Sometimes a security that's technically a derivative isn't complex, arcane, or volatile -- and Lehman Brothers says it has found one such structure safe enough even for retail clients.
The firm has established a program to divvy up blocks of prerefunded bonds into smaller securities suitable for purchase by retail investors.
The firm will use a secondary market trust, one of the tried and true structures from the derivatives market, for its new program, called Government Escrowed Municipal Securities Trust Asset Receipts, or Gemstars. But unlike most secondary market derivatives, the resulting securities will be registered with the Securities and Exchange Commission.
Under the Gemstar structure, Lehman will acquire large blocks of prerefunded bonds. Many such bonds were issued in denominations of $50,000 or $100,000, and a retail investor could not buy the bonds directly in smaller denominations.
Lehman then will sell the bonds to a special vehicle, a trust established for the Gemstar program. The trust will issue new securities in denominations as small as $5,000.
The trust will receive the tax-exempt principal and interest payments on the prerefunded securities. The money will be passed on directly to the Gemstar holders and will still be considered tax-exempt.
To help market the securities to small investors, Lehman will include retail-oriented and regional firms on the Gemstar deals. The other firms are needed because much of Lehman's retail brokerage force now works for Smith Barney Inc. as a result of the recent sale of Shearson Lehman Hutton.
In March of last year, Merrill Lynch sold a derivative product, a modified inverse floater with a minimum rate of 3%, to retail accounts. But the issue attracted the attention of the SEC and the product hasn't resurfaced.
The syndicate for the first Gemstar issue, backed by prerefunded bonds of the New York Local Government Assistance Corp., includes A.G. Edwards & Sons Inc., Dean Witter Reynolds, and Edward D. Jones & Co.
Lehman will place $65 million of prerefunded bonds originally issued in 1991 by the LGAC into a trust. The Bank of New York will serve as trustee. The trust will issue $75.9 million of receipts.
Lehman expects that the Gemstars will be rated Aaa by Moody's Investors Service, since they are backed by the Aaa prerefunded bonds.
The LGAC bonds carry coupons of 6 3/4% to 7 3/8% and originally matured in 2012 to 2021. But the bonds have been prerefunded -- backed by an escrow account of government securities -- and will be retired on their call dates in 2001 and 2002.
Since the bonds pay an above-market coupon and will be called at slight premiums to their initial par amounts, the trust can sell almost $76 million of receipts backed by $65 million of bonds. Also, some of the the Gemstars will have shorter maturities than the LGAC bonds.
The issue will be structured similarly to a typical serial bond offering. The securities will feature maturities from six months to almost eight years.
Under some circumstances, the trust would have to be dissolved. If, for some reason, the LGAC bonds defaulted -- a highly improbable event -- the trust would be dissolved. The LGAC bonds would be sold in an auction. The proceeds would be distributed pro rata to Gemstar holders and the Gemstars would be retired.
No Gemstar trusts will include prerefunded bonds that can be called earlier than the expected call date, Lehman said. Also, Lehman will not include bonds from any issuer that has previously attempted to call other issues of prerefunded bonds early.
Although the Gemstars in the first transaction will be identical to ordinary bonds, Lehman indicated in a filing with the SEC that it might include other types of securities in future deals.
A series of Gemstars may include two or more classes of securities that differ in the timing and amount of interest payments, the method for calculating payments, or maturity dates, the filing said.
The different Gemstars series may also feature different tax structures. Some issues may be designated partnership series. In that case, the Gemstar holders would be considered partners in the trust arrangement.
Alternatively, the Gemstars could be designated a strip series. In that case, the Gemstar holder is deemed to be the owner of a stripped bond or stripped coupon payment.
The LGAC-backed issue, for example, is a stripped series. Specific principal or interest payments are assigned to each maturity of Gemstars. The owner of the Gemstar maturing on April 1, 1995, essentially holds a portion of "stripped" coupons that will be paid on the LGAC bonds through that date.
Lehman's prospectus for the Gemstars includes a boilerplate warning about liquidity.
"There can be no assurance that a secondary market for any of the Gemstars will develop ... or that it will continue for the life of the Gemstars," the prospectus said. "The underwriter anticipates making a secondary market in Gemstars, but is not obligated to do so."