What are Residual Interest Bond (RIB)
Residual interest bonds (RIBs) are securities created when income from a municipal bond is divided into two segments. The first is a residual interest, floating-rate bond. The second is a primary-direct, floating rate bond. The resulting floaters will reverse relationship to a reference interest rate such as 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.
A residual interest bond is also known as an inverse floater or inverse floating-rate bond.
BREAKING DOWN Residual Interest Bond (RIB)
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 which 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 for these securities is elevated. An investor who holds an inverse floater maintains all of the underlying bond’s downside risk.
RIBs were first created in 1990 by Shearson, an investment banking firm. The goal of RIBS is to enhance yield and 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 individual investors.
What is a Municipal Bond
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. There are two main types of municipal bonds. With a general obligation 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 to pay the bond off.