We have written previously about money market reform and the impact the new rules had and continue to have on LIBOR. Another segment of the market that has been affected is the municipal bond market. Specifically, Variable Rate Demand Notes, or VRDNs, have seen a sharp rise in the yields offered. These bonds are issued as long-term debt on an issuer’s balance sheet, but are set up to function like a very short-term security, with either daily or weekly liquidity at face value. The bonds are priced using the effective municipal equivalent to LIBOR, known as SIFMA, and garner their liquidity from a specified financial institution that provides a Letter of Credit (LOC) promising to purchase the bonds should the assigned remarketing agent not be able to place a seller’s bonds with a buyer within the liquidity time horizon. Below is a summary of money market reforms that go into effect this year in October.
As investors have come to grips with these new realities, they are changing their investment preferences, and ultimately they are moving money out of many of these funds. According to Morgan Stanley estimates, AUM for municipal money market funds have declined from $250 billion to just over $150 billion, resulting in the cheapening of ultra-short-term instruments. This has created a great opportunity for investors like SNW to invest in highly liquid and interest rate insensitive instruments at attractive yields. However, the trade is not without risks. The LOCs supporting these bonds are typically in effect for a much shorter term than the life of a given issue and must be renewed from time to time (which requires monitoring as well as research on the LOC provider). On top of that, the LOC does not ultimately protect an investor from a lack of payment by the underlying municipal credit (which requires due diligence on credit quality). That said, the charts below help to illustrate why we believe this is an opportunity for our clients.
Source: Fidelity, Morgan Stanley, Bloomberg