Tax-exempt tenders — a dubious success

Bonds

In 2023 several municipal issuers made tender offers for their not-yet-callable high coupon tax-exempt bonds. In most cases, the intended goal was to refund and save interest.

These tenders turned out to be remarkably unsuccessful — the average acceptance ratio was only around 30%. There was a dearth of the usual press releases reveling about the savings. A noteworthy exception is one by New York City: ‘40% bondholder participation makes the City’s tender one of the most successful tender solicitations to date in the municipal bond market’. If 40% participation is a success, what would be a failure? We’ll explore below the reasons for these flops.

To set the stage, most tax-exempt tender candidates are long 5% coupon bonds callable at par in year 10. These are ideal showing savings at any cost: they will be refunded within 10 years by hook or by crook, even if interest rates substantially increase.   

Tendering and refunding not-yet-callable bonds has a long history in the taxable market. The first major tender program took place over 47 years ago, in January of 1977. Four Bell System telephone companies tendered for bonds that they issued in 1974, when the long Treasury rose to a post-war high above 8%. These 40-year bonds carried coupons near 10%, and were callable at a premium in 1979. The acceptance rates of the tenders were above 80%.

Another major wave of tenders occurred around 1985. Just as in 1977, the candidates were long-term not-yet-callable bonds. These had been issued in 1981, when the 30-year Treasury rate reached another record of roughly 15%, and the coupons of some utility bonds exceeded 18%. By 1985 rates significantly declined, and the lessons learned from the Bell System tenders could be put to good use. For example, because the 1977 tenders were at a fixed price over a one-month period, shrewd investors waited until the last minute to decide whether or not to participate.

In 1985 issuers introduced two improvements to avoid this problem: shortened the tender period, and switched from a fixed price to a fixed spread tender. The success ratios of the 1985 tenders were also in the 80% range, far above those of the current tax-exempt tenders.

How to explain the success of the tenders for taxable corporate bonds and the failure of tenders for tax-exempt munis? The tax and accounting considerations are critical. Let’s begin with the perspective of the issuer. Corporations can write off the premium paid over par as an ordinary expense, and this provides an incentive to transact. The tax-deduction of the premium today is worth more than the tax-deduction of the interest payments over time. Thus taxes provide a solid foundation for the refunding transactions by corporations. 

In contrast, tax-deductibility is irrelevant to municipal issuers. Municipal refundings prior to the call date are motivated solely by risk aversion: avoid possibly higher rates when the bonds become callable. A related appeal for management is the reporting of the resulting interest savings to the constituents.

Rigorous analysis reveals that waiting until the call date is likely to generate significantly greater savings than tendering and refunding today. The municipal tender/refunding transactions lack a theoretical underpinning, they are entirely speculative. They are reminiscent of the taxable advance refundings of not-yet-callable tax-exempt munis between 2019 and 2021, which ended up costing taxpayers billions of dollars.

Turning to the investors, taxable bonds are mostly held in non-taxable accounts. Their primary consideration is the tender price — if it is at a reasonable premium, they are likely to participate. This explains the roughly 80% success rate of the corporate tenders. 

In contrast to taxable bonds, tax-exempt munis are always owned, directly or indirectly, by taxable investors. The high-coupon tender candidates are usually held by savvy professionals, because the smaller retail investors are reluctant to pay over par. If the tender price exceeds the investor’s tax basis the premium is taxed as a capital gain. This tax would be detrimental — if held to maturity or call, high-coupon bonds have no tax consequences. In short, tax-aware investors are unlikely to sell at a gain. 

What if the tender price of a tax-exempt muni is below the investor’s tax basis? Selling would result in a loss, and the tax savings would be beneficial. A likely obstacle in this case is the ‘hold to maturity’ accounting method. This is the method normally used by banks and insurance companies for their investment portfolios, as they prefer not to mark to market. Although selling at a loss would be tax-beneficial, the resulting decline of book value would be unacceptable. For this reason ‘hold to maturity’ institutions don’t participate in the tenders. 

In summary, the tender/refunding programs for tax-exempt munis have turned out to be a disappointment for the municipal issuers. The primary reasons for the low investor participation are tax and accounting considerations. However, the poor outcome is actually good news for the taxpayers, because these speculative transactions are wasteful. The poorer the participation in the tender, the less is the waste from these premature refundings prior to the call date.

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