Investors favored a new twist in the third quarter, buying a growing number of inverse floaters structured in the secondary market with put rights attached.
Underwriters sold 47 inverse floater issues totaling $625 million in the secondary market last quarter, according to Moody's Investors Service. Inverse floaters with puts accounted for 41 of the issues. Moody's volume statistics include only issues rated by the agency.
The put right, attached to the floating rate portion of the transactions, allows money market funds to buy the secondary market deals. The funds do not buy the floating rate securities in ordinary floater/inverse floater transaction that lack put rights.
To create the product, an underwriter buys fixed-rate bonds and places them in a trust or partnership. The trust or partnership then issues floating-rate securities reset at auction and corresponding inverse floating-rate securities.
The floaters include a right to put back the securities to a trust. The put is backed by a liquidity facility, usually from a commercial bank.
The tax-free interest flowing into the trust or partnership is used first to pay fees to the underwriter, and then is divided between holders of the two types of securities. As the floating rate falls, more interest is available for the inverse floater holder.
But if the floating rate rises, less of the interest flows to the inverse floaters.
On most floater/inverse floater deals, the floaters are reset at auction but do not carry put rights. The inverse floater holders have call rights, allowing them to purchase a corresponding floating-rate security. By combining the two securities, the investor creates a fixed-rate bond.
Moody's does not rate the inverse floater portion of the secondary market deals with put rights. The agency's analysts are afraid that if the transaction unwinds, the inverse floater holders will not recoup all of their principal.
For example, if the remarketing of the floating rate securities fails, the secondary market trust will call on the liquidity provider for cash to pay investors exercising their puts. The fixed-rate bonds in the trusts would be liquidated at their market value to pay back the liquidity provider.
But the liquidation at market value of the underlying bonds may not raise enough cash to cover the liquidity provider and leave enough left over to fully pay back the inverse floater holders.
Moody's also reported rating 52 tender option bond issues in the secondary market last quarter totaling -591 million. The rating agency reviewed five strips programs totaling $279 million.
Total secondary market derivative volume, as measured by Moody's, rose 11% from the second quarter of this year and 126% from the third quarter of 1992.