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Income Investing

Understanding tender option bonds

closeup of a USD one dollar bill

Tender Option Bonds are special purpose trust investments that create leverage by borrowing primarily from money market funds to invest in high quality municipal bonds. Nuveen funds use Tender Option Bonds residual interests for portfolio management goals such as creating additional opportunistic exposure to a certain bond sector or part of the municipal bond yield curve, and/or to create long-term, strategic leverage exposure for the overall fund.

A Tender Option Bond (TOB) is the common phrase for a security issued by a special purpose trust (a Tender Option Bond Trust) into which bonds are deposited, and which then issues two types of securities. One of the securities — the floating rate security1 — is typically sold to a money market fund that is only permitted to buy investments of high quality and short maturity. The other security — the inverse floating rate security2 — is retained by the Nuveen fund. Only some bonds will qualify or make business sense for this structure, generally bonds that satisfy money market fund investment requirements, i.e., SEC Rule 2a-7.

Using inverse floaters effectively enables a fund to borrow (mainly from money market funds) and then use the money to purchase additional long-term, fixed-rate bonds for the fund’s portfolio. The expectation is that the purchased long-term bonds will yield more than the borrowing rate paid on short-term floating rate securities issued by the trust.

Tender option bond trusts issue two securities

1. Floating rate securities or “floaters”
 

2. Residual interest securities or “inverse floaters”

 

The TOB life cycle

The following diagram shows a hypothetical Tender Option Bond example, using a $50 million group of bonds held by a fund, and 4:1 gearing (the ratio of the floater value to the inverse floater value).

The TOB life cycle

The trust is created based on the expectation that the borrowing rate is less than the yield of the underlying bonds the trust purchases.

Things to consider about tender option bonds

For a fund shareholder, TOB inverse floaters offer the fund’s portfolio manager more flexibility in managing portfolio investments, as well as increased income and return potential from increased leverage. Leverage has a multiplying effect — it magnifies returns, both positive and negative, and it increases fund risk by magnifying the volatility of returns.

There are certain risks associated specifically with TOBs, however. Most of these risks lead to terminating a TOB trust. If that happens, the fund may choose to sell other assets to buy back the trust’s floating rate security, which could negatively affect fund performance, or liquidate the trust assets. Nuveen has several processes, procedures and people in place to try to mitigate these risks for fund shareholders. It is not possible for individuals to invest directly in securities issued by TOB trusts.

Nuveen strategies for mitigating TOB-specific risk
Risks associated with TOB trusts

Fund shares are subject to investment and market risks, including the possible loss of principal invested. Municipal bond securities are subject to interest rate risk (as interest rates rise bond prices usually fall); call risk; reinvestment risk; issuer credit risk; and tax risk. A fund’s use of inverse floaters creates effective leverage. Leverage creates the risk that the fund could lose more than its original investment and also increases the fund’s volatility and exposure to interest rate risk and credit risk.

What is leverage in a fund?

Closed-end fund TOBs on nuveen.com

Because closed-end funds often use TOB inverse floaters as a persistent form of leverage, Nuveen shows TOB exposure for closed-end funds and the resulting effective leverage in the Overview tab of each fund’s page on nuveen.com/cef.

The leverage created by TOB inverse floaters may be the only leverage exposure for a fund, or can be in addition to regulatory leverage from preferred shares or debt.

 


Capital structure 
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1 Floating rate securities are bonds whose coupon rates adjust periodically based on a specified reset mechanism. Floating rate securities include most bank loans and some preferred stock.

2 Inverse floating rate securities refers to a type of security with income that may vary inversely to the rate of a specified underlying bond held in a tender option bond trust.

The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

A word on risk

Past performance is no guarantee of future results. Prospective clients should review their investment objectives, risk tolerance, tax liability and liquidity needs before choosing a suitable investment style or manager. There are risks inherent in any investment, including the possible loss of principal. There can be no assurance that fund objectives will be achieved. Closed-end funds frequently trade at a discount to their net asset value.

This report is for informational purposes only and is not intended to predict or depict performance of any investment. The statements contained herein are based upon the opinions of Nuveen, LLC, and the data available at the time of publication of this report, and there is no assurance that any predicted results will actually occur.

Nuveen Securities, LLC, Member FINRA and SIPC.

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