Guidelines for effective uses of swaps in asset-liability management.

Editor's note: This article is reprinted with the permission of Fitch Ratings. The views expressed herein are the authors' and do nat represent the official position of GEQA or its standing committees.

The ongoing decline of interest rates has presented credit-worthy borrowers with exceptional financing opportunities. In this low interest rate environment, many borrowers have reduced their debt service costs by refunding outstanding debt and have financed new projects at very low costs. Lower debt service costs have also provided some budget relief. Simultaneously, low interest rates have affected returns on investments. The impact on tax-exempt borrowers with sizeable funds restricted to short-term fixed-income investments has been especially severe, as they repeatedly reinvest maturing principal at ever-lower rates.

Responses to the mixed blessings of the low interest rate environment have varied among tax-exempt borrowers and have to some extent depended on their management structure. Those that manage investments and liabilities separately may adjust only their investment policy without changing their debt policy or vice versa. These borrowers may also adjust both their debt and their investment policies-but in isolation.

Alternatively, in recognition of the potentially offsetting impact of interest rate fluctuations on certain assets and liabilities, some tax-exempt borrowers are adopting comprehensive asset and liability management policies. Such policies, which are more prevalent in corporate finance, incorporate coordinated investment and debt structuring decisions. The goal of such coordination is to use each side of the balance sheet to mitigate, or hedge, cash flow risks posed by the other side of the balance sheet.

Either as part of or separate from asset and liability management strategies, increasing numbers of tax-exempt borrowers have used interest rate swaps to hedge their exposure to interest rate fluctuations. They have used swaps to increase exposure to variable-rate debt through fixed-to-floating interest rate swaps and have hedged their exposure to variable interest rates through floating-to-fixed rate swaps. Although the current trend of increased use of interest rate swaps has developed during a period of declining interest rates, the use of interest rate swaps and other interest rate hedging products, such as caps and collars, is expected to continue even if the interest rate environment changes, as these products provide tax-exempt borrowers with financial flexibility not offered by traditional financing methods.

Fitch Ratings recognizes that, when used in the context of comprehensive asset and liability management strategies, variable-rate debt and interest rate hedges can enhance the finances of some tax-exempt borrowers. However, when used without a coherent strategy or by borrowers with finances that are already vulnerable, such financial products can result in adverse credit consequences. Furthermore, because many municipal swap features are both unique and relatively new, borrowers should consider carefully all assumptions underlying risk calculations.

The guidelines in this report are intended to inform municipal market participants of the factors that Fitch considers when analyzing the impact of variable-rate debt and interest rate swaps on debt issuer credit. Fitch finds that, while a number of elements may influence the credit impact of variable-rate debt and interest rate hedging products, the overall management framework is the most relevant indicator of future credit impact. Therefore, Fitch considers borrowers' policies and procedures for managing the benefits and risks of selected debt structures, investments, and any related interest rate hedging products (asset and liability management policies). Fitch also considers the application of asset and liability management policies, including overall debt structure and asset profile, future capital needs, consideration of alternative structures, and reasoning in support of selections, as well as the likelihood of achieving the goals of the adopted policies.

When borrowers use interest rate swaps to create or mitigate exposure to variable interest rates, Fitch focuses on the following aspects of swap transactions: priority of swap payments; basis risk; termination provisions; and counterparty credit risk. Fitch also considers borrowers' disclosure policies.

ASSET AND LIABILITY MANAGEMENT POLICIES

Adoption of comprehensive asset and liability management strategies will increase a borrower's chances to maximize the benefits and minimize the risks of variable-rate debt and interest rate hedging instruments. In Fitch's view, comprehensive policies include the following:

* Identification of investment objectives, including target asset allocations, expected investment returns, and, for fixed-income investments, a breakdown of short- and long-term investments

* Investment time horizons

* Identification of debt, investment management products, derivatives, and counterparty ratings acceptable to the debt issuer

* Forecasts of interest rate volatility over the short and long terms and expected performance of selected financial products under various interest rate scenarios

* Strategies for responding to changes in short- and long-term interest rates

* Designation of individuals responsible for negotiating financial products and coordinating investment and debt structuring decisions

* Designation of individuals responsible for monitoring and reporting on market conditions and their impact on performance of debt, investments, and any interest rate hedging products under consideration or already implemented

* Frequency and method of marking-to-market and monitoring investments and other financial products

* Sources and liquidity of funds available for potential swap termination payments

* Creation of hedge reserve funds

Although Fitch views adoption of comprehensive asset and liability management policies as a best management practice, Fitch also recognizes that many tax-exempt borrowers have not yet adopted a single comprehensive policy incorporating all of the elements listed above. Thus, if borrowers do not take such a comprehensive approach, Fitch evaluates the credit impact of variable-rate debt and interest rate hedging products in light of each debt issuer's asset allocation and investment policies, as explained below.

Application of Asset and Liability Management Policies.

Adoption of a comprehensive asset and liability management policy is an important first step for tax-exempt borrowers incurring variable-rate debt and/or utilizing interest rate hedging products. In addition to evaluating the contents of such plans, Fitch considers whether the debt structure incorporated into the plan is appropriate for particular borrowers. General bond market conditions, sources and costs of internal or external liquidity, natural and synthetic interest rate hedges, prior experience managing interest rate risk, and margins for tolerating increases in interest rates are factors in making such a determination.

Given that such factors vary for each tax-exempt issuer, Fitch does not recommend universal ratios of net variable-rate debt to total capitalization (total debt plus equity). However, Fitch does recognize common credit characteristics among borrowers for which issuance of higher proportions of variable-rate debt is appropriate. Such borrowers have strong, predictable cash flows and internal liquidity sufficient to absorb fluctuations in interest rates, characteristics that also correlate strongly with high investment-grade credit ratings. These borrowers are generally sophisticated and experienced in debt markets-further indicators of ability to assume percentages of variable-rate debt relatively greater than the percentages manageable for lower rated borrowers.

Furthermore, in evaluating borrowers' exposure to variable interest rates, Fitch focuses on net, rather than gross, variable-rate debt. This calculation subtracts from total (or gross) variable-rate debt amounts that are effectively hedged, either with forms of self-liquidity, including certain short-term investments, or with interest rate swaps meeting the standards outlined in the Interest Rate Swaps section.

Fitch considers short-term investments effective hedges to variable-rate debt because movements in interest rates should have offsetting impacts on both. If interest rates remain low, decreased investment returns should be offset by lower debt service costs. Conversely, if short-term interest rates rise, higher debt service costs should be mitigated by higher investment returns.

Strategy Execution. Fitch's expectation of successfully executed asset and liability management strategies is influenced by the debt issuer's experience in the financial markets and prior successful use of innovative financing tools. Inexperience may, however, be mitigated by longstanding relationships with experienced financial professionals charged with selecting and monitoring the performance of financing and investment products.

In addition, borrowers demonstrating an understanding of the benefits and risks associated with the selected debt structure and related financial products are more likely to realize their benefits.

Therefore, Fitch reviews and discusses with borrowers the following:

* Debt structure and financial products selected

* Alternatives that may have been considered

* Reasons for selecting or accepting certain provisions of swap documents

* Suitability of debt structure and selected interest rate hedging products in light of the issuer's policies

Suitability of debt structure also depends on the nature of a debt issuer's revenues. For example, borrowers with economically sensitive revenue streams, such as tolls, may reasonably expect that their revenues would increase during periods of increased economic activity. Increased revenues would be expected to result from both higher traffic levels and decreased resistance to higher toll rates, which could then offset the higher variable interest rates that are also likely during such periods. In contrast, borrowers with inflexible revenue streams or revenues that are not linked to general economic activity may be unable to offset the consequences of higher interest rates.

INTEREST RATE SWAPS

Tax-exempt borrowers have been utilizing interest rate swaps with increasing frequency. Floating- to fixed-rate swaps have been used to hedge interest rate risk on variable-rate demand obligations, or VRDOs; lock in fixed interest rates on refunding bonds that will be issued in the future; or take advantage of opportunities to obtain fixed swap rates that are lower than comparable fixed bond rates.

Other tax-exempt borrowers have created synthetic floating-rate debt with fixed- to floating-rate swaps. Such borrowers may receive the benefits of lower floating interest rates without incurring the remarketing and liquidity costs associated with variable-rate demand bonds. In addition, borrowers, including some hospitals, encountering barriers to obtaining either the liquidity support necessary to market VRDOs or the bond insurance preferred for marketing auction-rate securities, have also utilized fixed- to floating-rate swaps.

Fitch considers the impact of interest rate swaps in light of borrowers' overall asset and liability management policies. Review by Fitch of individual swap documents may be less likely when such policies include detailed parameters for acceptable swap providers and provisions. In those cases, Fitch may rely on the policies and management's commitment to adhere to them. However, when borrowers execute swaps without a comprehensive policy, Fitch may determine that a review of swap documents, including master agreements, schedules, and confirmations, is warranted. In either case, Fitch focuses on the aspects of interest rate swaps described below.

Priority of Swap Payments. Net interest payments on swaps by tax-exempt borrowers often rank on parity with debt service under related bond documents. Fitch believes that such ranking alone generally should not affect bondholder credit adversely. In addition, when Fitch is informed of swap agreements, the net impact of the issuer's obligations under such agreements is reflected in Fitch's rating. For example, debt service coverage calculations may be based on actual interest payments made after adding or subtracting payments made by or to the debt issuer under related swap agreements.

Borrowers and investors should, however, consider all potential consequences of ranking net interest payments on parity to senior debt. For example, failure by the debt issuer to make net swap payments may cause a default on bonds that are related and/or unrelated to the swap. Also, when swap payments are ranked on parity to senior debt, liquidity facilities supporting VRDOs may be subject to automatic termination following a payment default on the swap. Previously, definitions of senior debt in liquidity facilities included only publicly issued bonds or notes and did not include the debt issuer's contractual obligations, such as interest rate swaps. As long as debt issuer accounting systems treat net interest payments under swaps and debt payments identically, bondholders should incur no additional risk from this expanded definition of parity debt. However, investors should be aware of this development.

In contrast, Fitch supports continued ranking of termination payments below debt service obligations. This industry standard ensures that debt service payments would not be jeopardized by an unexpected or exceptionally large termination payment. Because swap termination events vary with the preferences and policies of borrowers and their counterparties, termination may be unforeseeable. Furthermore, termination payments are by definition nonrecurring and potentially challenge debt issuer liquidity. Ranking termination payments below debt service should ensure that borrowers have time to adjust their finances, minimizing the risk that a liquidity crunch caused by liability for a termination payment would impair long-term financial health.

Basis Risk. Basis risk arises when floating interest rates on bonds and swaps are based on different indexes. While floating tax-exempt bond rates generally track the Bond Market Association index (BMA), a composite index of weekly variable-rate tax-exempt debt, payments made by tax-exempt borrowers on most floating- to fixed-rate swaps are based on a percentage of the London Interbank Offered Rate (LIBOR), a taxable short-term interest rate. The percentage of LIBOR selected for most swaps is 67 percent, in recognition of the historical trading relationship between the indexes.

Basis risk is realized when the traditional relationship between the indexes erodes. During periods when BMA exceeds 67 percent of LIBOR, floating rates received on swaps are inadequate to cover floating rates paid on bonds, and total interest costs increase. For example, during periods of unusually high variable rate debt issuance, short-term tax-exempt interest rates may rise while LIBOR remains flat. Likewise, if federal tax rates are expected to or actually decline, the BMA rate may rise without any corresponding increase in LIBOR.

If an event with long-term consequences, such as a decrease in federal tax rates, pushes the ratio of BMA to LIBOR above 67 percent, floating swap payments received on swaps could be inadequate to cover floating rates paid on bonds for the life of the swap. Given the trend toward long-term swaps, borrowers should demonstrate to Fitch that they have considered and planned for this possibility through, for example, establishment of a hedge fund reserve or factoring basis risk into their budget as a cushion. They should also present their reasoning in accepting this risk. Fitch requests projections of additional debt service costs that may accrue under various interest rate scenarios and the debt issuer's means of absorbing and mitigating such additional costs.

Termination Risk. All interest rate swap documents include events of default and events of termination. Termination risk refers to the following two consequences of swap termination: reversion of swapped debt to its original variable- or fixed-rate form, possibly undermining a debt issuer's asset/liability strategy; and liability for potentially large payments if termination occurs during adverse market conditions.

Borrowers may eventually reverse these consequences by executing a new swap or issuing new debt at lower rates. However, in the interim, costs may be incurred and borrowers should have a plan to absorb them. Borrowers should, therefore, prepare or request from potential swap counterparties projections of potential liability for termination payments under a range of interest rate scenarios. Fitch analysts review such projections and evaluate the availability, liquidity, and adequacy of proposed sources of funds.

Limiting events of automatic termination to credit-related events, such as rating downgrades, bankruptcy/insolvency of either party, and nonpayment of debt by either party should further insulate investors. The likelihood of the occurrence of such credit events forms the basis for Fitch's debt ratings, and inclusion of such events of automatic termination should pose no additional risk to bondholders.

In contrast, the likelihood of the occurrence of noncredit-related events of automatic termination, such as default under separate agreements between the parties to the swap, is not necessarily reflected in Fitch's rating. These types of events could pose hidden risks for bondholders. Consequently, swap documents that incorporate noncredit-related events of automatic termination could cause Fitch to disregard such swaps and treat debt as unhedged. Alternatively, if Fitch views management positively, it may determine that there is minimal risk that a noncredit-related event of termination would occur.

Counterparty Risk. Counterparty credit ratings address their ability and willingness to meet their swap obligations. Such ratings should be an important selection factor because counterparty default on a swap and/or consequent termination leads to the results outlined in the previous section.

Fitch expects borrowers to select counterparties with ratings at least as high as their own ratings. In addition, swaps should include provisions requiring posting of collateral or termination of swaps when counterparty ratings dip below specified levels. Although termination raises the aforementioned risks, when events of termination relate to counterparty credit, such risks are incorporated into Fitch's counterparty rating.

DISCLOSURE

Fitch now monitors swaps executed by municipal borrowers more closely than in the past and requests that these borrowers disclose to Fitch, on an ongoing basis, the status of their swaps. Particularly, Fitch seeks prompt notification of occurrence of the following significant events, which could affect a debt issuer's financial performance: events of default or termination; triggering of requirements by either party to post collateral; any amendments to swap documents; and annually, the market value of outstanding swaps. Fitch also expects to be kept informed of plans to convert interest rate modes and actual annual interest rates on variable-rate debt. In addition to regular disclosure in financial statements, Fitch expects the occurrence of such events to be disclosed in a timely manner. Fitch believes that better managers take initiative on disclosure of significant events and considers such disclosure a best practice.

In certain cases, Fitch's credit reports and press releases will disclose to investors the existence of swaps and any terms that are unusual or that may pose additional credit risks. In addition, if a legal opinion regarding enforceability of swap agreements is not available, Fitch will also disclose that it has not reviewed such an opinion. Although many VRDOs are exempted from the continuing disclosure provisions of Securities and Exchange Commission Rule 15c2-12, superior disclosure practices incorporate a commitment to ongoing public disclosure by borrowers of significant events relating to VRDOs. At a minimum, such events should be disclosed to Fitch.

KATHERINE MCMANUS is a managing director for Fitch Ratings. KARL PFEIL and TRUDY ZIBIT are both senior directors.