Merrill Lynch & Co. has developed a new derivative that lets investors lock in current ratios between taxable and tax-exempt debt, using the company's triple-A rated derivatives subsidiary to ease credit quality concerns.
The product is designed to meet a dilemma facing investors in the current interest rate climate: Just as bond buyers are considering increasing their holdings of municipals because of attractive ratios to taxable debt, interest rates are threatening to reverse course and creep upward.
Merrill Lynch's latest derivative product, called the "deferred fixed-rate bond," attempts to solve that problem by letting investors lock in today's attractive ratios but not today's low fixed rates.
The ratio of taxable rates to tax-exempt rates is used by investors to compare the value of investing in one market versus another. When the tax-exempt market underperforms the taxable market, as has happened for most of this year, tax-exempt rates creep closer to their taxable counterparts and the ratio rises. That effectively boosts the after-tax return of tax-exempts.
Many investors believe that the ratio will move considerably lower than it is today, and hence take the view that tax-exempts will now begin to outperform taxables. Merrill's product gives them one means of placing that bet. Merrill officials say they have taken the unusual step of using their derivatives subsidiary, Merrill Lynch Derivatives Products L.P., for entering swaps backing the deferred bonds.
The triple-A rated subsidiary is attractive to issuers and investors uncomfortable with the parent company's single-A ratings. But the subsidiary has a limited amount of capital and the firm until now has limited its use to the most profitable transactions, generally not involving municipal issuers.
The deferred bond was first sold on a $20 million portion of last month's $119 million issue by the Bristol, Tenn., Health and Education Facilities Board. The bond structure was used again on a $5 million slice of last week's $600 million New York City issue.
"It can be used as a cash alternative for an investor who thinks that perhaps rates are going up but who also thinks that now is a great time to buy municipals because of the attractive ratios," said Robert Barber, managing director in municipal derivatives at Merrill.
The holder of the new derivative product will benefit if long-term rates rise over the next year. The investor also will benefit if the ratio of taxable to tax-exempt yields falls back to historically more common levels.
If, however, rates continue to decline or the ratio of taxables to tax-exempts actually continues to shrink, the deferred hold could underperform investors not locked in to the structure.
Merrill estimates, for example, that investors who bought the Bristol deferreds will break even if the rate on the 10-year Treasury note rises by 50 basis points by yearend or by 80 basis points by next September.
The holder of a deferred bond receives a short-term floating rate for up to the first year. Each month during that first year, the investor has the option of locking in a long-term fixed rate on the bond. The fixed rate is based on a taxable market rate, like the 10-year constant maturity Treasury rate or the yield on the Treasury's 30-year benchmark bond.
But the deferred bond, once converted to a fixed rate, will not pay investors taxable interest. The interest will be tax free.
So the fixed rate is adjusted based on the ratio of taxable to tax-exempt rates that was in effect when the deferred bond was originally sold.
Once the investor chooses to convert the deferred bond to a fixed-rate bond, Merrill calculates the rate by multiplying the latest yield on the fixed-rate benchmark by the older ratio of taxables to tax-exempts.
The ratio changes slightly depending on which conversion date the investor selects. The ratio is also adjusted upward if the maturity on the taxable rate is shorter than the bond's maturity. But in all cases, the ratios are set when the bond is sold.
After one year, if the investor has not exercised the option to convert to a fixed rate, the bond automatically converts to a fixed rate under the same procedure.
Investors will receive the fixed rate on an accelerated basis. If the higher fixed rate was simply paid out for the remaining life of the bond, investors would face call risk. The issuer might decide to refinance the bond before maturity.
So once the bond is converted, the fixed rate is paid over five years, up to the call date. The rate is adjusted upward to account for the accelerated payment schedule.
"We wanted to compress the benefit to a five-year period, inside the call date," Merrill's Barber said.
For example, on the New York City deferred bond, an investor can convert to a fixed rate based on the 10-year Treasury note yield starting Nov. 15, 1993. The conversion feature is available each month after that until Oct. 17, 1994, when the bond automatically converts.
If converted on the last date, an investor would receive 102.85% of the yield on the 10-year Treasury note. But the rate will be paid only until 1998. Instead of paying the rate of 102.85% for the life of the bond, the rate is amortized into the 1994 to 1998 period.
The investor would receive 335.28% of the 10-year's yield for four years, instead of receiving 102.85% of the 10-year's yield for 10 or 20 years.
From 1998 until the bond matures or is called, investors receive 5.65%.
The issuer enters into an interest rate swap with Merrill Lynch to hedge its obligation. By issuing the deferred bond and entering the swap, the issuer is able to create a synthetic fixed-rate interest cost that is 10 or more basis points lower than it would have received by issuing an ordinary bond.
If Merrill is unable to fulfill its side of the interest rate swap, however, the issuer will be liable for paying the possibly expensive interest going to investors.
The deferred bonds to have a maximum rate. Investors cannot receive more than 14% on the Bristol deferred bonds or 20% on the New York City bonds, for example.
"We were very comfortable with the degree of counterparty risk," said Roger Anderson, New York City's bureau chief for debt management. Using the deferred product, he noted, "We saved 10 basis points over issuing straight fixed-rate debt."
The rating agencies have concluded that even if Merrill Lynch went into bankruptcy or could not meet its own swap obligations, the separate subsidiary would not be affected. It would have enough of its own capital to keep meeting its swap obligations.
Merrill officials said they have recently begun using the subsidiary for municipal market transactions. But the subsidiary is only used for hedging transactions related to embedded derivatives, like the deferred fixed-rate bond or index-based inverse floating rate securities.
Merrill officials further argue that the swap backing the deferred bonds is not particularly risky.
One facet of an issuer's risk on a swap is the maximum amount that the issuer might have to pay. Another risk factor comes from the length of time covered by the swap.
If a derivative product pays a floating rate backed by a swap, the floating rate is generally free to float up or down for years. To fully assess the risk on such a swap, the issuer must also assess how far up or down rates are likely to float during the swap period.
But on the deferred product, although the investor receives a derivative-enhanced rate for up to five years, the rate is set after one year.
"The risks are somewhat more limited than a straight swap. It's just ratio transaction, and it's a limited time frame," Barber said.
Officials at Financial Guaranty Insurance Corp. agreed with Barber's assessment. They provided insurance on Bristol's entire $119 million deal, including the deferred portion.
If Merrill is unable to meet its swap obligations to Bristol, the board is still obligated to pay the higher yields to investors. And if Bristol cannot make that payment to investors, FGIC is on the book.
FGIC was reassured by its familiarity with Merrill as a counterparty and the short five-year term of the swap, company officials said.
Plus, the deferred bond "locks in within a year. Other products can fluctuate constantly," said Joseph Campion, director of the health-care group at FGIC. "It's a better deal in that there is less uncertainty. Not less risk, but less uncertainty in the product."