WASHINGTON -- An increasing number of municipal bond issues with indexed inverse floaters contain a new feature: an investor option to reverse an embedded swap and convert to fixed rates.
Industry officials said last week that the rate conversion feature makes inverse floating bonds more attractive to investors who are worried that rates may head up again and diminish their returns from these bonds, which act inversely to the market.
"The added flexibility is very attractive to investors," said Bradley W. Wendt, vice president and manager of derivative products for Goldman, Sachs & Co.
A manager of one mutual fund, who did not want his name or his fund's name used, said, "I think the reason we're seeing this conversion feature is that it's pretty widely agreed we're near the trough on interest rates.
"Inverse floaters have been hot because interest rates have fallen dramatically," he said. "But where they way overperformed as rates went down, they're going to way underperform as rates go up, and this is a way out if the market turns around."
Inverse floaters have become more popular in recent months because they offer issuers lower fixed-rate borrowing costs and investors above-market variable-rate returns when short-term rates are low or declining. They act inversely to the market because they pay investors more when short-term rates fall and less when rates rise.
In traditional inverse floater deals, a long-term fixed rate issue is sold in two equal, variable-rate portions. One side consists of floating-rate bonds whose rates are periodically reset through dutch auctions. The other consists of inverse floating-rate bonds whose rates are basically the issuer's fixed rates plus any residual interest that results if the floater rate set at auction is less than the issuer's fixed rate.
Each side of the issue results in variables rates for the investors over the issue's entire term. The combination of the two sides produces fixed rates for the issuer.
In the newest generation of inverse floaters that first surfaced late last year, an index replaces the need for floating-rate bonds reset through dutch auctions. These bonds, called indexed inverse floaters, are fixed-rate bonds with an embedded swap between the issuer and investor. Under the embedded swap, the issuer pays fixed and receives variable rates based on an index of short-term rates.
There is no actual swap, but the coupon payments on the bonds are structured to replicate a swap typically lasting seven to 10 years, after which the bonds convert to fixed-rate bonds. The issuer, who wants to pay out a constant fixed rate on a net basis, offsets this embedded swap with an actual swap with the underwriter or another financial institution. Under this swap, the issuer pays the underwriter the variable rate that it receives from the investor and gets a fixed rate.
The end result is that the issuer pays out a constant net fixed rate over the term of the bonds that is lower than market rates for comparable fixed-rate bonds. This is because the investor is willing to pay more for a product that produces higher returns when short-term rates fall.
The optional rate conversion feature allows the investor to unwind the embedded swap and convert to fixed rates if short-term rates rise. But it must pay for the conversion, a payment likely to take the form of a downward adjustment in the fixed rate it is to receive. Should the investor convert to fixed rates when short-term rates are falling, it could receive a payment or get an upward adjustment in the fixed rates it will receive. The payment or interest rate adjustment would depend on the rates for a fixed swap of a comparable maturity.
At least three recent deals done to provide financing for hospital systems contain indexed inverse floaters with optional rate conversion features. In each of the deals, a conversion to fixed rates would be paid for through an adjustment to the fixed rate the investor would begin receiving.
These deals are a $127.69 million issue sold in July by Salt Lake City for Intermountain Health Care Hospitals; a $78.5 million issue sold in August by the Industrial Development Authority of Roanoke, Va., for hospitals affiliated with the Carilion Health System; and a $63.2 million issue sold earlier this month by the Geisinger Authority in Montour, Pa., for a regional health care system.
Goldman, Sachs & Co. structured and underwrote the Intermountain deal. J.P. Morgan Securities Inc. structured and was lead underwriter on the Carilion deal, and was sole underwriter on the Geisinger deal.
The Intermountain Health Care deal involved almost $98.39 million of fixed-rate bonds, $17.5 million of which were indexed inverse floaters, or "indexed inflos" as Goldman calls them. J.P. Morgan calls them "residual adjustable yield securities."
Under the terms of the indexed inflos, Intermountain Health Care pays investors a fixed rate of 10.85%, which includes a bond rate of 6.15% and a base rate of 4.70%, minus the J.J. Kenny index rate for 30-day yields that is reset weekly. Intermountain Health Care gets back a rate equivalent to the J.J. Kenny index from investors. Meanwhile, under a swap agreement with Goldman, Intermountain pays Goldman the variable rate it gets from investors and receives back the base rate of 4.70% that it pays to investors.
The end result is that Intermountain pays out a net fixed rate of 6.15% over the term of these bonds. This rate is about 10 to 15 basis points below the rates for comparable fixed-rate bonds, according to Intermountain and Goldman officials.
Because investors are receiving a fixed rate of 10.85% minus the J.J. Kenny index rate, they get a higher net rate if the index falls. But they get a lower return if the index rises.
If the investor decides to convert to fixed rates, the swap agreement between the issuer and Goldman is adjusted accordingly. The payment for the rate conversion is based in part on the cost of keeping the issuer's fixed rate at 6.15%. The bonds convert to fixed rates in seven years if the investor does not convert before then.
Lawyers giving opinions on indexed inverse floater deals have taken the position that since the issuer is paying out a constant net fixed rate over the term of the bonds, this is the rate that should determine the bond yield for arbitrage rebate purposes. The IRS has not yet ruled on how issuers should calculate their bond yield for rebate purposes when the timing, interest rates, and maturity of a swap agreement do not exactly match those of the underlying bonds. The IRS has said the bond rate can be used for rebate purposes when there is a perfect match between the swap and the underlying bonds.
Increasingly, lawyers are giving opinions that if the issuer pays out a constant net fixed rate over the term of the bonds, this is the rate that should be taken into account for arbitrage purposes.
Several law firms also say the rate conversion feature in these deals should not undermine the tax exemption of the investor's interest earnings as long as the payment for converting to fixed rates is in the form of an interest rate adjustment to the investor.
Some lawyers worry that a lump sum payment for converting to fixed rates could be seen as a taxable swap payment rather than tax-free interest to the investor or as a partial new issue of bonds for the issuer, depending on who is making the payment.