What Is a Residual Interest Bond (RIB)?
Residual interest bonds (RIBs) are securities created when income from a municipal bond is divided into two segments. The two segments created are a residual inverse floating-rate bond and a primary direct floating-rate bond.
- A residual interest bond is a type of inverse floating-rate bond created by dividing the income from a municipal bond into two portions.
- These segments are an inverse floating-rate bond and a primary direct floating-rate bond.
- Residual interest bonds enable municipal bond funds to promise higher current yields to their buyers.
- Because of their high level of sophistication and potential volatility, most RIBs are owned by financial institutions instead of individual investors.
- The goal of RIBS is to enhance yield and assist portfolio managers in controlling the maturity of their overall portfolio.
Understanding Residual Interest Bonds
A residual interest bond (RIB) is a municipal bond that has been split into two segments. The first segment of a RIB is a residual inverse floating-rate bond and the second segment is a primary direct floating-rate bond.
The resulting inverse piece will have a reverse relationship to a reference interest rate, such as the London Interbank Offered Rate (LIBOR). The income from the municipal bond is then used to pay the coupon on the direct floater, and any remaining revenue will go toward the residual interest bond.
Purpose of Residual Interest Bonds
RIBs enable municipal bond funds to promise higher current yields to their buyers. As rates on municipal bonds rise, holders of RIBs will own bonds that pay a lower coupon, or yield. This dropping yield drastically reduces the price of the bond on the secondary market.
Buyers of residual-interest bonds receive a higher interest rate than a conventional municipal bond would provide. However, the risk of these securities is elevated. An investor who holds an inverse floater maintains all of the underlying bond's downside risk.
The goal of RIBS is to enhance yield and to assist individual portfolio managers in controlling the maturity of their overall portfolio. Because of their high level of sophistication and potential volatility, most RIBs are owned by financial institutions instead of by retail investors.
Municipal Bonds and Residual Interest Bonds
A municipal bond is a type of debt security commonly used by government entities such as states or municipalities as a means of financing large expenses.
For instance, Springtown needs to raise $5 million so the town can perform much-needed updates to its elementary school. The town releases $5 million worth of municipal bonds that investors can purchase, to be paid back to the investors at a predetermined interest rate. Municipal bond income is usually exempt from federal taxes, and sometimes state taxes as well.
Types of Municipal Bonds
There are two main types of municipal bonds: general obligation bonds and revenues bonds. With a general obligation (GO) bond, the bond is backed by the issuing entity. A revenue bond uses revenue from the project itself to back the bond. For instance, if a state releases bonds in order to fund the construction of a new toll highway, the money collected from tolls would help pay back the bond.
A general obligation bond is fully backed by the issuing entity and the payments made from its normal government functions, such as the collection of taxes. A revenue bond, on the other hand, only makes payments from the income generated by a specific project. If the project fails or if the income is not significant, then payments on the bond can be impacted. It is for this reason that revenue bonds carry a higher risk but also pay a higher yield.
A residual interest bond can be either a general obligation bond or a revenue bond, as this does not matter to the investor except for the different risk profiles of the two, which they would choose depending on their risk tolerance.
What Is Residual Interest?
In fixed income investing, residual interest refers to income that remains after primary obligations (such as more senior tranches) are paid off. In a strip bond, the zero-coupon bond that results is separated from the interest payments is also known as the residual.
Why Are Bonds Stripped?
Stripping a bond decomposes a security into its pieces. For example, a bond can be stripped so that its interest (coupon) payments become one piece while the repayment of the principal becomes a zero-coupon bond. This is done because some investors may want or require only one component without the other.
What Are the Main Types of Bonds?
Bonds are fixed-income securities that represent debt that must be repaid. These can come in many varieties, with some of the most common being issued by sovereign governments, corporations, and municipalities. These bonds are issued at varying maturities with either fixed or variable interest rates. They can also be structured with embedded options making them callable, putable, or convertible.
Bonds may also be stripped so that an investor only takes the coupon or principal portion of the debt. In addition, bonds can be collateralized (secured by assets) or unsecured, senior or junior, or repackaged into tranches. Indeed, the universe of bond types is large and varied.
Are Stripped Bonds Safe?
As with any bond, the riskiness of a stripped bond's components will depend on the credit quality of the issuer. A stripped government bond (such as Treasury STRIPS), for example, will be the safest of all stripped bonds.