Embedded derivative volume in the primary market is picking up along with the yearend surge of new issues. Over the past week, several deals included embedded derivatives, and underwriters hope to include them in a few more later this month.
Yesterday, the New York State Thruway Authority included $50 million of derivatives on its $204 million issue. Although Dillon Read & Co. managed the offering, the Thruway separately selected Goldman, Sachs & Co. to sell derivatives on the deal.
Goldman Sachs structured $50 million of the 2024 maturity as $25 million of variable-rate demand notes, with yields reset daily, and $25 million of convertible inverse floating-rate notes called INFLOs. The bonds were insured by Financial Guaranty Insurance Co. and carried liquidity support from FGIC's Securities Purchase Inc. subsidiary.
Usually, inverse floating-rate notes are paired with auction-rate securityies. But the VRDN structure, first used in the primary market on a Detroit issue in October, allows money market funds to treat the floating-rate securities as having a one-day maturity. The floating-rate portion of the Detroit deal will be repriced every seven days, versus every day on the Thruway issue.
The authority paid a bond equivalent yield of 5.24% on the 2024 derivative tranche, versus 5.35% in term bonds insured by Municipal Bond Investors Assurance Corp. due in 2020.
"The daily pricing mechanism represents an additional advantage on average, especiallyon New York paper," said Aaron Gurwitz, head of municipal capital markets of Goldman. "Historically, the spread of auction-rate [floaters] versus New York dailies has been about 70 basis points."
The lower yield on the floating-rate side should translate into a higher yield for the inverse floating side, according to Richard Kolman, manager of underwriting at Goldman. "There's a lot more information for the INFLO holder to keep track of with the daily reset," Kolman said. "But it should pay a superior yield."
Goldman also structured $15 million of the University of Minnesota's tax-exempt commercial paper program as embedded derivatives last week. Called LIBOR range notes, the interest on the nine-month securities will accrue at an unnualized rate of 3.50% every day the 3-month London Interbank Offered Rate stays between 3.25% and 3.875%.
For everyday that the LIBOR rate is above or below the range, no interest will accrue. If the rate stays in the range for the entire nine months, the yield to maturity will be 3.70%. If the rate stays in the range for half the days, the yield to maturity will be 1.85%, a Goldman Sachs official said.
The University entered a hedging agreement with Goldman Sachs locking in a fixed rate 15 basis point below the rate it would have received by issuing fixed-rate securities.
Last Thursday, Morgan Stanley & Co. priced $143 million of Massachusetts Health and Higher Educational Facilities Authority revenue bonds for the New England Medical Center Hospitals.
The deal included $24 million of structured yield curve notes in the 2013 maturity. A Morgan Stanley official declined to comment on the notes, but said they are based on a forward structure and saved the authority about 10 basis points.
The deal also included $30 million of inverse floaters and corresponding floating-rate notes in the 2019 maturity. The authority saved about 10 basis points on that maturity as well, the Morgan Stanley official said.
San Diego County may include an unusual embedded derivative on an upcoming taxable pension obligation sale, market sources say. The securities would be structured as zero-coupon bonds that include an extra interest component based on the return of the Standard & Poor's Corp.'s 500 stock index. The bonds would be sold in small denominations aimed at retail investors.
