The Volcker Rule is a federal regulation that went to effect on April 1, 2014. The rule, which is named after former Federal Reserve Chairman Paul Volcker, is actually section 619 of the Dodd-Frank Street Reform and Consumer Protection Act.
This rule prohibits banks from using their own accounts for short-term proprietary trading or to invest in hedge or private equity funds. Essentially, this rule prohibits banks from taking on too much risk in an effort to increase profits.
Tender Option Bonds, or TOBs, are structured products that use leverage to increase the overall yield of a municipal bond portfolio. So, let us take a look at how the Volcker Rule impacts these structured muni debt instruments.
A Brief Look at Tender Option Bonds
Typically, municipal bonds are conservative in nature, mostly suiting high income bracket investors looking for low risk to principal while collecting tax-free income. Tender Option Bonds are more aggressive in nature because they use leverage as a way to increase returns. With this leverage comes inherently more risk to the investor.
Make sure to use our Municipal Bond Screener when looking for your next potential investment.
The process starts when a municipal bond fund manager deposits high-quality municipal bonds into a trust fund. Then the trust issues both short-term floating rate investments and inverse floating rate investments. The short-term floating rate investments are then sold to money market funds, which pay cash directly back into the municipal bond fund. The second leg of the Tender Option Bond Trust issues inverse floating rate investments that pay residual income directly back to the municipal bond fund as well. In summary, the TOB Trust earns income in two ways. The first leg is earned on the spread between the high-quality municipal bonds in the trust over the short-term floating rate investments. The municipal bonds typically have a higher yield than the short-term floating rate bonds, thus creating extra interest in the spread. The second leg is the high interest generated from the inverse floating rate instruments.
Be sure to read our previous article where we showed investors how higher interest rates affect muni bonds.
The Volcker Rule and TOBs
The Volcker Rule affects the Tender Option Bond market because it was considered to be too risky of an investment for banks and thus not given an exemption like other municipal bond instruments. This ruling was most likely due to the leverage that is used in the formation of a TOB Trust. When a TOB Trust issues the short-term floating rate investments, leverage is established. Once the short-term investments are sold to the money market, the cash is typically moved back into the TOB Trust from the muni bond fund and is used to restart the process again.
The leverage involved in this process is referred to as the gearing ratio, which is the ratio between the short-term floating rate and inverse floating rate investments. The leverage is deemed too speculative for banks to be involved in and is similar to the actions that hedge funds and private equity funds use to increase their potential gains. Since the ruling has taken place, the market for TOBs has significantly dwindled, as most investors in this sector were banks.
Volcker Rule Revamp
In May 2018, President Donald J. Trump signed into law a new bill that is designed to ease the ruling on banks that are affected by the Dodd-Frank Act. The bill is designed to ease oversight for all banks below $250 billion in assets, which are mostly the community banks that have suffered by undergoing the same scrutiny standards as the large banks.
This bill also addresses a potential revamp of the Volcker Rule, as the Securities and Exchange Commission (SEC) was the last of five agencies to sign off on the proposal. This new proposal upholds the ban on proprietary trading for banks but it removes the assumption that positions held by lenders for fewer than 60 days are proprietary. Regulators are looking to simplify the original Volcker Rule and allow firms more leeway to take advantage of some exemptions in the ruling. In an effort to better understand the rule, the SEC has opened the topic to public comment for 60 days.
Likely Fate of TOBs Under the New Regulations
The Securities Industry and Financial Markets Association (SIFMA), which is an advocate for an effective and efficient market, have been on the frontlines with the argument of the characterization of TOBs in the Volcker Rule.
The Volcker Rule defines TOBs as a ‘covered fund’ and is lumped in under private equity or commodity pools. SIFMA wants the Volcker Rule to further clarify the ‘covered fund’ definition to exempt traditional TOBs because it is inconsistent with the statute and results in higher financing costs to U.S. businesses. During this 60-day period, regulators want to better understand how TOBs should be exempted and what makes them inherently different from other ‘covered funds.’
Some institutions, like Bank of America, have found a loophole that could help allow TOBs back into the marketplace that qualifies as exempt under the Volcker Rule. In Bank of America’s example, the TOB Trust was opened through its Merrill Lynch venture, which is not considered an FDIC bank. However, this structure only limits them to a maximum of 10 investors; otherwise it would not be exempt under the Volcker Rule.
Check out the different ways to invest in muni bonds to stay up to date with the current investment strategies.
The Bottom Line
In summary, regulators must have a conversation on Tender Option Bonds and their place in the Volcker Rule. The purpose of the revamping of the Volcker Rule is to ensure that legislation is the most effective rule possible and does not unjustly prevent an efficient marketplace. It is unknown whether TOBs will be exempt in the new revamping. However, the definition of ‘covered funds’ and why TOBs are not exempt should be further clarified.