In January 1981, the Municipal Assistance Corporation for the City of New York sold $100 million o 10 5/8% bonds due Jan. 1, 2008. The bonds came with two-year warrants allowing holders to purchase an additional $100 million of 10 5/8% bonds due Jan. 1, 2007 at par. The official statement shows that the warrants were unhedged.

MAC saved approximately 75 basis points in interest costs on the $ 100 million, or just about $65 per bond in January 1981 dollars. The Bond Buyer's 20-bond index of 20-year general obligation yields was just under 10% (9.9 1 % on Jan. 29, 198 1).

This was the first time warrants were ever issued on new municipal bonds. At the time, there was no market for long-term bond options of any type, let alone a municipal futures contract. Although U.S. Treasury futures had been trading for three years, no options contracts existed. Hedging the two-year interest rate exposure of the warrants in Treasury futures would have been costly, continuous, and precarious.

At first, it appeared MAC had bet right. By July 30, 1981, the 20-bond index had risen to 11.44%. So MAC sold some more warrants:a $ 100 million MAC issue in November included $59.5 million of 12 3/4% bonds due Jan. 1, 2008, with warrants to purchase $59.5 million more of 12 3/4s due Jan. 1, 2007, at 99.50. By comparison, the 20-bond index was now 12.44%. Both sets of warrants were to expire Jan. 18, 1983.

Who could have known that the great bond market rally of the 1980s was about to begin? Yields on all long-term bonds dropped dramatically in the fall of 1982. In January 1983, the 20-bond index stood at 9.48%, and the market for long MAC bonds was 11 %.

The warrants on the 10 5/8% MACs expired worthless, but the warrants on the 12 3/4s were exercised. The worst had occurred: MAC had to issue 12 3/4% bonds at 99.50 in an 11% market.

From the first issue of $100 million, MAC made $65 per $1,000 of bonds in warrant premiums, or $6.5 million in 1981 dollars. Invested for two years at 10%, those warrant premiums yielded $7.87 million. From the second issue of $59.5 million, it received $50 per bond in warrant premiums on $59.5 million (assuming another 75 basis points of savings), or $2.98 million, which invested at 10% for 14 months yielded $3.33 million. Thus it saved $11.2 million on the two issues.

Slim Profit/Serious Gamble

The loss of 175 basis points plus $5 that MAC incurred when the second set of warrants was exercised added up to a loss of $158.34 per $1,000 of bonds, or $9.42 million. Subtracting that from the $10.93 million resulted in a net profit of $1.78 million -- a slim profit on a serious gamble that probably was not worth the risk. (All of the above are approximate calculations for descriptive purposes.)

In fact, MAC was only 20 basis points or so away from an outright loss. By April 1983, municipals had rallied another 70 basis points, pushing the 20-bond index down to 8.82% on April 28. If the warrants had been four months longer, MAC would have lost roughly $1.5 million. Warrants have not been issued on municipal bonds since.

There were two major problems with the MAC offering, both of which have simple solutions.

First, MAC did not limit its long-term interest rate exposure to dropping rates in any way. In effect, it was shorting the bond market with $159.5 million of bonds without any contingency for guessing wrong.

Second, MAC was locked into this unhedged short for a long period of time. It is not easy to predict long-term rates over 30 days, let alone two years, and to pick the absolute level of rates.

Today, there are ways to effectively hedge such exposure regardless of the time frame. The swap markets are deep and efficient enough to offer two-year interest rate protection. Warrants structured to cover shorter periods of time, such as 30, 45, or 60 days, would be even more efficient, providing advantages to both buyer and seller.

First, consider the definition of a call option. The buyer pays a premium to obtain the right (but not the obligation) to purchase a good at a specified price within a specified time. In return for the premium, the seller is obliged to produce the specified good at the specified price within a specified time.

The buyer of a cash municipal call option can use it to facilitate short-term cash-flow transactions. The buyer can lock in, for the period structured, certainty as to both price and availability.

For example, a mutual fund is fully invested and expects an inflow of cash from the next large coupon payment date -- 45 days away. The portfolio manager sees a new issue that fits his purchase criteria. To buy those bonds, he has to arrange a loan and pay interest on it. That interest cost can be replaced by the option premium of a cash call on the issue.

The manager, of course, can wait until the cash arrives, but the market probably will have changed by then -- and availability will probably be a problem.

If issuers structured the timing of their sales and the duration of their call options to coincide with the largest coupon payment dates of the year, January and July, and the largest investor buying months, demand for call options is likely to be greatest for these periods. Presumably, these call options would have a secondary market for their life.

During this time the call options can be used as an accumulating tool, especially if their value drops in the weeks after issuance. Here the buyer can simply and cleanly arrange the purchase of a large block of new bonds without disturbing the market. Either way, the buyer has fixed the size and maximum price of the purchase during this period, but keeps alive the possibility of buying cheaper. Of course, the premium is the cost of this flexibility.

Valuable Vehicle

These call options may be valuable as a speculation vehicle. But they are more useful as a purchase right for a specific cash municipal bond, to be used as a pseudo-purchase. They deliver actual bonds direct from the issuer.

For the seller, the granting of call options is an enhancement to raising capital. No opinion on the future direction of interest rates is necessary as long as the options are hedged. This can be done by establishing for the issuer an escrow fund to purchase matched interest rate protection in the form of call options on either the Municipal Bond Index, or possibly the 10-year Treasury note, at the time of issuance. Protection against large interest rate movements in the 30-, 45-, or 60-day period is required.

If the municipal contract is close to a one-to-one correspondence to most new-issue par bonds, which is what the contract is by construction, then equal amounts of muni call options can protect equal amounts of granted warrants. Hedge ratios easily could be applied as necessary for a more exact match. The 10-year note contract may work equally well since any new callable muni term bond sold at par will trade up over par very much like a 10-year noncallable bond. A move above par is the only area of a warrant issuer's risk. With interest rates neutralized, all it takes for hedged call granting to be profitable is the ability to sell the cash muni warrants at a premium, or implied volatility above that of the hedge call purchased.

During the past five years, the implied volatility of options on the Municipal Bond Index contract and 10-year Treasury note have frequently been below 6%. There were periods, though, when buying calls was an inefficient hedge for selling warrants. If new-issue cash warrants can be sold for implied volatilities above the hedging volatility, non-random "vega" profits can be ensured. (Vega is the change in option price with respect to a change in implied volatility.) This means pricing warrants at levels in the 9%-11% range when the hedging volatility is in the 5%-6% range. (MAC received an implied volatility of 11.62% and 11.45% for its warrants in 1981.)

For an idea of the possible profits, look at Table 1. The table has the three time periods -- 30 days, 45 days, and 60 days -- across the top and various volatilities down the side. Two different strike prices are shown, 100 and 112, because these are the current "at-the-money" strikes for munis and notes. The 100 strike is used for pricing a new-issue warrant as well as the muni hedge option. The 112 strike is used for pricing a note hedge option.

A new issue priced at 100 with a 30-day warrant sold for 11% volatility would bring in a premium of $12.58 per bond. At 6% volatility the muni hedge call option would cost $6.86 per bond. This is a no-risk profit of $5.72 per bond. Using the note hedge would cost $7.69 per bond, resulting in a no-risk profit of $4.89. A look at the extreme -- a muni hedge with implied volatility of 4% -- shows a profit of $8.01 per bond.

The 60-day warrants show even larger numbers. For a muni option hedge, the maximum is $17.79 minus $6.47, or $11.32 per bond.

Another advantage to issuers is the lack of underwriting fees and associated costs on bonds issued through exercised options.

Basis is a major consideration in hedging, which offers yet another advantage to warrant issuers. The municipal contract has had a history of trading cheap to its index -- in other words, a wide basis spread. This is largely due to the inability of most market participants to short cash municipals efficiently. Warrant issuers have this ability. Whenever the municipal contract is undervalued, warrant issuers can capture this difference as well as their vega profit.

In addition, warrants slightly out of the money may still be exercised when availability is a problem to buyers and a block purchase in the Street would require running up the price of a specific bond. Here savings would be even greater than normal because issuance would take place above the market.

The main assumption for making this very low-risk profit is that warrants be sold for a volatility higher than the equivalent hedge option. How good is this assumption? Municipal options are options on an index of bonds and they deliver a futures contract on the same index. If the options are held to expiration, the future is settled at expiration as the debit or credit difference between the price paid or received for the future and the value of the index on expiration day. This is of little value to an investor or buyer who wants an actual cash bond in his account. Index options and futures are useful as hedging instruments but not as a pseudo-purchase, especially in a market such as municipals, with thousands of names, credits, coupons, and maturities.

There is more value to the purchaser of a cash call option; the buyer will pay more for it than an index option, because it is a substitute for the purchase of a real and specific article. These are reasons to believe that a cash option will out-trade an index or futures option.

Whatever stigma may be attached to an issuer selling warrants is unjustified. The MAC experience was an experiment that was tried before its time. The two problems it exposed -- the warrants covered too long a period, and the interest rate exposure wasn't hedged -- can be solved. An issuer can use warrants not as a gimmick to push a difficult product but as an intelligent means to lower the cost of borrowing capital. At the same time, an issuer can offer a useful product to the investing community, one that expedites the timing of purchase commitments and the availability of product.

Steven Kowal is director of research and trading for Tap Works, a commodities trading advisory firm. Before that, he was a vice president and municipal bond trader at Marine Midland Bank.

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