Leveraged investment strategies, which employ special techniques to amplify the performance of a derivative product, can boost returns but they also pose the risk of magnifying losses.
Investors looking to make leveraged bets in the tax-exempt area have several derivatives to consider.
The most popular is the leveraged inverse floater. The holder of an inverse floater receives more interest as rates fall and less interest as rates rise. Investors purchase inverse floaters to profit from declining rates or to hedge an existing portfolio that could face big losses if rates decline.
There are two basic types of inverse floaters. On a swap-based inverse floater, the issuer of the security hedges its exposure by entering an interest rate swap based on a market index. As the index declines, the issuer receives increased payments on its swap, which it passes along to the inverse floater holder.
On an auction-based inverse floater, the issuer sells an inverse floater with a companion security, usually a floating-rate bond reset periodically at an auction. The issuer's interest payment is divided between the two securities. As the auction-set rate falls, more interest is left over for the inverse floater holder. A small portion of the interest payment is set aside to cover the underwriter's auction fee.
On a non-leveraged inverse floater, the holder receives 1% more interest every time rates on the market index or auction-set floater decline 1 %.
A leveraged inverse floater gives the investor more bang for the buck. For example, on a triple-leveraged inverse floater, for every 1% decline in the floating rate, the rate on the inverse side jumps 3%.
Of course, the reverse is also true. If the floating rate climbs just 1%, the triple-leveraged inverse floater holder's rate falls 3%.
What is the source of the extra interest on a leveraged product?
On an inverse floater linked to an auction-set floater, the underwriter can vary the proportion of issuance of each type of security. If an issuer sells $30 million of floaters linked to just $10 million of inverse floaters, the inverse side is effectively triple-leveraged.
For example, the issuer may pay a fixed rate of 6% on the entire $40 million issue, or $2.4 million. If the rate on the floater side is 3%, then the issuer pays 3% on $30 million, or about $900,000. That would leave $1.5 million of the $2.4 million of interest for the inverse floater holder. The rate on the $10 million of inverse floaters would be 15%. In reality, a small amount of the leftover would go to pay the auction fees.
But what if the rate on the floater rises just 1% to 4%? Then the issuer would pay $1.2 million on the $30 million of floaters. That would leave $1.2 million for the inverse floaters, a drop of 3% to a rate of 12%.
On a swap-related inverse floater, leverage is created by boosting the notional value of the issuer's hedging swap. In an interest rate swap, two parties agree to exchange interest payments for a certain period. The rates are based on a set principal amount that is not exchanged - the notional value of the swap.
To create triple-leveraged inverse floaters, an issuer could sell $10 million of inverse floaters that pay the holder a fixed rate of 6% plus 15% minus three times the Public Securities Association's swap index. The issuer would then enter a swap with a notional amount of $30 million, or three times the amount of the inverse floaters issued.
If the PSA index is at 3%, the issuer would pay the inverse floater holders 6%, or $600,00, plus 15% minus three times the PSA rate, another $600,000. That would be $1.2 million, or a rate of 12%. On the swap, the issuer would pay a floating rate based on the 3% PSA rate on the $30 million notional amount, or $900,000. The swap counterparty would pay the issuer a fixed rate of 5% on the $30 million, or $1.5 million.
The issuer would pay out $1.2 million on the inverse floaters and $900,000 on the swap, while receiving $1.5 minion on the swap, for a net debt service cost of $600,000.
What if the PSA index dropped 1% to 2%? The issuer would owe the inverse floater holders 6% on the $10 million of bonds, or $600,000, plus 15% minus three times 2%, or another 900,000. As rates decline, the leverage magnifies the inverse floater holder's return.
On the swap, the issuer would pay the 2% PSA rate on the $30 million notional amount, or $600,000. The swap counterparty would still pay a fixed rate of 5% on the $30 million, or $1.5 million.
The net cost to the issuer remains the same. The issuer is now paying out $1.5 million on the bonds but, on the swap, is paying out $600,000 and receiving $1.5 million. The net cost to the issuer is still $600,000.