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Derivative investment policy in the public sector.

In recent years, the pace of innovation in the capital markets has accelerated, leading to a proliferation of products and presenting investors with an increasingly complex array of investment choices. Derivative products are at the leading edge of this innovation. Government finance officers in their role as cash and pension fund managers are increasingly offered derivative products for potential investment.

One of the more popular forms of derivative securities purchased by government entities has been mortgage derivatives, including some collateralized mortgage obligations (CMOs). Some government entities have invested in mortgage derivatives by purchasing them directly or indirectly through their selection of investment managers, such as mutual funds. Increased volatility in these securities has caused several government entities to report multimillion dollar losses in 1994.

GFOA, recognizing the special issues of complexity and volatility of derivative securities, recently issued a recommended practice for their use. The recommendations advise that government entities should be aware of the special risks incurred as a result of the use of derivatives. These special risks include market risk, as these securities may be illiquid and highly volatile and may be leveraged. In addition, many of these securities have not been market tested over prolonged periods and in differing market environments. Assigning values to these securities, independent of trading prices, may be difficult and achieved only through sophisticated computer models - which are highly dependent on assumptions about interest rate volatility, mortgage prepayment activity and other factors. To ensure that risks are adequately managed, the recommended practice suggests that internal controls be established for each type of derivative in use.

Collateralized Mortgage Obligations

Government entities have long relied on credit ratings and/or "government-backing" as a way to define prudently acceptable risk characteristics of investment securities. High credit quality alone, however, is not sufficient to safeguard against the assumption of derivative risks.

The collateralized mortgage obligation (CMO) market attracts investors with its relatively high yield and AAA or "government agency-backed" credit quality. CMOs are sliced into unique securities, called tranches, that receive principal and interest based on the priorities defined by the payment structure. Changes in interest rates and mortgage prepayment rates can drastically affect the amount and timing of cash flows. Some tranches, however, are designed to offer very limited volatility. Planned Amortization Class (PAC) tranches, for example, provide for stable interest and principal repayments so long as prepayments stay within some specified range. On the other hand, riskier tranches, such as Interest Only (IO) or Principal Only (PO) strips, are designed to be highly sensitive to interest rate and prepayment rate changes. In addition, the more volatile tranches can be highly illiquid. Exhibit 1 displays the growth in outstanding agency-backed CMOs in the marketplace.

Government entities purchasing CMOs should gain an understanding of the impact that changes in interest rates and mortgage prepayment rates would have on each CMO's cash flow, price and total return. The potential variability under changing interest rate environments provides a measure and disclosure of market risk. This type of volatility analysis should be conducted in a uniform manner across all tranches to provide maximum comparability among tranches. Moreover, it is often helpful if this analysis is conducted by a disinterested, independent source.

Mutual Bond Funds

Bond funds have grown in popularity as an investment option for government entities that are allowed to invest in such funds. Bond funds can offer several potential advantages over direct investing. A high degree of liquidity is provided - all or part of the investment can be liquidated within 24 hours at the then-current net asset value (NAV). Cost savings may be gained through reduced transaction costs and greater bargaining power that a larger fund may have. The larger asset base of a fund also provides the ability for greater portfolio diversification and resultant risk reduction, as well as the ability to hire dedicated management personnel. Finally, funds offer greater convenience, relieving the investor of individual security selection and the management of handling and reinvesting coupon and principal receipts.

Yet government entities that invest in bond funds need to redouble their due diligence efforts as outlined in the GFOA's release:

"Government entities should exercise caution in their selection of investment managers and ensure that these agents are knowledgeable about, understand and provide disclosure regarding the use of derivatives, including benefits and risks.... Government entities are responsible for ensuring this same level of safeguards when derivative transactions are conducted by a third party acting on behalf of the governmental entity."

Government entities were not the only investors to lose money in CMOs in 1994. Several prominent bond funds that invested substantial portions of their assets in IOs, POs, inverse floaters and other exotic mortgage derivatives have experienced significant declines in NAV. A survey of derivative use in mutual funds by the Investment Company Institute found that while the overall value of derivatives as a percent of fund assets was small, derivative holdings are highly concentrated in bond funds. Indeed, 84 percent of the market value of derivatives captured by the survey were held by fixed-income funds. The SEC is sufficiently concerned about mutual fund risks, including those posed by the use of derivatives, that it is seeking greater disclosure of market risks on the part of all funds.

When applying the GFOA standards of practice to the evaluation of bond fund investments, government finance officers should be aware that derivatives of one type or another are employed by most bond funds. The challenge is to determine the nature of derivatives used, how market factors will affect their value, how the derivatives relate to the total portfolio, and in what proportion to total fund assets they are used.

Independent, Accessible Information

Typically, investors have found it prudent practice to augment information they receive from brokers, dealers or advisors with independent research when conducting due diligence of potential investments. Sources include historical trading ranges, trend and volume, brokerage firm research, cash flow and present value analysis, and credit ratings and research. Unfortunately, much of this information is either unavailable or less meaningful for the mortgage derivatives market or for mutual funds holding mortgage derivatives.

One measure of risk often referred to is historical standard deviation of returns. Basing expected future risk on such a measure can be misleading, however, because it may be grounded in a set of market environments that are unique. For example, the historical standard deviation of returns for many mortgage derivatives was a poor indicator of returns in 1994, when interest rates and mortgage prepayment rates changed suddenly and dramatically.

Credit ratings are another independent analytical source that government finance officers have relied on to set internal investment guidelines. Now, through the securitization and structuring process, AAA-rated securities and funds also may carry extreme market and derivative risks that are wholly unaddressed by credit ratings. Rating agencies are increasingly concerned that investors may misconstrue ratings to apply broadly to all risks rather than being limited to credit risk. To address this issue, these organizations are developing market risk ratings which evaluate volatility of the security or portfolio under a wide range of potential interest rate and mortgage prepayment scenarios. In the case of CMOs, each tranche can be analyzed to produce market risk scores for price volatility and cash flow volatility.

A mutual bond fund's total risk can be disaggregated into several components by evaluating each security holding. Risk components such as interest rate, prepayment, credit, spread and liquidity, and currency risks, as well as derivative exposure and leverage, are analyzed to assess the risks that their use presents to fund managers and shareholders. Results indicate the degree of potential variability in prospective fund performance.


The responsibilities of government entities with respect to derivative investments, as outlined in the GFOA recommended practice, apply generally to mutual bond funds as well as individual derivative securities. Given the lack of information generally available in the marketplace, adequate disclosure and investor understanding of the risks associated with derivative securities is difficult at best. Increasingly, bond funds seek market risk ratings from rating agencies to provide comprehensive disclosure of the derivative risk and other risks to public institutional investors. Market risk ratings, when also applied to individual mortgage derivatives (i.e., CMO tranches), provide a useful benchmark to government entities as they establish guidelines for prudent management of derivative investments.

PETER G. JORDAN is managing director and JOHN L. SCHIAVETTA, CFA, is director, Mutual Fund Ratings, Fitch Investors Service, Inc.
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Author:Jordan, Peter; Schiavetta, John
Publication:Government Finance Review
Date:Feb 1, 1995
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