An introduction to municipal derivative products.Inverse (mathematics) inverse - Given a function, f : D -> C, a function g : C -> D is called a left inverse for f if for all d in D, g (f d) = d and a right inverse if, for all c in C, f (g c) = c and an inverse if both conditions hold. floaters/floaters, floaters floaters /float·ers/ (flo´ters) “spots before the eyes”; deposits in the vitreous of the eye, usually moving about and probably representing fine aggregates of vitreous protein occurring as a benign degenerative change. hedged with swaps, bull/bear securities and indexed/fixed-rate bonds conclude Government Finance Review's two-part discussion of municipal derivative derivative: see calculus. derivative In mathematics, a fundamental concept of differential calculus representing the instantaneous rate of change of a function. products and the risk factors associated with their use. During the last few years municipal finance officers have been presented with numerous financing proposals that incorporate the use of municipal derivative products. With the lure lure the skin-covered object which runs on a monorail on a Greyhound racing track and which the dogs are schooled to chase. The lure must be kept 30 to 40 ft ahead of the leading dog so that the field is stretched out. of significant interest-cost savings, the proposals urge municipal issuers to augment aug·ment v. aug·ment·ed, aug·ment·ing, aug·ments v.tr. 1. To make (something already developed or well under way) greater, as in size, extent, or quantity: their staid staid adj. 1. Characterized by sedate dignity and often a strait-laced sense of propriety; sober. See Synonyms at serious. 2. , "plain-vanilla," fixed-rate borrowings with these new products, whose characteristics generally are unfamiliar to issuers. These products include interest rate swaps Interest Rate Swap A deal between banks or companies where borrowers switch floating-rate loans for fixed rate loans in another country. These can be either the same or different currencies. , caps, floors and collars, as well as new fixed-rate programs with exotic trade names or acronyms, like RIBS/SAVRS, PARS/INFLOS and bull/bear floaters, and partial fixed/partial floating-rate products such as indexed bonds. While some of these products have been used in the corporate and government markets for many years, their use in the municipal market is a relatively recent development. Although derivatives may be useful to government finance officials in managing debt and reducing total interest payments, there may be risks associated with these products. Therefore, it is vital that the derivative products, as well as their risks, be well understood by the officials who employ them. The October 1992 issue of Government Finance Review included articles explaining how swaps work, how an issuer may analyze their usefulness and the use of swaps at the Port Authority of New York and New Jersey Port Authority of New York and New Jersey, self-sustaining public corporation established in 1921 by the states of New York and New Jersey to administer the activities of the New York–New Jersey port area, which has a waterfront of c. . Swaps are but one example of a collection of financing tools referred to as derivative products. The purpose of this article is to introduce and explain some of the other derivative products being used in the municipal market. The previous installment of this overview of derivative products, which appeared in Government Finance Review in February 1993, discussed interest rate caps, floors and collars. This article will focus on other derivative products: inverse floaters/floaters, inverse floaters Inverse Floater A bond or other type of debt whose coupon rate changes inverse (opposite) to short term interest rates. Notes: With an inverse floater, as interest rates rise, the coupon rate falls. hedged with swaps, bull/bear floaters and indexed/fixed-rate bonds. What is a Derivative Product? Derivative products are financial instruments whose own value is "derived" from or based upon the value of other assets other assets Assets of relatively small value. For financial reporting purposes, firms frequently combine small assets into a single category rather than listing each item separately. or on the level of an interest rate index. For example, the value of a stock option is derived from, among other things, the value of the underlying share of common stock. The values of interest rate swaps, caps, floors and collars are a function of and derived from present and expected future levels of interest rate indexes when compared with a contractual fixed interest rate. The term "derivative products," also refers to financial instruments which have complex structures with option-like features. These features can be embedded Inserted into. See embedded system. in another instrument, such as a call option on a bond, or can be stand-alone in nature, like an interest rate swap. It is possible for financial engineers to build, model and value these complex derivative securities Derivative security A financial security such as an option or future whose value is derived in part from the value and characteristics of another security, the underlying asset. by analyzing them as combinations of simpler underlying securities. In some cases, the use of a derivative allows an issuer to outperform Outperform An analyst recommendation meaning a stock is expected to do slightly better than the market return. Notes: Exact definitions vary by brokerage, but in general this rating is better than neutral and worse than buy or strong buy. a simpler instrument or structure. The derivatives most frequently used by municipal issuers are swaps, caps, floors, collars and leveraged products, also known as inverse floaters/floaters. Inverse Floaters/Floaters First introduced to the municipal market in March 1990, inverse floaters are considered derivatives because owning an inverse floater is economically equivalent to owning a fixed-rate bond and writing a fixed-to-floating interest rate swap that contains an interest rate cap. Inverse floaters are variable-rate instruments whose interest rate depends upon short-term interest rates Short-term interest rates Interest rates on loan contracts-or debt instruments such as Treasury bills, bank certificates of deposit or commerical paper-having maturities of less than one year. Often called money market rates. in the municipal market. As tax-exempt short-term rates rise, the interest rate on inverse floaters falls and vice versa VICE VERSA. On the contrary; on opposite sides. . Inverse floaters are usually issued in equal amounts with floaters (usually floaters issued as Dutch auction Dutch Auction An auction where the price on an item is lowered until it gets its first bid, and then the item is sold at that price. Notes: The U.S. Treasury (and other countries) uses a Dutch auction when it sells securities. securities). This results in a fixed-rate financing for a municipality MUNICIPALITY. The body of officers, taken collectively, belonging to a city, who are appointed to manage its affairs and defend its interests. , which has issued two inversely in·verse adj. 1. Reversed in order, nature, or effect. 2. Mathematics Of or relating to an inverse or an inverse function. 3. Archaic Turned upside down; inverted. n. 1. related variable-rate securities. A typical interest rate formula for this type of security structure is: Inverse floater rate + Floater Floater A bond or other type of debt whose coupon rate changes with market conditions (short-term interest rates). Also known as "floating-rate debt". Notes: For example, a floater bond may have the coupon rate set at "T-bill rate plus 0.5%". rate = 2 x Fixed bond rate What is the advantage to a municipal issuer of issuing floaters and inverse floaters? Because the municipal yield curve has historically been steeply sloped, i.e., short-term rates are lower than long-term rates, it is expected that, on average, the yield provided to the holder of an inverse floater will be higher than the yield available on a "plain vanilla Refers to the bare minimum of functions that are known to be available in an application or system. Contrast with bells and whistles. " fixed-rate bond. Under the inverse floater/floater structure, therefore, an investor may be willing to pay a higher price or to accept a lower fixed rate from an issuer. This translates into interest savings for the municipality. Exhibit 1 INTEREST RATE COMPARISONS FLOATERS/INVERSE FLOATERS AND "PLAIN VANILLA" BONDS Fixed rate Fixed rate Floating rate paid on paid on Floating rate paid on "vanilla" floater/inverse paid on inverse bonds floaters floaters floaters 7.00% 6.75% 5.00% 8.50% 7.00 6.75 5.50 8.00 7.00 6.75 6.00 7.50 Market experience has shown that issuers of floaters and inverse floaters have achieved a fixed interest rate 10 to 25 basis points below the yield on "plain vanilla" bonds. Exhibit 1 illustrates how floaters/inverse floaters work. With a floater/inverse floater, an issuer may take advantage of market segmentation Market Segmentation A marketing term referring to the aggregating of prospective buyers into groups (segments) that have common needs and will respond similarly to a marketing action. , offering half of its debt in the long-term, higher-yield market and the other half in the short-term auction market. Because investors in the auction market, typically corporations, traditionally have purchased corporate rather than municipal securities, debt sold in this market represents a net addition to the investor base for municipal debt. This strategy has proven especially attractive to the issuers of housing bonds because historically most housing bonds have been purchased by a relatively small group of institutional buyers with significant market power. Risk Factors. There are no significant risks to issuers of inverse floaters coupled with floaters. Interest payments on floaters and inverse floaters, however, occur on auction dates, typically every 28 or 35 days rather than twice a year as on fixed-rate bonds, which adds a slight administrative burden. Recently, investment banking firms have structured floater/inverse floater transactions that pay interest every six months. The interest rate to the municipality remains fixed for the life of the bonds regardless of what happens in the bond market, with all interest rate risks being borne by the holders of the inverse floaters. The interest rate savings of 10 to 25 basis points which were quoted earlier is on a bond equivalent yield Bond equivalent yield Bond yield calculated on an annual percentage rate method. Differs from annual effective yield. basis and takes the more frequent compounding of payments into effect. Not all issuers are able to take advantage of this product, however. It is difficult for issuers with a credit rating of less than a solid "A" to access the auction market. Also, a term bond size of at least $30 million has typically been required to provide an efficient auction. Exhibit 2 BULL/BEAR FLOATER INTEREST RATES Kenny Fixed Bear Bull Index coupon floater rate floater rate 2.075% 6.65% 0.00% 13.30% 3.000 6.65 1.85 11.45 4.000 6.65 3.85 9.45 5.000 6.65 5.85 7.45 6.000 6.65 7.85 5.45 7.000 6.65 9.85 3.45 8.000 6.65 11.85 1.45 8.725 6.65 13.30 0.00 Floaters Hedged with Swaps A variation on inverse floater/floater products is the issuance of inverse floaters together with an interest rate swap. Under this structure, an entire term bond is marketed as inverse floaters. A swap is then executed with a counterparty Counterparty The other participant, including intermediaries, in a swap or contract. in which the issuer exchanges its floating interest rate for a fixed-rate of interest. The debt service savings associated with this product are approximately the same as for the inverse floater/floater products. Although the risks associated with floater/inverse floater products are borne by the inverse-floater owner, there are some risks associated with inverse floaters hedged with a swap that are borne by the issuer. Municipalities face the usual risks associated with interest rate swaps: basis risk and counterparty risk Counterparty Risk The risk to each party of a contract that the counterparty will not live up to their contractual obligations. Notes: In most financial contracts, counterparty risk is known as default risk. . These risk elements are explained in part one of this article in the February 1993 issue of Government Finance Review. Another concern is that the market for inverse floaters is not as liquid or developed as the market for floaters, and under this structure there are twice as many inverse floaters to sell as with inverse floaters/floaters. Bull/Bear Securities A variation of inverse floaters/floaters known as bull/bear floating-rate bonds uses an embedded swap in place of an auction. This allows a larger group of municipalities to qualify as issuers. Bull/bear bonds may be issued even when: * the term bond on an issue is too small to allow for an efficient auction, * credit ratings are not strong enough to generate sufficient interest among money market investors to allow for an efficient auction or * the issuer faces regulatory restrictions which prevent payment of interest on a 28- or 35-day basis or prevent entering into agreements with an auction agent. Bull/bear bonds, like combinations of floaters and inverse floaters, combine two variable-rate securities whose interest rates add to a fixed rate. The difference is that the rates on bull/bear bonds are set via a predetermined pre·de·ter·mine v. pre·de·ter·mined, pre·de·ter·min·ing, pre·de·ter·mines v.tr. 1. To determine, decide, or establish in advance: formula, not through an auction. The formula uses a floating-rate index, however, so that the interest rate on the securities will reflect market conditions. The interest rate on both the bull bonds and the bear bonds converts to a fixed rate following a prespecified conversion date, typically the first call date. As with inverse floater/floater combinations, the issuer will receive a lower fixed rate of interest than is available on traditional fixed-rate bonds. The interest rates on the two securities are set through the following formula: Bull floater rate = |X~ + 2 x ||Y~ - Variable rate~ Bear floater rate = |X~ + 2 x |Variable rate - |Y~~ where |X~ and |Y~ are set at the time of pricing and |X~ reflects the fixed rate of interest payable by the issuer and |Y~ is the "at market" swap rate Swap Rate The rate of the fixed portion of a swap as determined by its particular market. This is the rate at which the swap will occur for one of the parties entering into the agreement. for a comparable-term, par-value, tax-exempt interest Tax-Exempt Interest Interest income that is exempt from federal income tax. Although it is not directly taxed, this income may still be required to determine other tax calculations such as social security benefits. rate swap. The variable rate for each interest period will equal the weighted daily average of the J.J. Kenny Index. After the conversion date, both the bull bonds and bear bonds will pay |X~. Exhibit 2 shows the rates that would be paid on bull/bear floaters where |X~ is equal to 6.65 percent and |Y~ is equal to 5.40 percent. Risk Factors. There are no serious risks associated with bull and bear bonds, although they may be difficult to issue in some markets. The market for bull and bear bonds is not as developed as the market for floaters and inverse floaters; hence the opportunities for successful issuance are fewer. Bear bonds, however, are attractive to holders of inverse floaters who would like to hedge their risk because the rate on bear bonds goes up as rates go up, while the returns on inverse floaters go down as rates rise. Indexed/Fixed-rate Bonds Indexed/fixed-rate bonds are effectively a combination of a fixed-rate bond and an interest rate cap. Indexed bonds carry a fixed coupon for the life of the bond, plus incremental Additional or increased growth, bulk, quantity, number, or value; enlarged. Incremental cost is additional or increased cost of an item or service apart from its actual cost. interest payments that are made during the first five years, only to the extent that a money-market index exceeds a particular level. This product is probably best described through an example. Suppose a municipality issued $40 million of indexed/fixed-rate bonds with a base coupon of 6.60 percent, which was 55 basis points below the yield on comparable fixed-rate bonds maturing in 2016. The municipality will make additional payments over the next five-year period if the PSA (Professional Services Automation) An information system designed to organize, track and manage all opportunities, work, resources, costs, revenues and invoices to improve the productivity and efficiency of the workforce. Municipal Swap Index exceeds 3.50 percent. After the expiration EXPIRATION. Cessation; end. As, the expiration of, a lease, of a contract, or statute. 2. In general, the expiration of a contract puts an end to all the engagements of the parties, except to those which arise from the non- fulfillment of obligations created of the five-year period, the bonds will pay 6.60 percent until maturity. In this example, the indexed/fixed-rate bonds produced a potential debt service savings to the municipality of more than $2 million present value over the life of the bonds. This savings compensates the municipality for facing five years of exposure to variable-rate risk. The break-even average PSA Swap Index rate for the municipality is 5.03 percent; to the extent that the average over the five-year period is lower than 5.03 percent, the municipality will save money through the use of the indexed/fixed-rate bonds. Risk Factors. In using indexed/fixed-rate bonds, a municipality faces the risk associated with unhedged variable-rate debt. This risk may have negative rating agency implications if a large portion of an issuer's debt is structured in this manner. Note that, in this example, the municipality has created a "synthetic" variable-rate bond without obtaining a liquidity facility or facing remarketing risk. Depending upon market conditions, it also would be possible to eliminate the variable-rate risk by purchasing an interest rate cap and locking in the spread between the cost of the cap and the savings on the indexed/fixed-rate bonds, if any. Such a hedge to reduce risk will entail entail, in law, restriction of inheritance to a limited class of descendants for at least several generations. The object of entail is to preserve large estates in land from the disintegration that is caused by equal inheritance by all the heirs and by the ordinary costs which may reduce or eliminate the expected interest rate savings. The risk of indexed/fixed-rate bonds, of course, is that interest rates may rise dramatically, resulting in higher-than-expected interest payments. Summary The explosion of "financial engineering" has led to a new generation of financial products. Among them are derivative securities, which potentially allow municipal issuers, under certain circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or , to issue debt at reduced interest rates by taking advantage of market opportunities. The following are important caveats when considering the use of a derivative product. * Understand fully how the derivative works  This article or section may deal primarily with the U.S. and may not present a worldwide view. and what the legal
obligations of the municipality are under its terms.
* Be fully apprised of the risks of the product--i.e., what could go wrong in the worst case and what the economic impact would be. * Many derivative products require the issuer to make an informed judgment about the future trend in interest rates; issuing officials must have sufficient information and authority to make such a judgment. * Carefully analyze the debt service costs with and without use of the derivative. Make certain that all relevant costs are included in the analysis and that the options embedded in an instrument are understood (e.g., effective loss of call option during a swap period). KATHRYN ENGEBRETSON is the treasurer of the City of Philadelphia and was formerly a vice president in public finance at Lehman Brothers Lehman Brothers Holdings Inc. (NYSE: LEH), founded in 1850, is a diversified, global financial services firm. It is a participant in investment banking, equity and fixed income sales, research and trading, investment management, private equity, and private banking. . GARY GRAY For the baseball player, see . For the Playboy TV host/writer, see . Gary Dickson Gray (December 18, 1936 – April 4, 2006) was an American child actor in films, and as an adult in television. is a senior vice president in public finance at Lehman Brothers who specializes in new product development. |
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