Wall Street has come up with another way to give investors the benefits of taxable investments in a tax-exempt structure.

Lehman Brothers' latest derivative twist, on a piece of last month's Philadelphia's $1.1 billion water issue, attempts to meld the taxable performance of futures contracts with the tax-exempt return of municipal bonds.

Lehman sold $38 million of the new derivatives, called Bull Forwards and Bear Forwards, as part of the Philadelphia transaction.

Municipal investors use futures to hedge their portfolios against adverse market moves and to leverage their bets on expected market changes. But futures contracts generate taxable capital gains, a problem for investors looking for tax exempt income.

By embedding artificial futures contracts in a tax-exempt bond, Lehman devised a structure designed to mimic the return an several futures contracts without generating taxable income.

"The price-performance characteristics should duplicate a fixed-rate bond combined with three futures contracts," said Gary Gray, senior vice president at Lehman Brothers. "This is the most volatile municipal derivative in the marketplace. "

Because of their volatility, the new derivatives will not be offered to retail investors, officials at the firm said.

Though intrigued by the Lehman securities, some buyers were worried that the structure was too complicated. "It would be nice to have tax-free futures, but at what cost?" one portfolio manager asked. "Many times a good idea on the drawing board doesn't work out in the market."

For the first year, the Bull Forwards and Bear Forwards will pay an identical fixed rate of interest. In the Philadelphia issue, for example, investors will receive 5.20% for the first year they hold either of the 12-year maturity securities.

One year after issuance, the yield on the Bull Forward and the Bear Forward will be adjusted, based on a complex formula designed to replicate he performance of futures contracts on The Bond Buyer's 40-bond index. The adjusted yield, once set, will be fixed for the remaining term of the securities.

Similar to Lehman's RIBs/SAVRs program, the amount paid by the issuer on both pieces together is fixed for the 12 years. The adjustment of yields reallocates the interest paid by the issuer between the two securities, but the issuer's total payment does not change.

Lehman officials said they were able to lock in a fixed rate on the Philadelphia securities that saved the city 10 to 15 basis points. Investors are willing to sacrifice a portion of the yield in exchange for the potential for above-average returns.

Lehman's model for adjusting the rate on the securities is based on the performance of a hypothetical bond during the first year the securities are outstanding. The hypothetical bond has a $5,000 face amount, a 20-year maturity, a noncallable provision, and a coupon equal to the yield to maturity of The Bond Buyer 40-bond index.

If the index rises during the first year, the price of the hypothetical bond will drop. If the index falls, the price of the hypothetical bond will rise.

The model takes the change in price of the hypothetical bond and calculates its present value over the remaining life of the derivative securities.

For example, if The Bond Buyer index drops to 5.00% from 5.55% over the next year, the hypothetical bond's price would rise $345, to $5,345 from $5,000. The value of the change in price of the hypothetical bond over the remaining 11-year life of the derivatives is $42 per year, or an increase of 0.847% in the interest rate.

Lehman plans to leverage the adjustment on the new securities. In the Philadelphia deal, Lehman will multiply the change in the hypothetical bond by three when adjusting the rate on the derivative securities.

In the above example, the 0.847% would be tripled to 2.54%. The Bull Forward, designed to benefit from falling market rates, would have its interest rate boosted by 2.54%. The rate on the Bear Forward, designed to benefit from rising rates, would drop by the same amount.

Institutional investors said they are still reviewing the structure.

"We're interesfed but skeptical." one portfolio manager said.

Another manager said he would consider the product but worried about the volatility. "In a way, it's bad for the industry. This is real live ammo," the manager said. If you give out ammo, some people will hurt themselves."

The securities are part of Lehman's existing bond payment obligation program that allows investors to selectively buy or sell portions of the interest and principal on a bond.

An investor holding a bond containing bond payment obligations, or BPOs, can create the Bull forward or Bear Forward by selling off certain pieces.

Derivatives professionals at some of Lehman's competitors suggested that the BPO format and the use of matched pairs of securities needlessly complicates the product.

"That's a tough way to do it," one professional said. "The idea [of embedding futures] is a good one, but we're working on it without the BPO framework."

But Gary Gray, who helped design the original BPO structure, said the format makes the securities more desirable to investors.

"We think this format is valuable to investors. The option is with the investor. They can choose to create the forward or uncreate it," Gray said.

The structure also allows issuers to offer a derivative product, gaining the benefit of a lower fixed rate, without having to take on additional risks.

If an issuer wanted to offer a futures-like payout in an ordinary bond, without using a RIBs/SAVR-type structure, the issuer would probably need to enter a swap or other hedging agreement with an underwriter. The issuer then could be exposed to unforeseen liabilities if the underwriter failed to make good on its side of the hedge.

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