The name sounds like a euphemism for drowning victims, but inverse floaters are nonetheless paying off for issuers, investors, and dealers capitalizing on declining interest rates.
First introduced by Lehman Brothers last year as a way for issuers to cut costs and investors to benefit even when rates fall, inverse floaters are now being offered by five other firms. The 43 issues executed so far amount to more than $3 billion, according to figures from Securities Data Co./Bond Buyer.
Even as the product is being offered as a "something-for-everyone" transaction, several major tax-exempt investors have decided the risks are not worth the payoffs. One portfolio manager at a major fund called the product "financial dynamite" waiting to blow up as soon as interest rates reverse course.
In the meantime, however, an extremely favorable interest rate environment is feeding demand for the tproduct, which works best when rates are low and expected to continue falling. A steep yield curve that keeps getting steeper is also adding impetus to the inverse floater boom over the past several months.
"This is a bull-market trade," said Samuel B. Corliss Jr., a managing director at merrill Lynch & Co.
With short-term interest rates at their lowest levels in decades, dealers' sales pitches so far are right on the money: Issuers are shaving an average 20 to 30 basis points from yields, and -- paradoxical as it sounds -- investors are winning above-market rates on their purchases.
From the issuer's perspective, about the only difference noticed between a standard term bond and an inverse floater is a welcome drop in yield. Although investors receive variable-rate interest payments, the issuer sees none of that, paying only the initial fixed rate for the life of the bonds.
Savings generated on deals to date have ranged from a low of 15 basis points to a high of 40, said J. Nicholas Rozsman, a managing director of new products at Lehman.
Steven Clements, a deputy director of finance at the Nebraska Investment Finance Authority, explained that the authority's decision to execute the municipal market's first-ever inverse floater in March 1990 was not difficult. "From our perspective, we shave 25 basis points off of long rates," Mr. Clements said. "It's as simple as that."
The complications arise on the investor side.
In a standard inverse floater, the issue is sold in two equal variable-rate portions: an "inverse" and a "floater."
The floater is a standard short-term investment featuring dutch auctions to reset rates periodically, usually every 35 days. If the auction results in a floater rate less than the issuer's fixed-rate payment, the difference is given to investors in the inverse portion.
Inverse investors, which take their name from the fact that they are compensated inversely to the direction of interest rates, are already receiving the issuer's fixed-rate payments, so the residual interest left over from the auctions is strictly a bonus.
That extra payment compensates for the risk that short-term rates will rise, lowering their take. If, for example, the auction results in a floater rate higher than the issuer's fixed-rate, the residual is a negative amount that is substracted from inverse yields. Theoretically, rates could rise so high that the inverse investor is left with 0%, but so far the process is paying off hand-somely because short-term, variable rates are low relative to the fixed-rate market.
In a recent revenue bond deal on behalf of Tacoma, Wash., for example, Lehman cut about 25 to 30 basis points from the 6.85% to 6.90% Tacoma would have otherwise expected to pay on a standard term bond, according to Lehman officials. The resulting 6.60% rate is fixed for the life of the bonds, regardless of where interest rates head.
While the savings are certainly a plus for Tacoma officials, investors so far are also pleased with their end of the bargain. The first dutch auction on the $42.4 million floater portion of the deal resulted last month in a 4.50% rate. The Bond Buyer's 30-day, tax-exempt commercial paper index, which would be expected to be slightly lower anyway because of the shorter maturity, was 4.00% at the time.
But the big winners were on the inverse side. Subtracting the 0.28% servicing fee Lehman charged for the deal, the floater yield was 172 basis points below the issuer's fixed cost of 6.6%, so inverse investors received 8.29%: the issuer's fixed payment of 6.6% plus residual interest from the dutch auction of 1.72% (the numbers do not add exactly because the floaters pay on a 360-day basis and the inverse portion pays on a 365-day basis). The Bond Buyer's revenue bond index for the week of the sale was 6.86%, 143 basis points below the rate investors in Tacoma's bonds received.
On top of the above-market rates resulting from the deal, inverse investors also have protection against the main risk they face -- spiking short-term interest rates. Investors afraid interest rates are heading higher can buy protection by linking their investment to the dutch auction product. Purchasing an equivalent amount of floaters effectively provides a yield equal to the issuer's fixed-rate, regardless of where interest rates head.
The other benefit of the link is increased liquidity, market sources say.
But several investors who say they have decided not to buy the product questioned whether it really is possible to offset the risks.
"Linking works wonderfully if you can predict a bear market with perfection," one tax-exempt portfolio manager said. "We don't think we can do that." He said by the time it becomes apparent a bear market is in place, it is too late, and linkage would only lock in the loss. "If the yield curve flattens -- or even worse, inverts -- the outcome is devastating."
Another major fund, Fidelity Investments, has also decided to stay away from inverse floaters. "We think they're too risky," explained Tracy Gordon, a spokeswoman for the firm. "Our credit people have decided to avoid them."
Officials at two other funds expressed similar sentiments.
Robert Martin, a vice president in the derivative products area at Kidder, Peabody & Co., agreed there are some risks, including the uncertainty associated with auctions. But he stressed that most can be mitigated by linking the product. And the payoffs so far have been substantial. Mr. Martin pointed out that even the lowest rates investors in inverse products have received so far are still higher than the Treasury's 30-year bond.
"We're not in imminent danger that the inverse side isn't going to be paid, but it's still a risk," Mr. Martin said.
From the issuer's perspective, the main risk is a failed auction, which would be more a public relations problem than a financial problem. The issuer's fixed rate is not affected by the outcome of the auctions, but such a situation could besmirch their reputations, making it more difficult to raise capital elsewhere, said D. Jeffrey Penney, a vice president for municipal financial products at First Boston Corp.
So far, however, virtually all of the dutch auctions have performed extremely well. In the municipal
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market, only one deal has soured -- Tucson Electric Power Co., which saw its auctions fail 16 months in a row after its strong credit rating sank to junk bond status.
But Mr. Martin noted that, unlike Tucson's stand-alone dutch auctions, which did not involve an inverse floater, auctions tied to inverse floaters hold the attention of a special group of people with an interest in making them work -- the investors in the inverse side. If an auction appears to be ready to fail, they could step in and bid to maintain their investments, he said.
Some dealers are already working on ways to avoid entirely the risks associated with a dutch auction. Morgan Stanley & Co. last month engineered the first inverse floater keyed to an index instead of a periodic auction.
The $25 million deal, on behalf of Los Angeles County, was intended to respond to investors' concerns about the uncertainty of the auctions, Morgan Stanley officials said. The use of the index also eliminates problems for long-term investors created by higher-than-market auction results.
Several officials at other firms already offering the dutch auction product said they are developing companion products that will key off an index as well. Because those products result in a floating rate exposre for issuers, interest rate swaps are necessary to create a synthetic fixed rate.
But the main marketing thrust is still the standard inverse floater. And, as seems to be the trend when new derivative products hit the market, firms are devising catchy service marks to distinguish their deals from competitors.
Lehman, which has a market share of more than 50% of the $3 billion of inverse floaters sold to date, calls its product "ribsavers." That tag represents an amalgam of Residual Interest Bonds, or RIBs (the inverse portion), and Select Auction Variable Rate Securities, or SAVRS (the floater portion).
Goldman, Sachs & Co., which ranks second with seven deals totaling $506 million, offers PARS/INFLOS. Other recent entries include Merrill Lynch & Co.'S FLOAT/RITES, Prudential's STARS/CARS, and Kidder Peabody's Rems/Maverics.
First Boston, which entered the fray only last month with a $48 million deal for Alliant Health System in Kentucky, apparently opted for simplicity. They call their product "inverse floaters."
