It’s a function of the relative value environment, which is normalizing, as the Fed pivots and inflation comes down,” he said.
“This as a pretty unique opportunity that got the fire lit under it in 2023 given market dynamics and awakening to Trump’s tax reforms,” Pruskowski noted. “It will always be an option, but to a lesser degree as markets normalize.”
Burger concurred, noting many of the eligible candidates have already been tendered.
There may be some new opportunities “popping up,” but many of the “low-hanging fruit has been captured on the taxable side,” she said.
Barclays strategists, though, think tender activity will likely remain “robust” in 2024, as there is still a “substantial universe” of taxables issued in 2021 through 2022 to advance refund tax-exempts could still be taken out.
If taxable muni yields remain high, “the tax-exempt versus taxable index yield differential should remain wide, and tenders will continue providing attractive savings to issuers,” they said.
