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New Products Changing the Face of Muni Bonds

April 04, 1993|KATHY M. KRISTOF

As demand for municipal bonds skyrockets amid concern about possible tax increases, Wall Street investment houses are concocting a variety of new--but complicated and potentially risky--muni bond products.

These new products--generically called "derivatives"--are attractive because they can boost lackluster yields. But they're also introducing new risks to the once safe and simple municipal market, industry experts say. Moreover, where derivatives were once purchased only by sophisticated institutional investors, they're now being introduced to retail customers as well.

Merrill Lynch, for example, the nation's biggest retail brokerage, says it recently started selling an "inverse floater" to savvy individuals. Risk-adverse amateur investors may have inadvertently picked up some of these risky securities through municipal bond mutual funds, which buy them to boost their reported yields.

Mutual funds purchased about $4.8 billion in inverse floaters--the most popular derivative product--during 1992, says Zane Mann, editor of the California Municipal Bond Advisor in Palm Springs. That accounts for less than 5% of the municipal market, but it's up from virtually nothing a few years ago, he notes.

Inverse floaters are not inherently bad, says Chris Mier, first vice president and co-manager of Kemper Financial Services' municipal bond funds. But investors would be wise to find out about them, because they definitely change the risks of municipal bond investing, and they seem to be here to stay.

What is an inverse floater? It's a municipal bond that's been cut in two pieces--one short-term and another long-term. The short-term piece is similar to a 28-day certificate of deposit. It pays whatever the market demands--right now, about 2.5%--for 28 days. Then the rate is adjusted to conform with current market rates, and it's sold again. Just like a short-term CD or Treasury.

It's the long-term side that's complicated--and attractive to mutual funds. The long-term side starts out just like any other municipal bond. It's tax-favored, usually guaranteed by a state or local government, and usually of a 30-year maturity.

Where it differs is in the rate. The rate starts out fixed, but the long-term investor gets an interest rate "kicker" that amounts to the difference between the short-term rate and the long-term rate, minus a management fee taken by the investment bankers.

To illustrate, consider a bond issued at 6%. Investment bankers take it, cut it in half. They sell one half as short-term paper at 2.5%. They take a 0.25% management fee for their trouble and then sell the other half of the bond to a mutual fund as an inverse floater.

In the first month, the bond yields 9.25%, which is the 6% rate plus the 3.25% difference between the price of the short bond and the long bond. Next month, if short-term rates rise, the institution gets less, because the "kicker" may drop to, say, 3% instead of 3.25%. But if short-term rates fall, they get more.

Sounds great? Here's the downside. If short-term rates spike, the interest rate kicker may evaporate completely. Theoretically, the buyer of the long-term bond might even have to pay part of his yield to the buyer of the short paper.

But in reality, most institutions get automatic "calls" that give them the right to buy the short-term portion of the bond if interest rates go against them, which limits their interest rate risk. Still, since investment bankers take a healthy fee to manage this deal, these bonds generally yield less than the average municipal if they're sold without the kicker.

Worse still, the secondary market for inverse floaters is highly volatile. When interest rates go against you, the inverse floater gets hit twice as hard as the average municipal bond, says Mier. When interest rates go in your favor, the price of an inverse floater will rise, but not at twice the rate of a regular muni.

Merrill's floater is even more complex.

It's part of a Puerto Rican triple-tax-free issue. It's privately insured and earns a triple-A credit rating. To limit the risk a bit, Merrill has put in a 3% floor on the long-term rate.

After that, the explanations get sticky, because investors who buy this floater are essentially buying both sides of the bond. Normally, buying both sides would cause you to reassemble the original muni and end up with something that looks familiar. But it doesn't work that way in this case.

Here you actually get two securities, one with a short-term rate and one with a long-term rate. But they both mature in six years. The result is a medium-term muni with a higher than average yield when short-term rates are low and a lower-than-average yield when short-term rates rise. Thanks to some of the bells and whistles Merrill has added, this bond isn't quite as volatile as the average inverse floater. But it's a lot more volatile than the average six-year municipal.

How do you know if your municipal bond fund is buying into inverse floaters?

You've got to ask, says Mier. Brokers should be able to answer the question if you invest in a load fund, and investor service representatives should be able to fill you in if you're in no-load funds, he says.

But you can't expect to see disclosures about inverse floaters in proxy statements or annual reports because there's no specific requirement that this information be disclosed, he says.

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