Inverse Floaters: Attractive Yield But Beware Of The Risks

by: Columbia Threadneedle Investments

Summary

A look at how inverse floaters work.

Two examples: one positive, one negative.

Beware of the risks in a rising rate environment.

Where do we stand on the effectiveness of inverse floaters?

By Chad Farrington, CFA, Head of Municipal Bond Credit Research and Senior Portfolio Manager

Many municipal 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, short-term 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 above-average 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 an inverse floater makes investment sense. In this paper, we will provide readers with an understanding of how inverse floaters work and will illustrate two performance scenarios to help investors recognize the risk-return tradeoffs these securities provide.

What is a TOB program?

A TOB program is typically initiated by an institutional investor, such as a mutual fund, and implemented by a bank. Prior to passage of the Volker Rule as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the bank provided credit enhancement and remarketing services for the short-maturity variable-rate securities that represented the institutional investor's leverage. The initiating investor used 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," was sold to money market mutual funds with daily or weekly interest rate resets. Market participants are currently working on adjustments to the structure to fit within the new regulatory framework, but the key principal of borrowing money to buy longer maturing bonds remains the same. The residual amount of income (interest earned on the longer bond less interest and fees due on the shorter floater) is retained by the institutional investor. The longer maturity security held by the institutional 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.

Exhibit 1: Inverse floater structure (initial setup and annual cash flow - excludes price)

This illustration is hypothetical and is not meant to represent any specific investment or to imply any guaranteed rate of return.

The profitability of this transaction is materially enhanced when the yield curve is steep, 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 for the holder of the inverse floater. This equates to a 9.3% yield on the original $5 million investment.

In this basic illustration, one missing component is price. Since only high-quality bonds (typically defined as rated AA or better) are eligible for purchase in a TOB, the 5% coupon bond in our example would have to be purchased at a significant premium in today's low-rate market. While this premium provides some cushion in the event of an increase in interest rates, the natural amortization of the premium over the remaining life of the bond will subtract from the total return an investor receives.

This can be seen in Exhibit 2, which assumes no change in market interest rates and a holding period of six months. As shown, placing a long-term fixed-rate bond in a TOB, if rates remain unchanged, provides an investor with an additional 100 basis points (bps) (a basis point is one one hundredth of one percent) of total return over holding the same bond with no leverage. Of course, if interest rates were to move lower over the six months, the longer duration of the TOB would result in even greater outperformance.

Exhibit 2: Inverse floater may add to total return (no change in interest rates)

* Issued 3/25/15
Assumptions: No change in interest rates; six month holding period.
Underlying bond: Dallas Texas Waterworks and Sewer System - 5% coupon bond due 10/1/2044 with a 10/1/2025 par call.
This illustration is hypothetical and is not meant to represent any specific investment or to imply any guaranteed rate of return.
Source: Columbia Management Investment Advisers, 05/15

However, Exhibit 3 clearly shows the risk inherent in inverse floaters. If interest rates increase by 50 bps across the entire yield curve, the loss associated with using the inverse floater is close to double that of the bond without leverage. Given that we are near historic lows in rates and the Federal Reserve is getting closer to moving the Federal Funds rate higher, there may be greater chance for interest rate volatility over the next six months. Interest rate moves of 50 bps or more in six months or less have not been uncommon in recent years. In less than four months, between April and late-July 2012, the 30-year benchmark Municipal Market Data (NYSE:MMD) rate decreased by 56 bps. Between May and September 2013, the 30-year benchmark Municipal Market Data (MMD) rate increased by 167 bps (source: Thompson Reuters). So it is possible to see fairly large changes in interest rates that can result in significant losses to inverse floater investments.

Exhibit 3: Inverse floater may result in a loss (increase in interest rates)

* Issued 3/25/15
Assumptions: 50bps increase in interest rates across entire curve; six month holding period.
Underlying Bond: Dallas Texas Waterworks and Sewer System - 5% coupon bond due 10/1/2044 with a 10/1/2025 par call.
This illustration is hypothetical and is not meant to represent any specific investment or to imply any guaranteed rate of return.
Source: Columbia Management Investment Advisers, 05/15

Where do we stand on inverse floaters?

Inverse floaters have been a profitable investment for many municipal bond mutual funds in recent years, as the steep yield curve provided cheap leverage while an almost steady decline in rates favored longer duration fixed-income investments. In the context of a large, diversified portfolio, employing a modest amount of leverage can make some sense, especially if the investment team's outlook for rates is fairly docile and the overall contribution to duration is not large. Although some mutual funds may attempt to hedge away the extra duration risk by using U.S. Treasury futures, interest rate swaps or other derivatives, history has demonstrated periods when these hedging instruments can be less than effective, particularly when they are needed most.

Although high-yield municipal bond funds are often thought of as the vehicles most exposed to credit risk, many such funds also take unexpected and outsized interest rate risk via their significant inverse floater holdings. When interest rates begin to normalize, the theory that credit exposure partially mutes interest rate sensitivity - since higher coupons and wider spreads help to dampen bond price declines when interest rates rise - could be tested for many of these funds that have large inverse floater positions. Therefore, investors should be aware of the risks, beyond credit, that have the potential to create total return volatility.

Important disclosure

The views expressed in this material are the views of Chad Farrington through the period ended May 28, 2015, and are subject to change without notice at any time based upon market and other factors. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. This information may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable. Past performance does not guarantee future results.

This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon and risk tolerance.

Income from tax-exempt municipal bonds or municipal bond funds may be subject to state and local taxes, and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal income tax rules will apply to any capital gains.

The fund's use of leverage allows for investment exposure in excess of net assets, thereby magnifying volatility of returns and risk of loss.

A rise in interest rates may result in a price decline of fixed-income instruments held by the fund, negatively impacting its performance and NAV. Falling rates may result in the fund investing in lower yielding debt instruments, lowering the fund's income and yield. These risks may be heightened for longer maturity and duration securities.

Diversification does not assure a profit or protect against loss.

Credit ratings typically range from AAA (highest) to D (lowest) and are subject to change.

Duration: A measure of the sensitivity of the price of a fixed-income investment to a change in interest rates.

Disclosure: None