Harried bond buyers offered a guarantee on principal

Picture the poor bond buyer: Interest rates have skyrocketed, dropping some portfolios by more than 30 percent in recent years. Long-term bonds are yielding 15 percent, while tax-exempt municipal bonds are in the 13- to 14 -percent range. Both make yesterday's yields and bond purchases look like so many autumn leaves. It's no wonder bond buyers have been a skittish lot recently.

To try to entice them back, Wall Street has hatched a new product. It's called an "option tender bond." In brief, it gives an investor the guarantee that no matter how high interest rates go, he can recapture his principal after five years, assuming there has been no default. The buyer is fully protected against any loss of principal by a letter of credit, guaranteed by Citibank. In fact, after five years on every Feb. 2, the individual will have the option to redeem, or tender, his bonds. Thus, the investor receives a high-yield, tax-free bond and an unusual liquidity feature.

So far, Kidder, Peabody & Co. and Citibank, the progenitors of the idea, have issued "option tender bonds" worth $250 million for five municipalities. In their latest deal, the investment bankers have successfully floated a $150 million single-family mortgage revenue bond, due Feb. 1, 2013, for the Brevard County, Fla., Housing Finance Authority.

According to Thomas Becker, vice-president of public finance at Kidder, Peabody, the bonds were oversubscribed within 24 hours in a weak bond market. More important, the interest rates were more favorable for Brevard County than they would have been without the option: The bonds sold with a 9 percent coupon rate, compared with 11 1/2 for similar AA- rated bonds. The county will then offer mortgages to home buyers at a 10.95 percent interest rate. Again, this is almost 1 1/2 percentage points below the mortgage rates on nonoptioned bonds. "This will help to ease the burden on monthly payments for consumers," Mr. Becker notes.

(The four other issuers of optioned bonds have also floated bonds below the market rate for comparable bonds. In December, for example, some $100 million worth of bonds were sold with a 9.5 percent coupon rate, compared with a market rate of 12 percent for similar bonds. Wall Street traders say other investment bankers and banks are considering similar types of deals.)

The added cost to Brevard County comes in the form of a letter-of-credit fee it pays Citibank. According to Martin J. McCormick, vice-president of Citibank, this comes to about 90 basis points per year, or $1.3 million. The county recoups this cost, however, as it does most of the rest of its expenses, in the difference between its borrowing cost and the lending cost.

The only party with a risk is Citibank. With the letter-of-credit fees, Mr. Becker says, Citibank has to set up hedges against "the worst scenario happening." The worst would be massive inflation and a huge redemption of the bonds after five years.

For its part, Citibank will not say how it is protecting itself from such a situation. The bank is vague, in part, because it has a virtual monopoly on these issues and feels its strategies are "proprietary" information.

One source close to the bank, however, says that it feels "comfortable with the risk," feels the compensation is appropriate, and doesn't need to go outside of the issue itself to protect itself. Should the bank have a large number of redemptions, the source says, it could just absorb the underlying securities, the mortgages themselves, as one fallback.

Another possibility is for the bank to reissue the securities, based on market value, and take some losses. Any information on how much pain the bank can stand, however, is considered "proprietary."

The bank also says it hasn't set any limit on the amount of such issues it will underwrite, although Mr. McCormick says that "it's not unlimited; we are looking on each transaction on an individual basis." Citibank should reap a nice reward for its efforts. So far, it will collect just under $2.25 million per year, or about $11.25 million before any redemptions.

If interest rates should break, investors in the bond markets could make a killing. This is a view suggested in Business Week, in its Feb. 16 issue. "Some experts . . . believe that when the interest rate dam breaks, bonds could appreciate as much as $300 per bond with a face value of $1,000," the magazine says. It goes on to tell its readers how to play the bond markets. Of course, if interest rates don't break . . . .

Blue chips helped lead the way last week as the market staged a small rally. The Dow Jones industrial average tacked on 5.03 points, closing at 952.30, its highest level in about two weeks. Volume was moderately active. Among the blue-chip leaders were American Telephone & Telegraph, General Motors, and Sears , Roebuck. Harcourt Brace Jovanovich was active and higher after Warner Communications said it had purchased 380,000 of the company's 4.4 million shares outstanding.

Although there was little in the news background to influence prices, analysts said investors were watching for signs in Washington that the new administration can pare the budget.Eileen E. Spinner of Smith Barney, Harris Upham & Co. noted that "skepticism about the administration's budget-cutting abilities intensified" after President Reagan's television speech provided few details of where the cuts would be made.