Tender option bond

What Is a Tender Option Bond?

A Tender Option Bond (TOB) is a structured fixed income security derived from an underlying long-term bond, most commonly a tax-exempt municipal bond. It is created by depositing the underlying bond into a special purpose vehicle (SPV), typically a trust, which then issues two new securities: a short-term, floating-rate certificate (the "floater," or the tender option bond itself) and a longer-term, inverse floating-rate certificate (the "residual"). The key feature of a tender option bond is the embedded option that allows the holder of the floater certificate to "tender" or sell the bond back to the trust at par plus accrued interest, usually on a weekly or daily basis. This tender feature provides investors with liquidity similar to short-term money market instruments, while the underlying long-term bond provides the cash flows for both certificates.

History and Origin

Tender Option Bond programs were developed by large U.S. banks in the 1980s primarily to finance their proprietary investments in tax-exempt municipal bonds efficiently. As these internal programs grew, some banks expanded to offer third-party programs to large institutional investors in the late 1990s. By the 2000s, dealers actively marketed TOBs to a broader range of third-party investors, including hedge funds, often with significant leverage.¹¹

The structure gained prominence as it allowed for the conversion of long-term credit risk from municipal bonds into short-term, liquid instruments appealing to money market funds, which typically have strict requirements for short maturities and high liquidity. The existence of a robust Tender Option Bond market has been significant in the short-term tax-exempt market, as it helped satisfy the demand for short-term tax-exempt products, which state and local governments do not always issue in sufficient quantities to meet investor needs.¹⁰

Key Takeaways

A Tender Option Bond (TOB) is a structured financial derivative that splits a long-term bond, usually a municipal bond, into two components: a short-term floating-rate piece (the floater) and a residual inverse floating-rate piece.
The primary appeal of the floater certificate is its embedded tender option, allowing investors to sell it back to the trust at par, providing enhanced liquidity.
TOBs are often used by investors seeking short-term, tax-exempt exposure or by funds to create leverage.
The value and interest rates of the floater and residual components are interdependent and influenced by the underlying bond's characteristics and broader market conditions.
Despite their benefits, TOBs carry risks related to interest rate fluctuations, liquidity support, and potential termination events.

Interpreting the Tender Option Bond

Interpreting a Tender Option Bond involves understanding the interplay between its two components: the floater certificate and the residual interest certificate. The floater, which is the actual tender option bond, offers investors a floating interest rate that resets periodically, often weekly, and the key feature of a "tender option." This option allows the holder to sell the bond back to the trust at par plus accrued interest, typically backed by a liquidity provider. This makes the floater attractive to investors, such as money market funds, that require high liquidity and short effective maturities, despite the long maturity of the underlying bond. The short-term credit rating of the floater is primarily based on the credit quality of the liquidity provider.

Conversely, the residual interest certificate receives the remaining cash flows from the underlying bond after the floater's interest payments and program fees are satisfied. This means the residual holder bears the majority of the underlying bond's market and credit risk, and also benefits disproportionately from any appreciation in the underlying bond's value or from a positive spread between the underlying bond's yield and the floater's borrowing cost. Understanding the relationship between these two pieces and the embedded tender option is crucial for assessing the risk and return characteristics of a Tender Option Bond.

Hypothetical Example

Imagine a long-term municipal bond with a par value of $100 million and a fixed annual interest rate of 4.0%. A financial institution decides to create a Tender Option Bond structure from this municipal bond to appeal to a wider range of investors.

Trust Creation: The $100 million municipal bond is deposited into a specially created trust.
Issuance of Certificates: The trust then issues two types of certificates:
- Floater Certificates (Tender Option Bonds): $95 million in floater certificates are issued. These pay a floating interest rate, say, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index plus 10 basis points, reset weekly. Crucially, each floater certificate grants its holder the right to tender (sell) it back to the trust at par ($1.00) plus accrued interest, typically every seven days. A bank provides a liquidity facility to ensure these tenders are met.
- Residual Interest Certificates: $5 million in residual interest certificates are issued. These certificates receive the remaining interest payments from the underlying 4.0% municipal bond after the floater certificates have been paid and all trust fees (e.g., for the trustee, liquidity provider, and remarketing agent) are covered.
Cash Flow Dynamics:
- If the SIFMA index plus 10 basis points is 1.50%, the floater holders receive interest based on this low short-term rate. The residual holders receive the 4.0% from the underlying bond minus the 1.50% paid to the floaters on $95 million and the fees. This creates leverage for the residual holders.
- If interest rates rise and the SIFMA index increases, the interest paid to floater holders increases, reducing the income available to residual holders.
Tender Feature in Action: An investor holding $100,000 of the floater certificates decides they need cash. They exercise their tender option, selling their certificates back to the trust at par ($100,000) plus accrued interest. The liquidity provider for the trust steps in to purchase these tendered certificates.

This structure allows the long-term municipal bond to support both short-term, liquid investments and a leveraged, higher-risk/reward residual piece.

Practical Applications

Tender Option Bonds (TOBs) are primarily used in the municipal bond market, offering several practical applications for various types of investors and financial institutions.

For Money Market Funds: TOBs allow money market funds to invest in high-quality, long-term municipal bonds indirectly. Because the floater certificates have a short-term tender option, they are considered short-term, liquid investments, satisfying the regulatory requirements for money market funds, such as SEC Rule 2a-7.⁹
For Leverage and Yield Enhancement: Investors, particularly institutional ones, can use the residual interests of TOBs to obtain leveraged exposure to the underlying municipal bonds. By holding the residual, they gain exposure to the long-term bond's yield while only putting up a fraction of the capital, potentially enhancing returns if the underlying bond's yield significantly exceeds the short-term borrowing cost of the floaters. This strategy can also be employed to achieve portfolio management goals, such as opportunistic exposure to specific sectors or parts of the yield curve.⁸
Arbitrage Opportunities: TOB programs can be established to capitalize on arbitrage opportunities between long-term tax-exempt bond yields and short-term borrowing rates. The creation of a TOB allows a longer-dated municipal bond to be funded at short-term tax-exempt rates, potentially generating a positive spread for the residual holder.⁷
Liquidity Management: For financial institutions and funds with large holdings of long-term municipal bonds, TOB structures can be a tool for managing liquidity and optimizing portfolio composition without directly selling the underlying bonds.
Regulatory Compliance: The Municipal Securities Rulemaking Board (MSRB) provides guidance and rules for brokers, dealers, and municipal securities dealers involved in Tender Option Bond floaters, underscoring their place within regulated financial markets and the need for proper disclosure and conduct.⁶

Limitations and Criticisms

Despite their utility, Tender Option Bonds are complex instruments with specific limitations and criticisms, primarily centered on their sensitivity to market conditions and their structured nature.

Interest Rate Risk: While the floater component mitigates interest rate risk for its holder due to the tender option, the residual component is highly sensitive to changes in short-term interest rates. If short-term rates rise significantly, the cost of funding the floaters increases, reducing or even eliminating the income to the residual holder. This can lead to substantial losses for those holding the residual.
Liquidity Risk and Tender Option Termination Events (TOTEs): The tender option relies heavily on the strength of the liquidity provider, typically a highly rated bank. If the liquidity provider's credit rating deteriorates or if there are adverse events affecting the underlying bond or the market, "Tender Option Termination Events" (TOTEs) can occur. These events can take away the demand feature, forcing floater holders to hold a long-term, illiquid bond or leading to the unwinding of the trust. This risk became particularly apparent during the 2008 financial crisis, when the municipal bond market, including the TOB sector, faced liquidity strains.⁵,⁴
Leverage Magnification: TOBs, especially the residual interests, are often used to create leverage. While leverage can magnify positive returns, it also magnifies losses. In adverse market conditions, the increased volatility can lead to rapid value erosion for residual holders and potentially force unwinds.³
Complexity and Transparency: The structured nature of TOBs can make them less transparent than traditional bonds, requiring investors to understand the intricate legal and financial mechanics of the trust, the liquidity facility, and the various fees involved. This complexity can make proper underwriting and risk assessment challenging.
Market Contraction Post-Crisis: Following the 2007-2008 financial crisis, the third-party TOB market contracted and became significantly less leveraged than it was pre-crisis, reflecting increased caution and regulatory scrutiny.² News outlets, such as The New York Times, reported on the spreading bond troubles, highlighting the impact on complex instruments like TOBs.¹

Tender Option Bond vs. Variable Rate Demand Note

While both Tender Option Bonds (TOBs) and Variable Rate Demand Notes (VRDNs) offer investors short-term liquidity with floating interest rates, their structures and origins differ significantly.

A Variable Rate Demand Note (VRDN) is a direct issuance by a municipal or corporate entity. It is a long-term bond that pays a floating interest rate and includes an embedded put option, allowing the bondholder to sell the note back to a liquidity provider (often a bank) at par on a specified short-term reset period, typically daily or weekly. VRDNs are single securities issued by an issuer.

A Tender Option Bond (TOB), in contrast, is a structured product created from an existing long-term bond, most commonly a municipal bond. The underlying bond is deposited into a trust or special purpose vehicle, which then issues two separate securities: a short-term floating-rate certificate (the TOB itself) and a residual inverse floating-rate certificate. The tender feature of the TOB floater is similar to a VRDN's put option, granting liquidity. The key distinction lies in the TOB being a repackaging of an existing bond into two new components, whereas a VRDN is an original issuance by the borrower. The TOB structure enables investment in longer-term bonds that may not otherwise meet the short-term requirements of certain investors like money market funds.

FAQs

What is the primary purpose of a Tender Option Bond?

The primary purpose of a Tender Option Bond is to transform a long-term bond, typically a municipal bond, into a short-term, highly liquid investment vehicle (the floater certificate) that appeals to investors seeking cash-like liquidity and short-term tax-exempt income, such as money market funds. It also creates a leveraged residual interest.

How does a Tender Option Bond provide liquidity?

A Tender Option Bond provides liquidity through its embedded "tender option," which is a contractual right for the holder of the floater certificate to sell the bond back to the trust (or its liquidity provider) at its par value plus accrued interest, typically on a weekly or daily basis. This allows investors to access their principal quickly.

What are the main components of a TOB structure?

The main components of a Tender Option Bond structure are the underlying long-term bond (usually a municipal bond), a trust or special purpose vehicle that holds the underlying bond, a short-term floating-rate certificate (the tender option bond itself, or "floater"), and a longer-term inverse floating-rate certificate (the "residual"). A liquidity provider also plays a crucial role in ensuring the tender option can be exercised.

Who typically invests in Tender Option Bonds?

Money market funds are primary investors in the floating-rate certificates (the TOBs themselves) due to their short-term, liquid nature and tax-exempt income. Institutional investors, such as hedge funds and other investment funds, often invest in the residual interests to gain leveraged exposure to the municipal bond market or for arbitrage opportunities.

What are the risks associated with Tender Option Bonds?

Key risks include interest rate risk (especially for residual holders if short-term rates rise), credit risk of the underlying bond and the liquidity provider, and the potential for "Tender Option Termination Events" which can remove the liquidity feature or force an unwind of the structure. The use of leverage also magnifies both potential gains and losses.