Wells Fargo Advantage Funds latest "Institutional Cash Management Portfolio Manager Commentary" says, "In our conversations with our shareholders and distribution channel partners, we get a number of questions about the markets and our money fund portfolios. For the last several months, the most frequently asked questions (FAQ) have centered on our view of Europe, our opinion on potential regulatory changes, and our holdings of municipal variable-rate demand notes (VRDNs) and tender option bonds (TOBs) in our prime funds. These are all good questions; the first two are very topical, and with (depending on which fund you look at) a quarter to a third of our prime funds' assets invested in the municipal sector, our stake is larger than your average prime money fund." We excerpt from their comments on muni holdings below.
Wells Head of Money Funds Dave Sylvester writes, "A clouded credit outlook in Europe and an uncertain regulatory environment lead us to conclude that the most appropriate structure for a prime portfolio is one that is both short and highly liquid. In this market environment -- where we want to construct portfolios that have minimal exposure to eurozone financials, are highly liquid, have a relatively short WAL, and contain solid credits -- VRDNs and TOBs meet all four of these criteria."
He explains, "VRDNs are long-term municipal securities that feature both a periodic coupon reset and a tender option that allows an investor to periodically sell the securities for payment at par plus accrued interest. Generally, the interest rate on VRDNs is reset every one to seven days based on the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index. VRDNs also generally have a one-day or seven-day "put" or "demand" feature that enables the investor to sell the securities back to a financial intermediary such as a remarketing agent, tender agent, or trustee on a one-day or seven-day notice. The daily or weekly coupon reset and one-day or seven-day par "put" or "demand" feature are the two key structural characteristics that make VRDNs attractive, liquid, stable value investments for money market funds, by combining the ability to invest in a wide range of high-quality municipal securities with the benefit of SEC 2a-7-eligible short-term securities."
Sylvester continues, "While issuers of VRDNs may provide their own liquidity to fund the purchase of bonds that are tendered, most VRDNs benefit from third-party credit and/or liquidity enhancement, such as letters of credit and standby bond purchase agreements. Such credit and liquidity enhancements are typically provided by a highly rated bank or other financial institution and are designed to ameliorate the risk of nonpayment by an issuer."
He adds, "TOBs are similar to VRDNs in that they also provide the benefits of a periodic coupon reset with the put option feature to sell the securities for payment on demand at par. An important difference between VRDNs and TOBs is that the former are primary market instruments, while the latter are created in the secondary market. They share more similarities than differences, though, since remarketing agents are responsible for resetting the rates on the TOBs; a remarketing agent is responsible for finding new buyers for tendered securities; and the liquidity facilities provided by highly rated banks and other financial institutions acts as a backstop for tendered securities to ensure that investors are paid par plus accrued interest on demand."
The Wells piece writes, "VRDNs and TOBs have historically been a core holding for most municipal money market funds due to their ability to provide liquidity and principal preservation in cash portfolios. The safety and soundness of the structures of these securities have endured through various market conditions and economic cycles and most notably persevered during the 2008 financial crisis. As a result, the popularity of these securities has increased over the years due to growing demand from nontraditional investors seeking the safety and liquidity offered by these products."
Finally, it says, "It was once the case that because the income from many VRDNs and TOBs was exempt from federal (and in some cases state) income taxes, their yields were significantly below equivalent taxable investments. More recently, however, the compression in yields and declining demand from municipal money market funds and corporate investors have led remarketing agents to reset VRDN and TOB rates at a level that is more in line with taxable yields."
