FHLB bond - too good to be true?

[ganda]

Opinions sought please.

Bond broker is offering me:

Coupon: 7.25% **

7.25% for 5 years (6/21/09)
10.00% for 5 years (6/21/14)
& 20% thereafter ...

FHLB (Federal Home Loan Bank) United States Government Agency Bond
AAA/AAA Rated (Moody's/S & P)
Maturity: 06/21/19
Price: 100
Callable: 09/21/04@100 and quarterly, thereafter.
Payable: Quarterly
FEDERALLY TAXABLE, STATE TAX-FREE.

**This Bond acts like a daily floater. If 6 month Libor is at or below 8.00%, the bonds will accrue at 7.25%, If 6 month Libor is above 8.00%, the bond will accrue at 0% for that day. The investor will receive coupon payments quarterly.

6 Month LIBOR (London Inter-Bank Offer Rate) is currently 1.59%.

This investment constitutes an interest rate risk, NOT, a credit/principal risk!

Now, this looks too good of a deal. No such thing as a free lunch and all that. What am I missing?

I know rates are rising but about 8% is pretty damn high and I can't imagine rates staying up there for prolonged periods. I don't understand "NOT, a credit/principal risk" - surely even an FHLB can go bust?

 

[JWR1945]

Welcome to the world of derivatives.

I have no specific knowledge about this investment.

If I understand this, you would be taking some of the interest rate risk that FHLB would like to avoid. That would permit FHLB to lock in a profit.

I can easily imagine LIBOR rates of 8% or more. That doesn't have to happen right away.

Notice that these instruments are (in effect) always callable. FHLB can use them to match up with actual mortgage redemptions.

The ability of home owners to hold onto or payoff (via refinancing) a mortgage is why mortgage backed securities have a higher-than-typical interest rate. To the extent that FHLB can get rid of that kind of risk, their long-term outlook (i.e., solvency) is improved. They are willing to give away a little bit of the upside in order to stay in business.

Have fun.

John R.

 

[brewer12345]

There is little or no credit risk because the FHLB is backed by the US Gummint. What there is a boatload of is interest rate risk, and it is risk that is a little screwy. Whay you are looking at is a relatively high-coupon note with an embedded interest rate derivative. It is something like a wonky inverse floater or a bond coupled with a swaption. Basically, you make out if rates stay under 8% and you get killed if rates go up too much. One thing you can be sure of is that you are almost certainly not being paid enough for the option you are granting the FHLB. That's why these structures (almong with callables, etc.) are offered very commonly to consumers: retail buyers don't understand how to properly price the option they are granting to the issuer of the note and therefore the issuer gets something for free at the consumer's expense.

Unless you have access to a bloomberg terminal and a pretty good understanding of interest rate derivatives, buy something else, preferabley a straight non-callable bullet.

 

[Nords]

Re:  In other words...

... if you're not nodding your head in agreement upon encountering terms like "wonky inverse floater", "swaption", "bloomberg", "interest rate derivative", and "straight non-callable bullet", then don't buy anything of this ilk until you're able to write posts like Brewer's.

But the fact that someone like FHLB is selling bonds and someone like Brewer wouldn't buy them is all you need to know to stay away from this "option".

 

[ganda]

Did someone just call me a moron?

(joke)

Seriously, thanks for the input.

 

[haha]

Did someone just call me a moron?

If so, then we all other than Brewer are morons. I think it was more an admonition-"Don't take your guns to town, son..."

Mikey

 

[brewer12345]

Guys, I am certainly not trying to hold myself out as an expert on this kind of thing. I just know enough to know when I am out of my league, at least given the amount of work I'm willing to do. Having seen how the industry works, I can tell you that this is not a deal (or even fairly priced) for the retail buyer, without doing all of the extra work necessary to give you an exact number. Remember, one of the top 5 reasons I want to FIRE is that I am lazy. ;}

 

[charlie]

Good for you, Brew. I look forward to your
commentary in the future. It sounds like you
have been there and done that!

Cheers,

Charlie

 

[brewer12345]

Good for you, Brew.  I look forward to your
commentary in the future.  It sounds like you
have been there and done that!

Cheers,

Charlie  

Unfortunately, I haven't "done that" as far as retiring early goes, but I am getting there. Just another 15 or so years to go (sigh).

 

[bongo2]

Just for reference 6-month LIBOR was at 7% as recently as 2000, and over 8% for basically all of the 80's.

Is this likely in the next ten years? I don't think so, but there is a chance.

I might think about trying to figure this bond out if it weren't continuously callable. If it ever becomes a good deal it will just be called away.

If rates go up, but remain less than 8%, the value of this bond may still drop a lot. The premium you are getting (7.5% - LIBOR) will go down, and the likelihood of no accrual will go up.

Derivative pricing is very difficult, and not intuitive. People who do this have PhD's and computers to tell them what something like this is worth, and there is no good way for a layman to figure it out. It smells like something that was carefully designed to be a bad deal, but look like a really good deal.

 

[wzd]

A different twist or way of looking at this. The structure - payment at 7.25 if LIBOR is below 8 and 0 if above - sounds very much like an insurance policy. The FHLB is looking for people to provide insurance to them. Now I buy insurance for low likelyhood events, but I am and will not be an issuer of insurance.

Yes, it may be unlikely. But the return you get above the market for a normal bond is the "insurance premium". If the rates go up, of course they will not call the bond, and you are stuck with a pot of money tied up getting no interest payments. I notice no term for the bond other than "thereafter". This means you are stuck with it for an indefinite period - until rates drop below 8% at which point you will get nice juicy payments at 10% or 20%....NOT. The bond will get called and you will get your principal.

I suspect the 10% and 20% payouts would never ever occur. Think about it! They look great on the marketing brochure, but if they have to pay it, they simply can call the bond and sell more new ones at 7.5% to someone.

Wayne

 

[John Galt]

Wayne has a good take on this, i.e. anything
continuously callable can be quoted with as high a rate
as the issuer wishes. Why should they care? They know they will never have to pay it. I have a bunch
of callable bonds, but I locked in a satisfactory fixed rate
going in and understood the risks.

John Galt