Derivatives, often used to exploit market inefficiencies, are now being brought to bear on funds that issuers deposit with their trustees prior to scheduled bond payment dates.
Most bondholders receive interest payments semiannually and principal payments annually. But most bond indentures require that issuers deposit 1/6 of the interest and 1/12 of the principal each month with their trustee.
The trustee invests the funds, typically in short-term money market funds known as sweep accounts, during the lag and gives the issuer the small return the investment generates.
Now derivatives firms are offering to pay an issuer substantially more on those deposits, at a guaranteed rate, if the issuer will enter an investment agreement on their terms.
And many of the firms are willing to give the issuer an up-front payment reflecting the present value of that rate over the life of the agreement.
Within the constraints of bond indentures, issuers are able to dictate how their trustee invests their funds.
"The trustee is the custodian, not the investment manager," said George Majors, director of financial services at Orrick, Herrington & Sutcliffe. "It's not the trustee's responsibility. It's a call to attention to the issuers."
However, investment agreements don't always make sense for an issuer, market participants said.
"The issuer is moving out the yield curve, which will usually give a better return, but that's not always the case," said Peter Shapiro, senior vice president at EuroBrokers Investment Corp.
In an inverted yield curve environment, for example, short-term rates are higher than long-term rates, so the agreement would generate a lower rate of return.
That's not a problem in the current market. On Tuesday, the Piedmont Municipal Power Agency in South Carolina entered a five-year investment on $313 million of interest and $60 million of principal at a rate of 6.58%. Three-month Treasury bills yield about 4.68%.
The power agency conducw. d a competitive bid for the agreement through EuroBrokers. Eight fnms vied for the deal, which was won by Credit Suisse Financial Products.
Another danger is the possibility of locking in a fixed rate at the wrong time. If short-term rates rise substantially, an issuer would have been better off without a guaranteed, fixed rate.
This year, derivatives firms have been knocking on doors across the country, pitching investment agreements for at least two important reasons.
For one, the agreements can be done with existing debt, providing a steady source of business even as new issue volume continues to plummet.
In addition, the agreements can be used by firms to hedge the most common municipal interest rate swap transaction, where a firm pays; an issuer a floating rate and receives a fixed rate. On the investment agreements, a firm is in essence paying a fixed rate and collecting a floating rate.
In some cases, the issuer is entering a souped-up guaranteed investment contract, or GIC, with a firm. In other cases, the agreement involves the forward delivery of Treasury securities by a firm to the trustee.
The GIC arrangement usually provides a-higher rate to the issuer, but not everyone can use it.
Bond indentures sometimes limit the investment choices of a trustee holding the issuer's money during tbe tag time. If the indentures require the trustee to invest in Treasury securities, for example, the trustee cannot invest the funds in a GIG.
Also, GIG providers willing to make up-front payments are taking on the credit risk of the issuer, so they can be picky about an issuer's ratings. If the issuer defaults on its scheduled payments down the road, the GIC provider would take a loss.
Bond insurance does not mitigate the risk. If an issuer defaults, bond insurers are only obligated to make payments when bondholders are paid, not on a monthly schedule.
The GIC alternative gives issuers a higher rate because it is generally less costly for the provider. Instead of delivering securities to the trustee, the provider puts up the GIC.
"Our GIC rate is usually better than our forward delivery rate because we don't have all the administrative hassles of finding the Treasuries and delivering them every month," said JoAnn Palazzo, vice president at AIG Financial-Products.
AIG will pay an issuer up-front for contracts stretching up to 30 years, Palazzo said.
The GIC may be backed by collateral. Some issuers still remember what happened to GICs provided by Executive Life Insurance Co. Once rated triple A, the insurer went belly-up after its investment portfolio of junk bonds collapsed.
For issuers that can't use a GIC, or simply don't want to, the forward delivery agreement contract is an option.
The contract obligates a trustee to invest an xssuer's tunes m Treasury securities provided by a firm. But the firm agrees to provide securities at a preset price that will mature on, the next scheduled payment date.
If the firm fails to provide the appropriate securities, the trustee is not obligated to invest the funds with the firm.
In some cases, the securities do not mature on the payment date, but the firm agrees to make up any shortfall when the securities are liquidated.
Both kinds of agreements can complicate a bond call. The agreement provider expected to receive a stream of payments over a long period. If the call cuts off that stream, the issuer might have to make a termination payment to the provider, especially if the firm paid the issuer its return up front. In the case of a refunding bond issue, the contract might dictate that payments for the newly issued bonds also be subject to the agreement.
So some issuers have chosen to enter agreements that end after only a few years instead of matching the maturity of a bond.