Many municipal issuers are finding value in puts and calls this year.
The two types of options are more common in the equity market, but are making their mark in the tax-exempt market.
A call option gives the holder the right to buy something at a preset price by a certain date. A put option gives the holder the right to sell something at a preset price by a certain date.
In both cases, the option holder has an option. If there's no money to be made by buying or selling at the preset price, the option holder is not obligated to act.
The entity that sold the option, known as the option writer, is obligated to follow the dictates of the option holder. If the holder wants to buy or sell at the preset price, the option writer must act.
Both options can be used in hedging transactions, to help issuers minimize risk.
For example, many issuers are required to invest their debt service funds in Treasury securities before the funds are distributed to bondholders. Typically, the funds are invested in very short-term Treasuries paying a minimal amount of interest.
The issuer usually deposits one-sixth of the semiannual interest with its trustee each month. The trustee invests the funds in Treasury securities that will mature on the date of the interest payment. The trustee then uses the proceeds from the maturing Treasuries to pay bondholders.
Why can't the trustee invest in longer-term Treasuries, to give the issuer a higher rate of return on the debt service funds? Couldn't the trustee just sell the Treasuries in the open market when the funds are needed to pay bondholders?
The problem is that if the Treasuries do not mature on the interest payment date, there is no way of knowing how much the trustee will raise by selling the Treasuries. The market value of a long-term Treasury bond fluctuates unpredictably as interest rates change.
If the value of the long-term Treasuries dropped, the trustee would have a shortfall when it came time to pay bondholders.
But, using a put option, the issuer can invest debt service funds in long-term Treasuries without much market risk.
The put option gives the issuer, or its trustee, the right to sell the long-term Treasuries for a preset price -- a price high enough to cover the interest payment owed to bondholders.
The issuer has to pay for the put option. However, by investing debt service funds in longer-term Treasuries, the issuer receives a higher rate of return that more than covers the costs of the option.
The risk is that the option writer, usually a Wall Street firm, might go bankrupt or for some other reason might not be able to make good on its side of the bargain. The issuer would then have to sell the Treasuries in the open market and might not raise enough to make its interest payment.
To mitigate this credit risk, issuers usually require that the option writer have a high credit rating or post collateral.