All derivatives are not created equal.
Some securities known as "derivatives" are no more risky for issues than ordinary, fixed-rate bonds. Other securities create additional risks that may or may not be acceptable, depending on the savings created and the issuer's goals and enabling legislation.
Issuers, financial advisers, and politicians concerned about the risk of "derivatives" should be careful to distinguish which product they are considering.
For example, one of the most popular derivatives is a two-part structure, with one security paying a floating rate and the other security paying an inverse floating rate. The structure is commonly called a floater and inverse floater.
The derivative goes by many names, depending who the underwriter is. Some names include Residual Interest Bonds and Select Auction Variable Rate Securities (RIB/SAVR), Auction Rate Notes and Yield Curve Notes (ARN/YCN), Periodic Auction Reset Securities and Inverse Floating Rate Securities (PARS/INFLOS), Auction Rate Cerfificates and Leveraged Reverse Rate Securities (ARC/LevRRS), and Floating Auction Tax-Exempts and Residual Interest Tax-Exempt Securities (FLOAT/RITES).
Although each underwriter has its own twists, the basic structure is the same. The issuer pays a fixed amount of interest that is sliced and diced, but ultimately is divided between the two securities.
The issuer is not exposed to additional credit risk. There is no counterparty. As the variable rate on one security rises, the rate on the other falls.
The issuer does not have floating rate exposure. Under no circumstances will the issuer be responsible for paying one side of the deal and not the other. And the securities have been structured to include a mandatory conversion to a fixed rate at some point in the future.
While issuers are generally off the hook, investors do have to watch out for risks on such derivatives, as the securities can be volatile.
Several underwriters have sold similar securities that slice and dice an ordinary bond into more than two pieces. Investors may buy or sell individual interest coupons or strips of coupons.
Other types of derivatives, however, create greater risk for issuers. For example, issuers have sold embedded swap securities. The securities pay a variable rate of interest pegged to a market index or other security, like a futures contract.
The issuer is able to offer the unusual variable rate and lock in a fixed rate for its won interest cost by entering a swap. The issuer pays a fixed rate to the swap counterparty, and in return, the counterparty pays the issuer all of some of the variable-rate component due on the derivative securities.
Swaps carry a host of risks for issuers to consider. The issuer may be exposed to additional credit risk, floating rate risk, basic risk, or other kinds of risk. These risks can be hedged, and may or may not be appropriate for a particular issuer.
But the savings available to issuers on swap-related derivatives can greatly exceed the savings available on less complicated structures. While issuers usually save about 10 basis points by selling floating-rate securities and corresponding inverse floating-rate securities, a swap-embedded derivative could create 25 to 50 basis points of savings.