Municipal issuers barred from advance refundings by federal regulations have found a new way to make derivatives accomplish the job.

Last month, the Modesto Irrigation District Financing Authority in California wrote a call option that garnered the benefits of a refinancing on $116 million of debt that could not be advance refunded.

Although stand-alone call options are common in the equity markets, fixed-income players generally confine themselves to embedding call options in new bond issues.

Over the past year, some municipal issuers have used an interest rate swap to synthetically capture the savings of an advance refunding. But Modesto officials said they felt more comfortable using the option method.

"It's difficult to explain a swap to our board. They have a lot of questions," said Robert De La Cruz, the authority's treasurer. "But this transaction made everything look like an advance refunding. It was much more straightforward."

An option writer sells an option to an investor for an up-front premium on some security or commodity to be delivered in the future at a preset price. A call option writer agrees to sell the investor something at a preset price, while a put option writer agrees to buy something from the investor at a preset price.

Twice, Modesto had already advance refunded its outstanding bonds, carrying coupons of 6.80% to 7.25%, and the Internal Revenue Service prohibits a third advance issue.

But with current rates well below the rates on the bonds, a savings opportunity existed.

Lehman Brothers designed a transaction to allow the district to capture the savings without violating the advance refunding limit. The firm calls the product the Call Hedging Option Program.

First, Lehman structured and priced a $134.9 million mock advance refunding, complete with serial and term bonds, coupons, call provisions, and insurance from Municipal Bond Investors Assurance Co. The yields on the mock bonds, from 3.75% to 6.00%, reflect the rates the district would have paid if it could have issued refunding bonds in the current market.

Given the rates on the mock issue, the district could have generated about $8 million of present-value savings, Lehman officials said.

Then Lehman designed an option on the entire mock issue. The option, first exercisable just before the call date on the $116 million of outstanding bonds in 1996, allows the holder to purchase a $134.9 million bond issue from the district. The option expires after five years. The terms of the bonds are identical to the mock refunding issue's terms.

For example, the mock issue included $5 million of four-year bonds with a yield of 4.70%. The option includes the same $5 million of bonds, issuable in 1996 and due in 2000.

The district sold the option to Lehman for an up-front fee of about $8 million, equal to the savings it would have gotten if it had done an ordinary advance refunding. Lehman paid about $2.6 million immediately, with the remainder put in escrow at the authority's request until the option is exercised or expires.

Lehman sold the option to two institutional investors for an undisclosed sum.

In 1996, near the call date of the outstanding bonds, the investors may or may not exercise their options. Regardless, the district has captured the savings of an advance refunding.

If rates are higher in 1996, the mock issue of bonds will be worth less than when the option was written and the investors would be unlikely to exercise the options. Modesto's current $116 million bond issue would remain outstanding.

But if rates are lower in 1996, the mock issue of bonds will be worth more and the investors would be likely to exercise their options. Modesto would issue $134 million of new bonds, adhering to the terms and yields in the option documents, and use the proceeds to call the old $116 million issue.

Although the $134 million of bonds would be issued at rates above the then current rates, the district would be in the same position if it had done an ordinary advance refunding this year.

"You can play a lot of what-if games, but rates are lower than they have been in a long time," said the authority's treasurer, De La Cruz. "We set a target for savings and we met it doing this type of transaction."

For investors, the option helps hedge against reinvestment risk, according to Lehman Brothers officials.

An investor may have high-coupon bonds maturing or pre-refunded bonds being called away in the next few years. Either way, the investor must reinvest the returned principal. The investor knows today when the money will be returned but doesn't know what rates will be available for reinvesting in the future.

If rates are higher when the principal is returned, the investor can reinvest at high rates. But if rates are lower, the investor will have a big dropoff in income after reinvesting.

"The option allows the investor to hedge against reinvesting in a low rate environment," said Gary Gray, managing director at Lehman Brothers. "They know they will have the assets roll off and [with the option] they know the minimum rate they have for reinvesting."

The district also considered a synthetic refunding using a swap and forward bond issue. At first, both transactions would have met the district's savings target. But since the municipal market outperformed the Treasury market in the second quarter, the swap became more expensive and the district opted for the option deal.

The value of the option is more than the amount Lehman paid the authority, market participants said. Lehman profits by buying the option for about $8 million and selling it to investors at its theoretical value.

"Obviously, we wouldn't be buying an asset whose value is less than what we're paying," Lehman's Gray said. "In a new market, there will be differences among participants as to what this asset will be worth."

Gray declined to reveal how much Lehman sold the option for, but said that the authority was told the price.

The value of most options can be derived using the Black-Scholes pricing model. The model requires five variables: the current value of the underlying security, the exercise price, the time until expiration, the interest rate on a "risk free" investment, and the expected volatility in the value of the underlying security.

The amount by which the current value of the underlying security exceeds the exercise price is known as the intrinsic value of the option. All other things being equal, the model values the option higher the longer the time until expiration, the higher the "risk free" interest rate, or the higher the expected volatility.

Since Modesto's mock bonds were priced at the current market value, the intrinsic value of the option was probably zero, market participants said. But given the long time until expiration and the high volatility in the current market, the option still has considerable value.

Several other issuers are considering the sale of a call option to capture the savings of an advance refunding, market participants said. And at least three other firms in addition to Lehman are said to be shopping similar structures to issuers.

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