Understanding Residual Interest Bonds (RIBs): Higher Yields with Increased Risk

A Residual Interest Bond (RIB) is a specialized form of municipal bond that divides income into two segments, generating a residual inverse floating-rate bond and a primary direct floating-rate bond. RIBs offer higher current yields but carry an increased risk, making them primarily owned by financial institutions. Municipal bonds, including RIBs, come in different types, such as general obligation bonds and revenue bonds, each with varying risk profiles. RIBs aim to enhance yields and assist portfolio managers in managing their portfolios.

Basics

A Residual Interest Bond is a specialized form of municipal bond created by dividing income from a municipal bond into two distinct segments. This split generates a residual inverse floating-rate bond and a primary direct floating-rate bond.

Understanding Residual Interest Bonds

RIBs function as bifurcated municipal bonds, consisting of a residual inverse floating-rate bond and a primary direct floating-rate bond. The residual inverse piece operates in an inverse relationship to a reference interest rate, such as the London Interbank Offered Rate (LIBOR). Income generated by the municipal bond is utilized to pay the coupon on the direct floater, with any surplus revenue directed towards the residual interest bond.

Purpose of Residual Interest Bonds

RIBs serve the primary purpose of offering higher current yields to buyers. However, as rates on municipal bonds increase, RIB holders might experience a decrease in bond value on the secondary market due to the lowered coupon or yield. The risk associated with RIBs is heightened, as the holder of an inverse floater is exposed to the entire downside risk of the underlying bond.

These bonds are designed to augment yields and aid portfolio managers in managing the maturity profile of their portfolios. Due to their complexity and potential volatility, RIBs are primarily owned by financial institutions rather than retail investors.

Municipal Bonds and Their Types

Municipal bonds are debt securities commonly utilized by government entities—such as states or municipalities—to fund significant expenses. These bonds are issued to investors at a predetermined interest rate and are typically exempt from federal taxes, and sometimes from state taxes as well.

Types of Municipal Bonds

• General Obligation Bonds (GO): Backed by the issuing entity, GO bonds are supported by the government's regular functions, like tax collection, providing a higher level of security.
• Revenue Bonds: Utilize revenue generated from a specific project to back the bond. For instance, if a state issues bonds to fund a toll highway's construction, toll revenues contribute to the bond's repayment.

A residual interest bond can exist in the form of a general obligation or a revenue bond, affecting an investor's risk tolerance based on the different risk profiles of the two types.

Conclusion

Residual Interest Bonds represent a complex form of municipal bonds aimed at elevating current yields. By creating inverse floating-rate bonds alongside primary direct floating-rate bonds, RIBs offer higher interest rates but also amplify the associated risks. These bonds serve to enrich yields and aid portfolio managers in their management strategies. Municipal bonds, on which RIBs are based, come in two primary types—general obligation bonds and revenue bonds—each carrying distinct risk profiles that cater to different investor preferences and tolerance levels.