The next hot derivatives product may be options on municipal bonds, according to some market professionals.
With new-issue volume plummeting and a record volume of bonds set to be called in the next few years, investors may be able to ensure they will have something to buy by using options, the professionals said at a conference in New York City sponsored by International Business Communications.
Gary Gray, a managing director at Lehman Brothers, suggested investors could hedge against reinvestment risk from bonds maturing and being redeemed with options.
Reinvestment risk is the danger that rates will decline and investors will face the task of reinvesting their principal at lower yields.
By buying an option on an existing bond, or an option on a bond to be issued in the future carrying today's rates, investors can effectively lock in a minimum reinvestment rate. In return, investors must pay an up-front premium for the option.
Christopher Dillon, vice president and municipal market strategist at J.P. Morgan Securities Inc., said his firm expects rates to continue moving up, which ordinarily would mitigate reinvestment risk.
But municipals will be in short supply. The volume of maturing Treasury securities backing advance refunded bond escrows, sometimes called SLGs, has not yet peaked, he said.
"There was a lot of concern about redemptions in January and July, but in 1995, we will see the largest amount of SLGs maturing and bonds going out of the market," Dillon said.
Investors may also be concerned about the convexity of their portfolios, he said. Convexity is the tendency of a bond's price to move more than or less than what would be expected from a given change in interest rates.
The price of callable bonds, for example, is limited by call provisions. So a market rally will not add as much to the price of a callable bond as a noncallable bond. The callable bond has negative convexity.
In the case of a callable bond, the investor has in effect sold a call option on the bond to the issuer. To minimize negative convexity, an investor could buy a call option on a similar bond.
Then, if the market rallies, the gain in the option's value will offset the lagging performance of the callable bond.
Dillon and Nat Singer, managing director at Bear, Stearns & Co., also recommended that investors use municipal futures contracts on the Chicago Board of Trade.
Singer said futures are highly liquid and pricing is less complicated than for other derivatives such as options.
One problem is the short maturity of the futures contract. Theoretically, the board of trade stands ready to buy and sell futures contracts maturing in three-month intervals for years into the future.
But 99% of the volume of trades is limited to the nearest expiring contract. Trading in longer maturity contracts is too limited to provide liquidity.
Singer said investors hoping to use the contract for longer periods would have to roll over their positions.