SIFMA Market Stress Creates Significant Pressure for All Parties
Liquidity pressures in all short-term markets have made their way into the U.S. Municipal short-term money market. The short-term municipal market index (SIFMA Index) reset at 5.20% on Wednesday, March 18, up from 1.28% the week before. Healthcare Variable Rate Demand Bond (VRDB) programs with weekly resets that trade relative to the SIFMA Index reset at rates between 9-11%, demonstrating significant spreads to the SIFMA Index.
This is dramatically increasing interest expense for healthcare borrowers that maintain a portion of their capital structures in a SIFMA-based floating rate mode. Dealer inventories are spiking for tradable instruments as banks work to support the market by buying bonds from investors, but investors are tendering programs too quickly. Anecdotally, dealer inventory is more than five times usual levels and currently represents approximately 20% of the market.
How Significant Is This?
As an indication of how dislocated the SIFMA market has become, the equivalent taxable short-term market (1-Month LIBOR) reset at 0.924% on Thursday, March 19. SIFMA historically resets at a percentage of LIBOR less than one because of the tax-exempt nature of the SIFMA market. That ratio is currently 563%.
How Does This Manifest Itself to Borrowers?
Borrowers will see three primary impacts:
- Increasing pressure on the SIFMA market is creating higher interest cost on existing programs that continue to trade.
- Clients with interest rate swaps are experiencing basis mismatch between LIBOR-based swap receipts to hospitals and SIFMA-based payments that hospitals make to bondholders; in the current market, there is a material gap between the two indices at the present time.
- When VRDB programs do not have enough buyers, borrowers are facing mandatory redemption of those bonds in the form of tenders.
A Liquidity Problem Needs a Liquidity Solution
Current pressures in the SIFMA market are focused on a shortage of liquidity. As noted above, investors are selling, and bank inventories are already staggering. Action by the Federal Reserve would be the ideal solution, either by buying municipal market VRDBs directly or permitting banks to offer VRDBs as security for Federal Reserve loans to purchase VRDBs. On Monday, March 23, the Federal Reserve announced its intent to begin purchasing municipal VRDBs. We expect this to be helpful, but it will take several days before we know whether this will be effective and to what degree.
What Can Borrowers Do?
Until and unless the Federal Reserve gets involved, we will need to look for other sources of liquidity. Clients are interested in looking at options to address the spike in rates if the Federal Reserve’s actions are not entirely effective. Options for borrowers include the following:
- Wait and See. The Federal Reserve is actively considering its role in providing a solution for the SIFMA market, and it is taking action quickly. Fed action may bring rates back to normal ranges in relatively short order; in 2008, SIFMA market disruption initially lasted about a month. During other market dislocations, crossover buyers have entered the market to participate. While this is not ideal, it does provide a new range of buyers, but at elevated levels.
- Involve Remarketing Agents. Encourage remarketing agents to purchase VRDBs and hold on their balance sheets to make a market in the bonds. This is currently of limited effectiveness while dealer inventory is already so significant, but it may be useful in combination with other alternatives.
- Utilize Letters of Credit. Most VRDB programs are already “wrapped” by a letter of credit (LOC) from a bank which provides credit and liquidity support for that VRDB. The benefit here is that these agreements are often already in place and designed for this purpose. These bank agreements come with specific mechanics that provide for warehousing bonds for a period of time at specified rates if investors put the bonds back to the borrower. Consider coordinating with the remarketing agents to use the LOC to absorb investor tenders for a period of time. Check your documents to determine the mechanics for doing so, and consult with counsel about the ramifications of doing this.
- Evaluate Alternative Modes. Most VRDBs are issued under multi-modal indentures that permit a change in mode with a fair amount of flexibility. It may be attractive to convert to an alternative mode which provides better stability, or which permits a bank to buy and hold securities for an interim period of time on a private basis.
- Buy and Hold (for a while). In certain circumstances, borrowers can buy back bonds in the secondary market and hold them on their balance sheets until markets return to better levels. It is important to consult tax counsel about whether you should use your own funds or draw on certain bank facilities to fund this, and to determine for how long they can be held. It may be useful or necessary to utilize bank credit capacity to fund your purchase of existing VRDBs. Work with banking partners to put lines of credit in place and consult counsel on the parameters for doing so.
- Align Banking Relationships. Expect more from your primary banking relationships and acknowledge that banks need to do the same. As banks potentially begin to ration credit and support, evaluate whether you are getting the most out of your existing operating and commercial bank relationships, and determine if it is necessary to proactively consolidate relationships and responsibilities to key players with mutually beneficial relationships. This will let your banking partners better advocate on your behalf.
- Derivative Solutions Are Available. Derivative strategies that reverse or cap these dynamics for an interim period of time are available. Consult with your advisor to learn more.
- All of the Above. We expect that solutions which combine these tactics will be required to work through the disruptions in the SIMFA market.
Process Is Important
Each alternative should be reviewed with your bond/tax counsel and financial advisor to determine its permissibility and suitability. Bond documents have been updated since the Credit Crisis to provide for more and better flexibility, but following the process outlined by the documents and with guidance from counsel is critical. Much of what we did in 2008-2009 is relevant, so there is a playbook for how to think about this.