Interest Rate Chicken

Marilyn Cohen, Forbes Magazine, 04.29.02

Freddie Mac has notes that pay three to four points over the yield on investment-grade bonds. They are lucrative--but scary.

Remember the hot-rod game of chicken in Rebel Without a Cause, starring James Dean? Well, Freddie Mac has some intriguing debt instruments called Range Notes that challenge you to a game of interest rate chicken. I am going to put up a yellow light for these investments. You can make a nice return from them, but you can also get killed. Go in with eyes open.

Freddie Mac (nyse: FRE - news - people ) has outstanding some $5 billion of medium-term structured notes, "structured" meaning that you don't have a simple coupon. Example: the Freddie Mac structured note maturing Feb. 28, 2012, issued in January. The nominal coupon is 10.125% a year, about four points better than what you would expect on a ten-year Freddie. But you earn that 10.125% only on days when a money market interest rate (specifically, the three-month London Interbank Offered Rate, for dollar loans) stays below 7%. On days when Libor tops 7%, your coupon drops to 0%. Freddie Mac can call the note at any time after the first three months. I will explain in a moment why callability is an extremely significant feature of this note.

At the moment Libor is 2%, thanks to Alan Greenspan's efforts to revive the economy by dumping wheelbarrows full of currency on the streets. It is highly likely that short-term money rates will creep up over the next year or two. But they would have to move a full five percentage points before your coupon goes to zero.

At the moment, holders are happily pocketing the high coupon. Should you take a chance on a structured note? Maybe. But you should consider these five caveats.

First, don't for a moment think that this is a bond with a 10% yield and compare it to other yields available in the bond market. What you've got is a 6% bond coupled with a side bet in which you collect 4% for writing an insurance policy for Freddie Mac. The policy insures Freddie against the unlikely event that interest rates go haywire in the next decade. If they do, Freddie will come to you and collect on the policy, and that will hurt. Worst-case scenario (or almost worst): Interest rates, short and long, shoot to 10% tomorrow and stay there. Then your note turns into something scarcely better than a ten-year zero coupon bond, and that bond would have a market value of only 38 cents on the dollar.

Second, that call feature is bad news. By issuing paper like this, Freddie can watch what happens to interest rates for, say, the next year. If they stay fairly low, Freddie calls in the note and you collect your 4% insurance premium for only a year. If rates shoot up--if they get even close to the 7% trigger point--Freddie leaves the note outstanding, knowing that the odds are good it will collect something on its insurance policy. It's like a poker game in which Freddie has the option of folding after the cards are dealt, losing only the ante, but if you get dealt a bad hand, you have to put more money into the pot.

Third, know that if you want to play interest rate chicken, there are other ways to do it. Instead of buying one of these things, you could buy a conventional Treasury bond and then, using a small part of your funds, take a modest flier in the options market. For a bullish bet about the money market (that is, a bet that interest rates will stay low), buy a eurodollar futures option on the Chicago Mercantile Exchange. If you are right, you will make a nice profit. If you are wrong, your loss is limited to the option premium. Recently, a March 2003 call option on $1 million of three-month eurodollar deposits, with a strike price that assumes a 3.5% interest rate, would have cost you $325. If the eurodollar rate ends up at only 2.5%, your option would be worth $2,500 at expiration.

If you win your game of chicken, you will be better off at tax time with the option than with the structured note. Option gains are taxed at a blended short-term/long-term capital gain rate. The coupon on the Freddie Mac is pure ordinary income.

Fourth, liquidity can be low. Although there are a lot of structured notes outstanding, individual issues I have seen and participated in are relatively small, $15 million to $40 million. This means your chances of getting out before maturity at a good price are slim.

Fifth, think about who is selling you this note. Freddie Mac is not in the business of handing out excess returns to small investors. It is a good assumption that Freddie--or some bond trader who might be your immediate source of the note--has access to a fancy computer program that evaluates all the possible trajectories of the interest rate curve over the next decade and the probability of each. These guys might sell you the note for a price higher than its intrinsic value. They definitely will not sell it for less.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

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