A type of derivative contract in which the underlying is a municipal financial instrument, municipal index or portfolio, etc. Municipal derivatives were originally introduced to meet the requirements of municipal bond mutual funds. Over time, their use expanded to accommodate the financing needs of non-sovereign government entities and investors in their debts. Most local government debt is exempt from federal taxation, and hence sellers of municipal derivatives embark on this distinct feature in marketing these products. In recent years, a number of municipal derivatives have been created from the basic fixed-rate municipal bond.

Essentially, a municipal derivative is created by splitting up a fixed-rate bond into two parts (tranches): a floater and an inverse floater. While the interest and principal payments of the issuer don’t change with this process, the splitting up of interest payments between the floater and the inverse floater might vary over the life of the bond. The coupon rate paid on the floater is a variable rate (it is reset based on the outcomes of a Dutch auction), while the rate paid on the inverse floater is the difference between the fixed rate paid on the original bond and the amount paid on the floater.

These two bond classes have been given the name derivative securities because they derive their value from the underlying fixed-rate municipal bond. Examples of municipal derivatives include: INFLOS, M-Beddo, municipal swaps, and so on.