Linking may not be best way to hedge inverse floaters.

Investors trying to hedge their inverse floating-rate securities might be better off avoiding the securities linking feature.

With rates going up, many investors have exercised their right to link their inverse floaters with corresponding floating-rate securities. After linking the two derivatives, the linked security becomes a fixed-rate bond.

But Bart Mosley, an analyst at Smith Barney Inc., suggests an alternative strategy. Instead of buying a corresponding floating-rate bond and linking, an investor could buy a short-term fixed-rate bond, such as a pre-refunded security.

The combination of the pre-refunded security and the inverse floater would reduce the investor's exposure to rising interest rates without giving up as much yield.

For example, Mosley.wrote in a research report last week, a $5 million inverse floater due in 2014 with a current yield of 9.21% has a duration of 22.59 years. Its corresponding floater, also due in 2014, yields 3% and has a dtiration of 0.10 years.

An investor could put $5 million to create a $10 million 6% coupon bond with a current yield of 6.14% and a duration of 11.34 years.

Or, the investor could buy a $4.5 million pre-refunded security with a 7% coupon due in 1997 at a current yield of 6.41% and a duration of 2.50 years. (The pre-refunded bond is selling at a premium, so the hedging transaction includes a lower principal amount).

The combined $9.5 million position has a current yield of 7.91% and a duration of 12.58 years, Mosley wrote. Taking on just over a year of added duration gives a 1.8% yield boost.

But some portfolio managers say they don't want to hedge their inverse floaters they want to unload them.

In part, that's because the derivatives can cause marketing headaches for mutual funds, they say. Also, some managers say they think rates will continue rising and they want to dramatically lower the duration of their funds. The Smith Barney strategy results in a slightly higher duration than the linking strategy.

While investors have had difficulty selling inverse floaters outright this year, linking the derivatives and creating a fixed-rate bond eases the task of unloading the position.

"From a portfolio standpoint, combining [an inverse floater] with a pre-re does get your duration down," one portfolio manager said. "But it doesn't improve the bid on an. inverse floater you're trying to sell."

And while the linking strategy creates a hedge until the inverse floater matures, the alternative hedge evaporates when the pre-refunded security matures.

More Software

Although many firms rely on proprietary software developed in-house for evaluating derivatives, the market for commercial programs continues to expand.

Theoretics Inc., a Utah-based software developer, announced two new programs last week for derivatives traders and investors.

The programs, called Term Structure Analysis and Tier-1, evaluate bonds and derivatives such as swaps, swaptions, caps, and floors.

In other vendor news last week, Securities Data Co. announced that it will not include secondary market derivatives in its data bases.

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