Despite swings in short-term rates, issuance of variable rate demand obligations and other floating-rate debt has steadily increased over the past several years, with variable rate (short put) issuance during the first half of 2024 rising to $7.077 billion, an 11.6% increase year-over-year, LSEG data shows.
Issuance rose to $13.239 billion in total in 2023 from $11.533 billion in 2022, an increase of 13.8%, according to LSEG data.
VRDOs may be a “short-term solution” for issuers to refinance when the Fed starts cutting rates, said James Pruskowski, chief investment officer at 16Rock Asset Management.
And “when rates start declining, that seems to be a good economic tradeoff for municipalities, as opposed to locking in today’s higher absolute levels on longer-term debt,” he said.
It’s also helpful that there’s a record amount of money sitting in money market accounts, and market participants are utilizing the liquidity of that demand base, Pruskowski said.
“As the Fed begins to cut interest rates, that’s going to be confirmation for that money to begin to step out and get reinvested, not just in munis, but equities as well,” he said. “And that provides the liquidity and opportunity as rates decline and demand increases in longer-term debt refinance out.”
But while issuance rose, it’s unlikely to reach pre-financial crisis levels due to fewer issuers using the structure due in part to past losses, current market volatility and an inverted yield curve. This marks a change from the start of the year when
The recent levels of VRDO issuance pales in comparison to issuance before the financial crisis, with VRDOs falling from its high of $61.8 billion in 2005 by nearly half to $32.333 billion in 2009 and almost in half again, to $15.017 billion, in 2012, according to LSEG data.
During the pre-financial crisis, the short-term market was mostly used to achieve a lower synthetic rate, with the VRDOs connected to an interest rate swap where the issuer would receive floating payments.
However, after the financial crisis, few issuers engaged in swaps, with issuance becoming more “concentrated,” said Lisa Washburn, chief credit officer and managing director at Municipal Market Analytics.
Issuance is usually done by hospitals, housing agencies, and some higher education institutions and universities, along with issuers with more “financial management functions,” she noted.
Some market participants just do not like VRDOs, said Rick White, an independent consultant with more than 25 years in the industry.
“They don’t they don’t like the volatility,” he said. “They don’t understand it. They don’t want to risk doing something. They’re more comfortable issuing a longer-term deal at a fixed rate, even if they could potentially save more money by going very great down the road. This is the known versus the unknown.”
Pruskowski noted VRDO issuance has “fallen out of favor” due to the inversion of the yield curve and long-term rates are tighter than historical highs.
Issuers are now funding their needs rather than “recycling” into flows and there is no budgetary pressure in terms of tax receipts and rainy day funds, he noted.
Collections have been running at a “robust rate,” alleviating pressure to finance any short-term needs, Pruskowski said.
Uncertainty over when the Fed will start cutting rates is also playing a role, White said.
“It’s hard for an issuer to stomach issuing a floating-rate piece of paper at rates over 4% versus a long-term fixed-rate deal at very attractive rates,” he noted.
Additionally, “people are looking for ways to lock in higher yields, so they’re getting less involved and having less than an appetite for the VRDN space,” said Chris Brigati, senior vice president and director of strategic planning and fixed-income research at SWBC, noting that may exacerbate any of the expected market volatility.
There have been stretches of volatility this year, as seen in the whipsawing figures from the SIFMA Municipal Swap Index Yield over the past few months.
January saw wild swings before entering a more “normal” environment with slight increases in February through April before volatility spiked in May and continued through June, White noted.
Despite the recent volatility, White said it has “calmed down” from the “incredible” volatility of 2023 where the SIFMA Index saw weekly changes of more than 50 basis points for 27 weeks.
He noted the size of the market plays a large part in that, as it is just a “fraction” of what it once was.
Furthermore, the volatility heading into July — one of the best seasonal months with the most amount of cash returning to market — can be cyclical.
Despite market volatility, floating-rate products offer issuers flexibility, White said, noting that many of the larger issuers have variable-rate debt in both daily and weekly mode and can convert to other modes if their bond documents allow.
“Having debt issued in daily mode versus the more common weekly form is benefitting municipal issuers as the overall interest savings are dramatically better than it has been historically,” he said.