When rates rise, holders of inverse floaters have several options to limit their losses, other than simply selling their securities.
Generally, the rate on an inverse floater can be converted from a variable rate that moves in the opposite direction of market rates to an ordinary fixed rate. But different types of inverse floaters have very different conversion features.
One type of inverse floater is sold in conjunction with a corresponding floating rate security. The issuer pays a fixed rate, which is divided between the two.
The rate is set on the floating rate portion by a remarketing agent or in a dutch auction. The remaining interest goes to the inverse floaters.
To convert to a fixed rate, the inverse floater holder is given a call option on the floating rate piece. The holder can exercise the option, joining the two halves and receiving all of the previously divided fixed rate that the issuer had been paying all along.
To exercise the option, though, the inverse floater holder must put up cash to repay the floater holder's principal. And because the issuer used the structure to lock in a fixed rate 10 basis points below market rates, the linked rate is less than the fixed rate the investor would have gotten by buying an ordinary fixed rate bond in the first place.
But the linked security may be more liquid than the inverse floater. Sometimes, portfolio managers trying to unload inverse floaters have exercised their call options and converted to a fixed rate before selling the securities. Some inverse floaters do not have corresponding floating rate securities, so linking is not an option.
Instead, the issuer pays the inverse variable rate due on the securities directly, but hedges its liability by entering a corresponding interest rate swap. The notional value of the swap corresponds to the principal amount of the bond issue, so the issuer receives on the swap the amount it owes on the inverse floaters.
This type of inverse floater also has a feature that allows the holder to convert to a fixed rate, but the rate is not entirely determined when the securities are initially issued.
Rather, it is based on an initial fixed rate plus or minus the changes in the market value of the swap that the issuer is using to hedge its liability on the securities. The initial fixed rate is set when the inverse floaters are sold at about the rate that the issuer would have paid if it had sold ordinary fixed rate bonds.
That is because when an investor exercises the conversion, the issuer no longer needs a swap with a notional value equal to the principal amount of the original bond issue. The issuer can pay the fixed rate on the converted securities without needing a hedge.
So the issuer is allowed to reduce the notional amount of the swap to account for converted securities. But, like any other swap, ending a transaction - or even a portin of a transaction - requires a termination fee.
The party that is holding the profitable side of the swap, either the issuer or its counterpary, will be compensated for the loss of the expected payments.
For example, an issuer may be paying a fixed rate of 5% on a swap and receiving a floating rate based on the Public Securities Association's municipal swap index, currently at about 2.77%. The swap counterparty is receiving a net payment of 2.23%, so to terminate the transaction before maturity, the issuer would have to compensate the counterparty for the lost expected payments on a present value basis.
In the case of an inverse floater, the early termination of a portion of the swap is an option of the security holder, so the termination fee is passed along the holder.
If the market value of the swap has turned in favor of t he issuer since the inverse floaters were sold, the counterparty will pay the issuer an early termination fee. The issuer then passes the fee along to the holder of the converted inverse floater in the form of a higher fixed rate.
But if the market value of the swap has moved against the issuer, the issuer will owe the counterparty a fee for early termination and the converted inverse floater holder will receive a lower fixed rate.
Generally, if the variable rate index that the securities are based on has dropped, the conversion rate will be higher than the initial fixed rate. But if rates have rises, the conversion rate will be lower.