Tender option bond (TOB) issuance rose in the first-quarter 2025 as supply pressures, fund outflows, and macroeconomic uncertainty lifted long-dated municipal bond yields. This uncertainty was further exacerbated as markets responded to the universal tariffs announced by the Trump administration on April 2, 2025.

We rated approximately $3.0 billion in TOB issuance across 167 trusts in first-quarter 2025, up from $2.2 billion in fourth-quarter 2024 and $1.1 billion in first-quarter 2024. Nearly half of this activity took place in March when yields confidently moved above 4% (see chart 1). At the same time, approximately $1.45 billion in TOB issuance was paid down, representing a $1.55 billion net increase in TOBs outstanding.

S&P Global Ratings believes there is a high degree of unpredictability around policy implementation by the U.S. administration and possible responses--specifically with regard to tariffs--and the potential effect on economies, supply chains, and credit conditions around the world. As a result, our baseline forecasts carry a significant amount of uncertainty. As situations evolve, we will gauge the macro and credit materiality of potential and actual policy shifts and reassess our guidance accordingly (see our research here: spglobal.com/ratings).

Chart 1

Municipal Bond Yields Increased

Levered funds took advantage of higher yields as municipal bonds cheapen.  Municipal bond issuance reached a four-year high with $125 billion new bonds issued in the first quarter (see chart 2). Investor demand remained steady in January and February, with certain weeks showing inflows of over $1 billion. However, demand weakened materially in March partly due to macroeconomic and policy uncertainty.

These forces resulted in lower bond prices, particularly among long-dated bonds, with 'AAA'-rated 30-year bond yields rising above 4% in eight of the first 14 weeks of the year, compared with only one week during the same period in 2024 (see chart 3). As of April 23, 2025, 'AAA'-rated 30-year municipal bond yields were 4.56%, which is higher than at any point in 2024, according to Bloomberg's BVAL Muni Benchmark 30Y Index.

Chart 2

Chart 3

Although municipal investor sentiment soured in March, TOB fund sponsors took advantage of the higher yields by collapsing old trusts and establishing new ones to capture higher yielding bonds and offset capital gains through tax loss harvesting.

Chart 4

Tax Loss Harvesting: How Funds Secure Higher Yields

When a TOB trust is created, a municipal bond is sold to the trust according to a sale agreement. The sale agreement specifies the price and deposit yield of the municipal bond. The price is typically set based on either the price the TOB trust sponsor paid to acquire the bond or the prevailing price that the bond would trade for in the secondary market. Once the bond is sold to the trust, the price and deposit yield are set for the duration of the trust's life. As bond prices fluctuate due to changes in interest rates or supply and demand, the bond in a TOB trust also changes in value. However, these changes are unrealized until the trust is unwound and the bond is sold.

Bond prices fell in first-quarter 2025. As a result, the TOB trusts that were created in 2024 are currently holding bonds that have depreciated in value and are yielding lower rates than bonds that are currently trading. TOB fund sponsors have responded by taking certain steps to improve their book yields while maintaining the positions they established throughout 2024 (see chart 5).

Chart 5

The fund sponsor, as the residual security holder (the residual holder), retain the right to demand the tender of the floating-rate security holder (the floater) and collapse the trust. Once this occurs, the fund would retain ownership of the bond, and it would then sell the bond at a loss in the secondary market. Simultaneously, the fund would purchase a similar bond in the open market, typically at a premium. The fund would then set up a new TOB trust and deposit the new bond into the trust, resulting in a gain on the sale.

This new transaction achieves two goals. First, the loss on the old bond offsets the gain on the new bond (tax loss harvesting). Second, the new bond has a higher yield, which will be set once it is sold to the TOB trust (yield harvesting). It is worth noting that the fund cannot use the same bond in a new trust since that could be considered a wash sale, and the loss would not count toward the fund's tax deduction.

What Tariffs Mean For TOBs

On April 2, 2025, President Donald Trump signed an executive order imposing tariffs on all U.S imports effective April 5, 2025. The municipal bond market responded with heavy losses as selling pressure increased. However, prices briefly reversed after the Trump administration paused tariffs above 10% for 90 days for all countries except China on April 9, 2025. Despite the temporary reprieve, long-dated municipal bonds yields remain elevated above 2024 levels.

Policy uncertainty at the federal level could affect revenues and expenditures for U.S. public finance issuers.  U.S. public finance entities entered 2025 with record reserve levels, boosted by pandemic funding support and robust economic growth. Policy shifts, including tariffs, that slow growth or worsen inflation could have an outsized effect on issuers that are struggling to maintain balanced operations in the current economic environment (see "Credit Conditions North America Q2 2025: Uncertainty Prevails," published March 26, 2025).

Chart 6

Chart 7

While traditional municipal funds may sell a bond upon credit deterioration, high-yield funds are taking on more risk in pursuit of greater returns.  The total investment portfolios of the largest and most active TOB fund sponsors primarily consist of high-yield unrated municipal debt. These funds utilize TOBs to leverage their investment-grade (rated 'BBB-' and above) municipal debt in pursuit of greater returns. For example, Nuveen High Yield Municipal Bond Fund had 68.8% of unrated debt in its $14.9 billion portfolio as of Feb. 25, 2025. It is the largest and most active TOB fund sponsor, with approximately $6.2 billion in outstanding trust par amount (see charts 8 and 9). The fund sponsored 21 TOB trusts in first-quarter 2025--the most by any individual fund.

Chart 8

Chart 9

Chart 10

Significant depreciation in the underlying asset could lead to deterioration in the asset coverage ratio.  Although a minimum asset coverage ratio (the value of the underlying bond over the outstanding par amount of the floaters) is not required under Rule 2a-7, which governs asset eligibility for money market funds, the common market practice is above 102%. In response to falling bond prices, some fund managers may seek to shift the trust's leverage, which is measured as the ratio of outstanding floaters to residuals. This can be accomplished through a deleverage amendment that decreases the outstanding floaters and increases the outstanding residuals by an equivalent amount, while maintaining the underlying bond par amount and improving the asset coverage ratio. Chart 10 shows a breakdown of average leverage across newly created fund-sponsored trusts.

Credit Remains Strong As Policy Uncertainty Continues

Outstanding floater portfolio remains well positioned ahead of tariff-induced rating volatility.  TOBs remain well positioned from a credit perspective. Approximately $1.5 billion (6.5%) TOB floaters have both a 'A-1' short-term rating and a 'A' long-term rating, which is two notches from potentially constraining the short-term rating to 'A-2' (see chart 11). In first-quarter 2025, downgrades outpaced upgrades for the third consecutive quarter (see chart 12). Most of the downgrades in the first quarter followed the downgrades of the Chicago Sales Tax Securitization Corp. and the Los Angeles Department of Water & Power.

Chart 11

Chart 12

Related Research

• Credit Conditions North America Q2 2025: Uncertainty Prevails, March 26, 2025