Investment bankers have taken to describing many structured municipal securities as "containing embedded derivatives."
Why? What is the difference between a derivative and a security containing an embedded derivative?
The definition of a derivative traditionally included options in the equity market and interest rate swaps, caps, floors, collars, and the like in the fixed-income arena.
Some bankers, however, argue that many products categorized as derivatives are really just another kind of variable-rate bond. The derivative transaction, they say, is between the issuer and another party, usually to hedge the issuer's variable-rate exposure on the bonds.
Since the issuer is usually passing along the swap payments to bondholders, the derivative is "embedded" in the bonds. Thus, the bonds are just bonds.
Technically, a derivative is a security whose value is based on another security, benchmark, or index.
Similarly, the price of an interest rate swap is derived from the difference between two other interest rates.
But take the case of a synthetic floating-rate note. The note pays an investor a yield high enough to price the note at par. The rate is reset every day, every week, or every month, either by a remarketing agent or in an auction.
The issuer may enter an interest rate swap to cover its potentially risking interest costs.
Although the swap is unquestionably a derivative, what is the note itself?
Some bankers argue that the bond's value is unconnected to the swap. The factor's value is built in, including the credit quality of the issuer, for example.
Why are Wall Street bigwigs worrying about a seemingly technical debate over terms? Much like the movement in the 1980s to call junk bonds "high yield debt," people are afraid of the negative connotations the word "derivatives" carries in some quarters. With all the negative press derivatives have received lately, wouldn't it be nice for Wall Street to just sell variable-rate bonds?
As one banker complains: "Every time some guy with money in a mutual fund reads one of these crazy stories, he calls his fund manager to get rid of those terrible derivatives."