Last September, Clark Wagner told a derivatives conference audience that secondary market liquidity for inverse floaters was pretty good. But, the chief investment officer at First Investors Management Co. said, the bullish products had not been tested in a bear market.
Last week, Wagner was back, speaking in front of a derivatives conference in New York City sponsored by International Business Communications. And now he had the bear market of early 1994 under his belt.
Selling inverse floaters proved to be much more difficult in a down market, Wagner said. There were fewer bids, and bid-ask spreads were much wider. And the market price for his inverse floaters proved to be below the estimated values provided by his pricing service.
"Secondary market liquidity is inconsistent," Wagner said at the conference. "In a bear market, demand decreases. The ability to link or convert inverse floaters becomes key without liquidity."
In other words, investors wanting to unwind their derivatives may have alternatives to selling in a weak market.
Other speakers at the conference defended the liquidity of the products. Aaron Gurwitz, vice president and manager of municipal capital markets at Goldman, Sachs & Co., said investors should avoid making apples-to-oranges comparisons when judging the liquidity of derivatives compared to fixed-rate bonds.
Noting that some investors fear the wider bid-ask spread on derivatives will wipe out any performance advantages, Gurwitz said that "the bid-ask spread is wider on derivatives, but it is only true that the spread is substantially wider when the bid side of the municipal market is really lousy anyway. If you compare like market circumstances to like market circumstances, the illiquidity question is a bit of a red herring."
Mike Maples, vice president at the bond pricing service Kenny S&P Evaluation Services, said that 95% of all disagreements about the pricing of derivatives that his firm has seen "are as a result of differences in pricing the cash market."
Wagner gave several case Studies of selling inverse floaters, which come in two basic varieties. Some are tied to an auction-set, floating-rate security, while others are ultimately backed by an interest rate swap.
Most inverse floaters tied to another security can be linked. The investor can call the floating-rate piece and combine it with the inverse floater to create a fixed-rate bond.
Most inverse floaters backed by a swap can be converted to a fixed-rate bond. The investor notifies the underwriter to unwind a portion of the swap. If the sWap was paying in favor of the investor, the investor receives a fixed-rate bond and either a temporarily higher coupon or a cash payment. If the swap was going against the investor, however, the investor ends up paying the cash or receiving a lower coupon.
Why would linking or converting an inverse floater be preferable to selling it outright? Three factors limit the liquidity of inverse floaters, Wagner said.
While most municipal bonds are purchased by retail investors, derivatives appeal only to institutional buyers.
"There is finite demand for derivatives," Wagner said. "Only institutions buy derivatives, and they have limits on how much they can buy."
Second, many of the products have proprietary features added by underwriters. Underwriters are sometimes unwilling to bid on products sold by their competitors. As for inverse floaters created in the secondary market, "other dealers are very unlikely to bid," Wagner said.
Finally, information about a particular derivative may be hard to find. For a swap-based derivative, a potential buyer might want to know the identity of the swap counterparty, but the information is not always immediately available. Tracking down the information delays the trade, and the buyer may have gone elsewhere to make a purchase.
Wagner praised an initiative by the Public Securities Association to provide such information in a standardized form. But "progress is not yet sufficient," he said.
Despite the limitations, Wagner said he had few problems selling inverse floaters back in 1993. Within 24 hours of soliciting bids, several dealers offered to buy a $9.6 million block of inverse floaters issued by the Massachusetts Health and Education Facilities Authority. He sold the derivatives for slightly more than the price quoted by Muller Data Services.
But once the market turned down this year, liquidity dried up. For a $9.6 million block of leveraged inverse floaters from the same issuer, Wagner received bids this past May more than one point below Muller's current price.
So Wagner began to explore linking and converting his inverse floaters before selling them. Wagner expected to fare better putting an ordinary fixed-rate bond out for bid, despite the rocky market conditions.
For a $4.7 million block of inverse floaters issued by the Michigan State Hospital Finance Authority, Wagner bought the corresponding $4.7 million of auction-set, floating-rate securities and linked them together.
But he was surprised to find, upon offering the $9.4 million of fixed-rate securities, that bids were extremely low. Although The Bond Buyer's Revenue Bond Index was down only one basis point from when he bought the inverse floaters, he sold the linked securities to yield 18 basis points less than the original rate.
Part of the difference reflects the structuring premium of 10 basis points built into the derivatives. Issuers generally agree to sell derivatives because they can lock in a lower fixed rate.
Ironically, the market further discounted the bonds because they had a 35-day pay component instead of the usual semiannual payment schedule. Being paid more frequently is economically preferable, but "the market is not geared to 35-day pay. People don't understand it, and some institutions don't want the hassle," Wagner said.
Goldman's Gurwitz confirmed Wagner's experience. He said Goldman has been able to purchase linked fixed-rate bonds with a 35-day component for less than comparable fixed-rate bonds that pay semiannually.
For convening swap-related inverse floaters, Wagner said he preferred cash payouts to adjusted coupons. With a cash payment, the bond becomes an ordinary fixed-rate bond with no unusual features, Wagner said. But a bond with coupons that change over time is an unusual animal in the tax-exempt market, with fewer potential buyers.
Wagner also told investors that not all firms have supported their derivatives in the secondary market. He said he would only buy products from Lehman Brothers, Merrill Lynch & Co., and Goldman Sachs, despite some pointed questions from the conference audience about other firms.
"If you want liquidity, I would strongly advise you to limit your transactions to those three dealers," Wagner said. "They are the only ones strongly committed to the derivatives market."