LOS ANGELES -- Los Angeles County today plans to sell a variation on inverse floating-rate securities that eliminates the need for holding periodic auctions to set the short-term interest rate portion of the deal.
So-called inverse floaters have become more popular with the municipal market in recent months, based on underwriters' assertions that the product can lower the overall interest cost for issuers and also meet the needs of both short- and long-term investors.
Unlike previous inverse floater deals -- which divideda conventional long-term fixed-rate bond into two floating-rate parts for short- and long-term buyers -- there will be no short-term investors in the Los Angeles County deal. Instead, the short-term investors are replaced with a surrogate, the weekly J.J. Kenny Index of high-grade short-term securities.
"We think it has some value" from both the standpoint of satisfying certain concerns about the auction process and easing administrative requirements, said Anthony Taddey, a managing director of Morgan Stanley & Co., the senior manager on the $85 million certificate of participation issue
About $25 million of today's planned sale is expected to be priced as Structured Yield Curve Certificates, which is Morgan Stanley's name for the variation on inverse floaters.
Lehman Brothers introduced the inverse floater structure into the tax-exempt market in early 1990 with RIBs and SAVRs, the firm's service marks for "residual interest bonds" and "select auction variable-rate securities."
In typical RIBs/SAVRs deals -- which also are done by other firms with different acronyms -- a fixed-rate obligation ends up being issued as two floating-rate obligations.
The SAVRs portion of a loan has a variable rate set at Dutch auction every 35 days. In the Dutch auction process, potential investors submit bids reflecting the yield they would be willing to accept to purchase the bonds. The lowest bid needed to clear the entire issue is determined, and every bidder at or below the given level receives that yield.
The rate on the RIBs portion of the loan is determined by calculating the difference between the payment stream made by the issuer and the variable-rate interest paid on the SAVRs.
In a simple example that ignores service fees, a deal might cost an issuer 6.5% and the SAVRs auction might result in a 4.5% return. That residual -- the difference between the two rates -- would then be added to the 6.5% to produce the return for the RIBs holder.
Underwriters have said that the structure can lower an issuer's borrowing costs by roughly 20 basis points over a regular par bond and also offer certain advantages to both short- and long-term investors.
Morgan Stanley developed its variation on inverse floaters in response to demands "from the buy side," John Straus, a principal and sales manager for Morgan Stanley, said yesterday.
Investors are looking for greater current yields, he noted, and also have expressed a degree of uncertainty about the pricing mechanism provided by Dutch auctions.
Dutch auctions have often produced rates of as much as 25 to 50 basis points higher than comparably rated securities in the short-term tax-exempt market, Mr. Straus noted. Such a disparity eats into the return of long-term investors since the short-term rate is subtracted from the issuer's payment stream to produce the residual long-term rate.
Accordingly, long-term investors might gain some yield advantage if the short-term rate is calculated by a surrogate -- such as the Kenny Index -- rather than by an auction process, Mr. Straus said.
Sharon Yonashiro, director of public finance for Los Angeles County, noted that reliance on an index also provides "a more controlled environment" that can help to reduce vagaries arising in an auction. Some issuers, for example, have expressed concerns over the possibility that an auction may at some point fail to go smoothly.
From an efficiency standpoint, Ms. Yonashiro also noted that there probably will be fewer administrative burdens involved in structures that do not entail regular auctions.
But the structured yield curve certificates developed by Morgan Stanley also resulted in other changes for the issuer. In a typical RIBs/SAVRs deal, for example, the issuer's payment stream remains the same, no matter what happens in the market. By contrast, Los Angeles County would be saddled with a floating rate by relying on the index.
As a result, the country will enter into an interest rate swap with a Morgan Stanley affiliate so the issuer ends up with a fixed rate.
The structured yield curve certificates -- which involve a 2011 maturity -- will automatically convert to a fixed rate after five years.
The Los Angeles County deal is also somewhat novel in that the issuer only sent out one preliminary official statement for the transaction. Other issuers often have provided separate prospectuses when inverse floaters and other types of bonds -- such as regular current interest securities -- are involved.
"Issuers necessarily are trying to preserve their flexibility," Mr. Taddey said, adding that the county's prospectus allowed it until the last minute to select from various options, including current interest certificates, capital appreciation certificates, and inverse floaters using either a Dutch auction or the variation with the Kenny Index.
Morgan Stanley officials stressed yesterday that their structured yield curve certificates do not replace inverse floaters featuring auctions, but rather provide another alternative for issuers to consider.