Are all inverse floating-rate securities created equal?

An inverse floating-rate security, or inverse floater, pays the holder a rate of interest that rises as another interest rate falls. Investors who believe rates will decline or who are trying to hedge their portfolio's exposure to declining rates buy inverse floaters.

A key distinction among inverse floaters is how the variable rate is set. Some are based on auctions, others on swaps.

The rate on an auction-based inverse floater is linked to the rate on another security, typically an ordinary floating-rate note. The rate on the ordinary note is set periodically, at auction.

Interest payments from the issuer are split between the two securities. As the auction-set rate on the ordinary floater declines, more of the issuer's interest payment is paid to the inverse floater. The two rates don't exactly add up to the issuer's rate because a portion of the total interest also pays the auction fees.

From the issuer's point of view, the interest payment is always fixed. Some of the payment goes to the floater and some of it goes to the inverse floater, but the total never changes.

The rate on a swap-based inverse floater, by contrast, is usually linked to a market index, such as the Public Securities Association's Municipal Swap Index. The inverse floater usually pays the holder a set amount minus the index, so as the index falls, the rate rises.

Since there is no ordinary floating-rate security in this structure, issuers use interest rate swaps to lock in a fixed rate. The issuer agrees to pay the floating index rate to a swap counterparty, and the counterparty pays, in return, a fixed rate. The interest rates for the swap are calculated off a base amount, the notional amount of the swap, that is usually equal to the amount of inverse floaters sold. The combination of the inverse floater and the swap creates a "synthetic" fixed rate for the issuer. On the security, the issuer is paying a fixed amount minus the index, and or the swap the issuer is paying the index minus a fixed amount. The difference between the fixed amount on the security and the fixed amount on the swap is the issuer's synthetic fixed rate.

For example, an inverse floater may pay investors 10% minus the PSA index. Last week, the PSA index was at 2.39%, so the investor would receive about 7.61%.

The issuer would enter into a swap, paying the PSA index and receiving, for example, 4.70%. At last week's rates, the issuer would be receiving a net payment on the swap of 2.31%.

Taken together, the issuer is paying 7.61% on the security and receiving 2.31% on the swap, for a net cost of 5.30%. No matter how the index moves up and down, the issuer will continue to pay 5.30%, which is the difference between the base 10% rate on the security and the 4.70% base fixed rate on the swap.

It is possible that the swap counterparty will not be able to make its payment, defaulting on the swap. The issuer might then have to pay the inverse rate on the security. In some cases, the security would revert to a fixed rate if the swap counterparty defaulted.

The risk of counterparty defaults can be mitigated in a number of ways. For example, a swap may require the counterparty to post collateral, consisting of Treasury bonds, if the counterparty is downgraded. If the counterparty defaults on the swap, the collateral would be turned over to the issuer. The issuer could use the funds to meet the interest payments on its inverse floaters or to purchase a replacement swap, reconstituting the hedge.

On the auction-based inverse floater, there is no credit exposure to a swap counterparty. The holder of the inverse floater may be more exposed to the credit quality of the issuer than the holder of an ordinary bond.

If the credit quality of the issuer declines, investors holding the auction-set floating-rate security will demand a higher yield, even if overall interest rates have not changed. And a higher yield for the auction side means a lower yield for the inverse floater.

So an investor who purchased an inverse floater, hoping to profit from declining rates, might lose out if the credit quality of the issuer declined.

Again, steps can be taken to mitigate this risk. If the securities are backed by credit enhancement, such as a bond insurance policy, the issuer's credit quality would have less effect on the yields.

The auction-based inverse floater provides an additional benefit to investors. The security frequently gives the holders the right to call the opposite piece, the auction set floating rate security, and link the two securities into one fixed-rate bond.

On a swap-based inverse floater, the investor could create a similar effect by buying a floating rate bond on the open market, but that would result in a less perfect match.

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