Inverse floaters: Attractive yield but beware of the risks

by Chad Farrington, CFA, Head of Municipal Bond Research

> A look at how inverse floaters
> Two examples: one positive, one
> Where do we stand on their

Many tax-exempt bond mutual funds invest in inverse floaters, a component
of what is commonly referred to as a tender option bond (TOB) program. The
inverse floater strategy, in which a mutual fund borrows money at low, shortterm variable rates and invests the borrowings in higher yielding, long-term
fixed coupon bonds, is especially attractive when the yield curve is steep, as it
has been in recent years. Depending on the amount of leverage employed, the
additional income an inverse floater provides can be significant.
However, as with all investments that employ leverage, inverse floaters introduce
a significant amount of interest rate risk. While market rates are currently
hovering near historical lows, an increase in interest rates can result in severe
price declines for longer duration bonds, which can quickly overwhelm the aboveaverage yield provided by the inverse floater. An investor’s interest rate outlook
and the portfolio’s overall duration positioning are key factors that determine
whether or not inverse floater investments make sense. In this paper, we hope
to provide readers with a better understanding of how inverse floaters work and
will illustrate some performance scenarios to help investors better understand
the risk-return tradeoff these securities provide.

What is a TOB program?
A TOB program is typically initiated by an institutional investor, such as a mutual
fund, and is implemented by a bank. The bank provides credit enhancement
and remarketing services for the short maturity variable rate securities that
represent the initiating investor’s leverage. The initiating investor uses this
borrowed capital to purchase a longer maturing, fixed-rate bond, which is placed
in a TOB trust. The short-term variable rate debt, also known as a floater, is
sold to money market mutual funds with daily or weekly interest rate resets. The
residual amount of income (interest earned on the longer bond less interest
and fees due on the shorter floater) is available to the institutional investor. The
longer maturity security held by the investor is known as the inverse floater.

How an inverse floater works
An example of an inverse floater structure is outlined in Exhibit 1 and illustrates
a very conservative leveraging scenario. As illustrated, a $5 million investment
in a 5% coupon bond leveraged one-to-one can significantly increase the
portfolio’s yield, since the use of $5 million of leverage results in a $10 million
investment generating $500,000 of gross annual income. The profitability of
this transaction is materially enhanced when the yield curve is steep, as it is
today, allowing for very low short-term borrowing costs and considerably higher
long-term investment yield. In this example, the floater costs $32,500, leaving
$467,500 available to the holder of the inverse floater. This equates to a 9.3%
yield on the original $5 million investment.

5% coupon.20% -7.6 years Income yield 2. between April and late-July 2012. 07/01/22 par call This illustration is hypothetical and is not meant to represent any specific investment or to imply any guaranteed rate of return. However. six month holding period Bond Leveraged 1:1 in TOB Par amount invested $5 million $10 million Recent trade price/yield* $115.6 years Income yield 2. the 30-year MMD rate increased by more than 40 bps in December 2012.57% Price return -0.16% 3. if rates remain unchanged. provides an investor with an additional 94 basis points (bps: a basis point is one onehundredth of a percent) of return over holding the same bond with no leverage. the loss associated with using the inverse floater is close to double that of the bond without leverage.P. Exhibit 3 clearly shows the risk inherent to inverse floaters. Of course. due 07/01/43. Morgan) Underlying bond: LA Dept of Water & Power. if interest rates were to move lower over the six months.3% yield return This illustration is hypothetical and is not meant to represent any specific investment or to imply any guaranteed rate of return. Residual interest $467. 07/01/22 par call This illustration is hypothetical and is not meant to represent any specific investment or to imply any guaranteed rate of return. Morgan) Underlying bond: LA Dept of Water & Power. Exhibit 3: Inverse floater can result in a loss Assumptions: 50 bps increase in interest rates across entire curve. If interest rates increase by 50 bps across the entire yield curve. long rates have recently shown more volatility.57% Price return -4. the 30-year benchmark Municipal Market Data (MMD) rate decreased by 56 bps.02% * Actual MSRB trade 12/26/12 (J.7 years 13. resulting in fairly significant losses to inverse floater investments.03% -4. one missing component is price. given the Federal Reserve’s quantitative easing efforts. 9.61% -1. This can be seen in Exhibit 2. . the 5% coupon bond in our example would have to be purchased at a significant premium in today’s market.P. the natural amortization of the premium over the remaining life of the bond will subtract from the total return an investor receives. In this basic illustration.53/3. which assumes no change in market interest rates and a holding period of six months.INVERSE FLOATERS: ATTRACTIVE YIELD BUT BEWARE OF THE RISKS Exhibit 1: Inverse floater structure Initial setup and annual cash flow (excludes price) Floater Inverse floater (Mutual fund) on milli $5 ST debt costs $32. In less than four months. As shown.16% 3. It is possible that rapid moves lower could be reversed quickly.05 Duration-to-worst 7.08% Total return 1.53/3.49% * Actual MSRB trade 12/26/12 (J. due 07/01/43. Since only high-quality bonds. 5% coupon. While a 50 bps rise on the front-end of the curve is probably not likely anytime soon. While this premium provides some cushion in the event of an increase in interest rates.05 Duration-to-worst 7. Most recently.500. the longer duration of the TOB would result in even greater outperformance.7 years 13.40% Total return -2. placing a long-term fixed-rate bond in a TOB.55% 2. six month holding period Bond Leveraged 1:1 in TOB Par amount invested $5 million $10 million Recent trade price/yield* $115.1% $131. typically defined as rated AA or better.1% $131.500 $5 m illio n (Money market funds) $10 million 5% coupon bond in Tender Option Bond Trust Exhibit 2: Inverse floater may add to total return Assumptions: No change in interest rates. are eligible for purchase in a TOB.

the theory that credit exposure somewhat mutes interest rate sensitivity — since higher coupons and wider spreads help to dampen price declines when interest rates rise — could be tested for many of these funds that have large inverse floater positions.S. especially if the investment team’s outlook for rates is fairly docile and the overall contribution to duration is not large. Treasury futures.INVERSE FLOATERS: ATTRACTIVE YIELD BUT BEWARE OF THE RISKS Where do we stand? Inverse floaters have been a profitable investment for many municipal mutual funds in recent years as the steep yield curve provided cheap leverage and an almost steady decline in rates favored longer duration fixed-income investments. In the context of a large. Therefore. . Although the duration risk is often theoretically hedged away by using U. employing a modest amount of leverage can make some sense. history has demonstrated periods when these hedging instruments can be less than effective when they are needed the most. there are many funds that are also taking outsized interest rate risk via their significant inverse floater holdings. diversified portfolio. When interest rates begin to normalize. investors should be aware of the risks beyond credit that have the potential to create total return volatility. Although high-yield municipal bond funds are often thought of as the vehicles most exposed to credit risk. interest rate swaps or other derivatives.

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