Risky new 'derivatives' haven't been tested yet


July 18, 1993|By JANE BRYANT QUINN

NEW YORK — New York--More money has probably been lost chasing higher yields than in all the world's investment scams. And today, the chase is on again -- this time for higher paying tax-exempt municipal bonds and bond mutual funds.

As interest rates drop, old tax-exempt bonds paying 8 percent to 10.5 percent are being recalled by their issuers. When you get the cash back to reinvest, you find that today's higher-quality munis yield only 5.3 percent. What a comedown. No wonder investors will listen to anyone offering something that pays more.

When buyers are in so receptive a mood, you can be sure that Wall Street will sell them something. The brokers' newest product: a class of weird, tax-free securities, paying more than everyday bonds. Right now, they're being sold mainly to people who manage tax-exempt bond mutual funds. But versions are already being offered to certain individual investors.

These new investments are broadly known as "derivatives." They're not actually muni bonds themselves; they're securities "derived" from munis. Some investors get the bond's income; others get its principal.

I'll spare you most of the gobbledygook, with one exception: The most widely held derivative is known as an "inverse floater." For every $1 invested in a floater, you win $2 if interest rates fall or lose $2 if rates rise, says Peter Allegrini, manager of the Fidelity Advisor High Income Municipal Fund.

That's investing in a nutshell. You'll get a chance at a higher return if you'll take a higher risk.

Tax-exempt derivatives earn pots of money any time short-term interest rates decline. In recent months, the mutual funds that bet on them have produced phenomenal returns.

If you're an investor who picks a tax-exempt mutual fund from the top of a performance list, you're doubtless neck deep in the "floaters" game, right along with your money manager.

As estimated 20 percent of tax-exempt mutual funds now use derivatives, says James Lynch, editor of the Municipal Bond Advisory based in New York City.

The question is, what will happen to these darling derivatives -- and to the mutual funds that own them -- when short-term interest rates run up? They'll lag many other investments, for sure. But by how much? No one knows, because these securities haven't been tested in a broad-based market decline.

If all the funds that hold them try to sell at once, the tiny market for derivatives will freeze up, Allegrini says. Fund investors might suddenly lose a large slice of their income or principal.

Lynch thinks that a big fund with no more than 5 percent in derivatives probably can weather a slump without too much pain. The more floaters a fund owns, however, the greater the trials for its shareholders.

It's all but impossible for you to learn how many floaters (or derivatives) your fund owns. You can try telephoning; someone might tell you. But positions come and go so quickly that truth today isn't truth tomorrow.

tTC It's not only the high-yield mutual funds that run a risk from derivatives. General tax-exempt funds own them, too, says Michael Lipper of Lipper Analytical Services in Summit, N.J. In fact, any tax-exempt fund that's well ahead of the rest of pack has probably earned at least some of its performance from these turbocharged investments.

Ian MacKinnon, head of Vanguard's fixed-income group of mutual funds, currently owns no derivatives, although he might sometime in the future.

Right now, he says, they're overpriced for the market risk that owners take. Only a handful of people understand them, or think they do, MacKinnon says. In his opinion, "they're totally inappropriate for individuals, and probably inappropriate for most institutional investors, too."

So far, most of these far-out securities go to professional investors. Soon, they'll be touted to a larger base of individuals, too. But no one should try to sell them to me. Like Will Rogers, I'm not so concerned about the return on my money as I am the return of my money. Tax-exempt mutual funds with a lot of derivatives haven't yet shown they can meet that test.

7+ (c) 1993, Washington Post Writers Group

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