Although some big issuers were considering derivatives last week, most dropped their plans by the time they headed to market, leaving the week's activity to smaller issuers.
Merrill Lynch & Co., for example, considered including about $20 million of derivatives in a 2012 maturity of a $420 million Dade County, Fla., issue, market sources said. But the derivatives were eliminated when the deal was repriced.
Although Dade abandoned its derivatives plans at the last minute, a $36.7 million Spokane, Wash., deal on Monday included $16.6 million of derivatives. Lehman Brothers structured all of the 2010 maturity as swap-based inverse floating-rate notes.
The derivatives were insured by AMBAC Indemnity Corp.
A Lehman official said the deal was one of the first swaps by a municipality in Washington State. The state recently adopted legislation explicitly authorizing municipal swaps.
On the horizon, the North Carolina Municipal Power Agency, market sources say, is planning a forward swap transaction that may include the sale of forward derivatives - in effect, a derivative of a derivative.
In a forward swap transaction, an issuer agrees to sell floating-rate bonds on a specified future date, usually a few months to a few years away. At the same time, the issuer enters an interest rate swap.
On the swap, once the forward bonds are sold, the issuer will pay the swap counterparty a fixed rate. The swap counterparty will pay the floating rate due on the bonds or a floating-rate index.
The terms of the transaction, including the synthetic fixed rate the issuer will pay once the bonds are sold and the swap kicks in, are set when the forwards are sold. The issuer pays a slight premium in return for locking in today's rates.
Goldman Sachs & Co. will sell the forwards and act as the North Carolina agency's swap counterparty.
The agency's forward variable-rate bonds, when-issued in 1994, may include Goldman's Municipal Embedded Derivative Securities, called M-Beddoes. The derivatives can be highly customized to meet investors' demands and may be structured differently every time the product is used.
In the last month, Goldman has included binary swaps based on the London Interbank offered Rate in embedded derivatives. But the North Carolina derivatives could be based on a host of other market indexes - taxable or tax-exempt.
Goldman is not the first to use a derivative bond in a forward sale. Lehman Brothers included an inverse floater on an 11-month forward swap transaction for Brooklyn Union Gas Co. earlier this year, officials at the firm said.
In other derivatives news, AIG Financial Products, the derivative subsidiary of triple-A-rated American International Group Inc., may be expanding into the embedded derivative business, market sources said.
Until now, AIGFP has entered mostly straight interest rate swaps with municipalities locking in a synthetic fixed rate on variable-rate bonds. But the firm may begin offering embedded swaps based on more esoteric indexes or spreads between indexes. AIG officials did not return calls.
New details became available this week on a $143 million Massachusetts Health and Higher Education Facilities Authority issue, which was sold on Dec. 9 and included $24 million of structured yield curve notes. According to sources familiar with the transaction, the notes will pay a fixed rate of 5% until Jan. 1, 1995. At that time, the rate on the notes will be adjusted based on the performance of a market index.
The issuer entered a swap with Morgan Stanley & Co. to cover the variable-rate component and lock in a synthetic fixed rate of 5%. If Morgan defaults on the swap, the issuer's variable rate is capped at 15%. After Dec. 31, 1999, the deal reverts to a fixed rate, between 5% and 5.38%.
