Variable-rate debt rises to highest level since 2017

Issuance of variable rate demand obligations and other floating-rate debt increased in 2023 year-over-year — despite swings in short-term rates — marking the highest total since 2017.

However, market participants remain uncertain whether that trend will continue into 2024 as issuers rethink the product amid continued volatility.

Variable rate issuance rose 13.8% in 2023, increasing to $13.239 billion from $11.533 billion in 2022, according to LSEG Refinitiv data.

The total pales in comparison to pre-financial crisis figures. VRDBs were at a high of $61.8 billion in 2005, then fell almost in half to $32.333 billion in 2009 and almost in half again, to $15.017 billion, in 2012.

Issuance has fluctuated throughout the years since, following along with interest rate changes — rising when rates rise and falling when rates fall — but have fallen below $15 billion every year since 2012, save for 2017 when sales hit $15.234 billion.

The short-term market was primarily used in the pre-financial crisis to achieve a lower synthetic rate, with the VRDBs connected to an interest rate swap where the issuer would receive floating payments.

But after the financial crisis, few issuers engage in swaps.

Some issuers continue to integrate variable-rate debt and that structure into their overall debt portfolio, said Nicole Riggs, vice president of US Bank.

But there are fewer traditional governments left in the VRDO market, with hospitals, universities, industrial development funds and state housing agencies more likely to use the products.

New York City and its governmental authorities and agencies are “active users” of variable rate products, David Womack, deputy director for financing policy and coordination for the New York City’s Mayor Office of Management and Budget, said, using them as alternatives to long-term fixed-rate bonds.

While VRDOs have allowed for savings in the past, the value proposition for floating-rate paper right now is “not great,” and there has been some reluctance to issue them, Womack said.

Market participants said issuers may hesitate to use floating-rate debt products in 2024 due to recent market volatility.

That volatility can be attributed to a “reaction function of Federal Reserve policy and the fluctuation in interest rates and outflows of the market as a result of unwinding tender option bonds and/or as interest rates spike, instituting new TOBs,” said James Pruskowski, chief investment officer at 16Rock Asset Management.

It can be seen in the whipsawing figures from the SIFMA Municipal Swap Index yields.

“We can remember a time when variable rates moved 10 basis points and it was a lot,” Womack said.

Part of the volatility comes from the market being too small and the insufficient amount of floating-rate product available “versus the flows in and out,” said Matt Fabian, a partner at Municipal Market Analytics.

“It’s trying to fill up a teaspoon at your kitchen faucet. It’s very hard to do because it’s either overflowing or half empty,” he said.

Fabian added, VRDBs can be “a dangerous debt instrument these days for the borrower; it’s a completely unpredictable interest rate payment that you’re going to make.”

The reluctance on behalf of the issuers indicates market challenges “when you have some of the biggest issuers starting to think about possible alternatives,” Riggs said.

Several market forces are working against greater issuance, especially on the margins, she said.

For one, the curve is still not “normal,” she noted.

“So the savings that you would typically see in a normal interest rate environment on the short end of the curve, that magnitude of savings isn’t outweighing the risks and the volatility,” she said.

Additionally, regulatory changes that require banks to hold more capital for the credit liquidity facilities that support this debt are “eating into” the savings to some degree for VRDBs versus fixed-rate issuance.

“Are you saving money at that point, because you’re creating a headache for yourself,” said Giles Nicholson, head of the quantitative solutions group at Siebert Williams Shank & Co.

Due to market volatility, there is a “sense of discomfort,” Pruskowski said.

“There’s a sense of not knowing what’s going on, which is creating a more cautious tone and greater research in work with your banker, which increases the cost of doing business, he said.

Additionally, the volatility from municipalities’ perspective adds some certainty to interest expense and ultimately, the budget, Pruskowski noted.

But once the Fed starts cutting rates, it should add comfort for issuers and be a “clear sign” for increased issuance, he said.

Additionally, variable rates have been “valuable” resources over time, and once the yield curve returns to a “more traditional shape,” it will make more sense to issue them, Womack said.

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