Understanding municipal derivatives.
Derivatives also carry risks that issuers must carefully consider before incorporating these products into their overall debt and investment strategies, and these are discussed later in this article. GFOA's recommended practice, Use of Debt-Related Derivatives Products and the Development of a Derivatives Policy, encourages governments to develop a sufficient understanding of derivatives and to adopt a derivatives policy before using these instruments. (1) This article describes the most common derivative products used by state and local governments and some of the benefits and risks associated with these products.
INTEREST RATE SWAPS AND RELATED PRODUCTS
To preserve market liquidity for issuers, principles and practices in the municipal derivatives market have generally reflected principles and practices in the general derivatives market. For example, municipal derivatives transactions are typically documented using globally recognized documentation published by the International Swaps and Derivatives Association. (2) However, participants in the municipal derivatives market understand that many of the concerns and objectives of government issuers are different than those of corporate end-users. The range of products offered by dealers in the municipal derivatives market generally reflects the characteristics of the debt financing and balance sheet management activities of issuers. Municipal market derivatives are often required to be structured in accordance with the provisions of the Internal Revenue Code and state laws that apply to the issuance of tax-exempt financings. As such, the most common use for derivatives in the municipal market is the execution of interest rate swaps and related interest rate-based products to hedge issuers' interest rate exposure for new, anticipated, or outstanding debt.
Interest rate swaps are two-party agreements to exchange payments based on periodic changes in interest rates. In the typical interest rate swap, one party agrees to make payments to the other based on a fixed rate in exchange for payments from the other party based on a floating rate. In another form of interest rate swap, a "basis swap," the parties pay different floating rates to each other. Payments are made at the frequency and for the term specified in the agreement, and are calculated on the basis of the "notional amount" specified in the agreement. While they are often associated with debt, interest rate swaps are not themselves debt contracts. As such, principal is not exchanged by the parties to an interest rate swap, and so swap payments are not payments of interest. In the typical interest rate swap, the fixed and variable payments are netted such that only one party actually makes a payment on each payment date.
Because governments typically use interest rate swaps to hedge, offset, or reduce the cost of borrowing in connection with a tax-exempt financing, floating rate payments are frequently calculated on the basis of a tax-exempt index, primarily the The Bond Market Association Municipal Swap Index (the "BMA Index") which is produced by Municipal Market Data. However, some issuers choose to receive variable payments on the basis of a LIBOR index of taxable variable rates. The BMA Index is a weekly reset benchmark index that is based on the average interest rate on approximately 650 money market eligible non-AMT tax-exempt weekly reset variable-rate demand obligations.
In a fixed payer swap or floating-to-fixed rate swap, the issuer pays a fixed rate and receives a variable rate. Issuers typically enter into fixed payer swaps to hedge against the interest rate volatility of variable-rate debt. Floating rate payments by the dealer will ideally offset the issuer's variable-rate debt exposure such that the issuer is, as a consequence of the debt issuance taken together with the swap, a net fixed rate payer. As noted later in this piece, a basis risk is involved, as the variable swap rate received is structured to be close to the variable-rate interest payment made. In reality, however, the two are seldom exactly equal. Entering into such a transaction might be attractive to an issuer if the fixed rate it pays on the interest rate swap (plus variable-rate debt program and administrative costs) is lower than the fixed rate at which it could issue a traditional fixed rate bond. Such a transaction is illustrated in Exhibit 1.
In a fixed receiver swap or fixed-to-floating rate swap, the issuer pays a floating rate and receives a fixed rate. These transactions are typically entered into by issuers in connection with fixed-rate debt. Entering into such a transaction might be attractive to an issuer seeking floating rate exposure without paying the administrative costs and fees (such as letter of credit fees or remarketing fees) typically associated with the issuance of variable-rate debt. Such a transaction, taken together with a related bond issue, results in an issuer paying a net floating rate. Such a transaction is illustrated in Exhibit 2.
The fixed receiver swap raises one of the most frequently asked questions about interest rate swaps: "Why would a swap provider agree to pay a high fixed rate to an issuer in exchange for a low variable rate?" The answer lies in the basic construct of the swap market itself. Swap providers run so-called "hedged" books. That is, swap providers stand in the middle of two counterparties, providing market liquidity and credit support, while at the same time setting prices based on supply and demand and other market factors. Exhibit 3 illustrates the two sides of the swap market, with the swap provider in the middle, insulated from changes in market rates but exposed to the individual credit of each distinct issuer or counterparty.
Another type of interest rate swap that has a variety of applications in the municipal derivatives market is a basis swap. In a typical transaction, the parties exchange payments of the BMA Index for payments of a LIBOR-based index, frequently plus or minus a fixed spread. Such a transaction is illustrated in Exhibit 4.
There are a number of products related to interest rate swaps. These are briefly described as follows:
* Rate Lock--A financial contract in which an issuer hedges interest rate risk on a future fixed rate bond issue by agreeing to make or receive a settlement amount calculated based on changes in long-term interest rates from the date of execution of the transaction to the date of expected issuance of the bonds.
* Swaption or Swap Option--An agreement under which one party has an option to either enter into or cancel an interest rate swap with the other under specified terms.
* InterestRate Cap--An agreement in which one party agrees to pay the other an amount determined by the degree, if any, that a floating rate exceeds a predetermined fixed rate, called the strike rate. Interest rate caps are typically purchased by issuers in connection with variable-rate debt to economically provide a maximum rate payable on variable-rate debt without actually subjecting the terms of the debt to a maximum rate.
* Interest Rate Floor--An agreement entered into by two parties in which one party agrees to pay the other an amount determined by the degree, if any, to which a floating rate is below a predetermined fixed rate, also called the strike rate. Interest rate floors are typically used by issuers or obligors in connection with variable-rate debt, to economically provide a minimum rate payable on variable-rate debt without actually subjecting the terms of the debt to a minimum rate in exchange for receiving a premium.
* Interest Rate Collar--An agreement in which one party purchases an interest rate cap and sells an interest rate floor and the other sells an interest rate cap and buys an interest rate floor.
NATURE OF THE ISSUER'S SWAP OBLIGATION
The execution of an interest rate swap or similar product typically does not affect the nature of an issuer's obligation or its legal liability to bondholders on any related bond issue. In the case of a fixed payer swap, for example, the issuer continues to be legally obligated to its bondholders to make variable-rate debt service payments--even after execution of the swap. From an economic perspective, the fixed payer swap allows the issuer to synthetically create a fixed-rate obligation, but the issuer's bond and swap obligations are separate and distinct.
An issuer contemplating an interest rate swap must also consider the nature of its obligation to the swap dealer. Virtually all derivative transactions include a bilateral set of defaults and termination events (such as payment default, bankruptcy, covenant default, or certain ratings downgrades), the occurrence of any of which generally triggers the termination of all derivatives transactions between the parties, thus creating a termination risk with the transaction. Upon termination, one party or the other will typically owe a termination payment reflecting the mark-to-market value of the terminated transactions. These amounts may be substantial.
Prior to engaging in a swap or similar transaction, the issuer's indentures, resolutions, and related financing documents, including outstanding credit agreements, must be reviewed to determine the quality and priority of the source of security under the interest rate swap. For example, if an interest rate swap is being contemplated in connection with bonds issued under an existing indenture, does the issuer's indenture permit payments under the swap to be made on a parity with debt service payments? Likewise, if the issuer's bonds are insured, or if the issuer is seeking swap insurance to cover its obligation on the interest rate swap, will all payments on the swap (including regularly scheduled on-going payment as well as any termination payments) be payable on the same basis and at the same level of priority? Issuers should consult with bond counsel to answer these and other important questions about the security for a proposed swap.
An issuer considering entering into an interest rate swap or similar transaction should familiarize itself with the range of risks associated with these transactions and address these risks in a derivatives policy. Generally speaking, the risks fall into the following categories:
* Market or Interest Rate Risk--The risk that rates will increase or decrease, and the effect of such changes on the interest rate swap's cash flow and market value.
* Basis Risk--The mismatch between the rate received by the issuer under an interest rate swap and the rate payable by the issuer on any related obligation. For example, basis risk describes the risk in a fixed payer swap that the floating rate received by the issuer under the interest rate swap may not equal the floating rate paid by the issuer on the variable-rate bonds that it is hedging.
* Tax Risk--A specific basis risk stemming from changes in the relative interest rate of the issuer's tax-exempt variable-rate bonds, as a result of the occurrence of tax events affecting the issuer's bonds or tax-exempt bonds generally, including changes in marginal income tax rates and other changes in the federal and state tax systems.
* Termination Risk--The risk that an interest rate swap could be terminated prior to its scheduled termination date as a result of any of several events relating to either the issuer or its counterparty. Upon an early termination, a substantial mark-to-market payment could be due and payable; the issuer may either owe a termination payment to the dealer or receive a termination payment from the dealer depending on market interest rates.
* Amortization Risk--The risk of a mismatch between the principal amount of any obligations related to the interest rate swap and the notional amount of the related interest rate swap.
* Counterparty Risk--The risk that the dealer will not fulfill its obligations as specified by the terms of the interest rate swap.
As an essential part of their business, municipal derivatives market dealers regularly consider the risks incumbent upon their execution of swap and other transactions with municipal counterparties. Dealers have generally made it their goal to promote the continued education of the municipal marketplace as to dealer principles and practices, and, through their participation in The Bond Market Association, have expressly made it a market-wide goal. In December 2003, The Bond Market Association reaffirmed its adoption of The Principles and Practices For Wholesale Financial Market Transactions, first published in 1995 to provide guidance for the conduct of derivative transactions. (3) Issuers should familiarize themselves with dealer practices as part of their efforts to develop expertise in managing and evaluating derivatives.
LEGAL CONSIDERATIONS AND DOCUMENTATION
Issuers must determine whether they possess the requisite legal authority to engage in interest rate swaps or related transactions. Such authority may be found in state constitutions, statutes, regulations, and the judicial decisions interpreting them. At the inception of the municipal derivatives market there were no state statutes expressly governing the execution of derivatives by state and local governments. Today, approximately 40 states have some form of legislation expressly permitting issuers to enter into derivative transactions. (It should be noted, however, that derivatives legislation is not a prerequisite for all state and local issuers; many have the requisite legal authority without express legislative authority). Even where there is explicit authority to engage in derivatives, issuers need to consider whether execution of an interest rate swap or similar transaction would violate any other statutory or constitutional limitation, including any limitation on the issuance of debt.
Documentation of interest rate swaps, as mentioned above, is typically accomplished through the execution of documents published by ISDA. In 1992, ISDA published a special set of municipal counterparty provisions geared for the municipal derivatives market, including a set of municipal market definitions. Issuers can expect, like other users of derivatives in the financial markets, to negotiate and execute a master agreement governing all of the derivatives transactions entered into with a particular dealer, until the two parties otherwise mutually agree. Execution of a master agreement is accomplished through the negotiation of a schedule to the master agreement. If transactions must be collateralized, the parties will also negotiate the terms of a credit support annex to the master agreement. The terms of individual transactions, as agreed to by the issuer and the dealer from time to time, are spelled out in a confirmation, a short-form document containing the business terms of the transaction. Under the "single agreement structure," the ISDA Master Agreement--not the individual transaction--is the contract between the parties. The confirmation serves as evidence of an individual transaction, which is incorporated by reference into the master agreement.
The use of interest rate swaps and related products in the municipal market has grown significantly over the past several years as many issuers have found derivatives to be useful tools in hedging and managing interest rate risk and lowering debt service costs. Issuers who are contemplating a derivatives transaction must carefully consider both the benefits and risks, and, together with their advisors and counsel, familiarize themselves with market practices to determine how derivatives can best serve their objectives.
This article was written by David L. Taub on behalf of and in conjunction with The Bond Market Association's Municipal Financial Products Committee. The committee consists principally of dealers in the market for derivatives in which the end-user is a borrower of the proceeds or an issuer of tax-exempt debt (e.g., U.S. governments and non-profits). The Bond Market Association is an international trade association representing approximately 200 securities firms and banks that underwrite, distribute, and trade in fixed income securities in the U.S. and internationally. More information about The Bond Market Association and its members and activities is available on its Web site www.bondmarkets.com.
(1.) This recommended practice can be found at http://www.gfoa.org/services/rp/debt/debt-derivs.pdf.
(2.) See 1992 ISDA municipal counterparty definitions.
(3.) This document is available online at http://www.newyorkfed.org/fxc/annualreports/ar1995 /fxar9518.html#Committe_Letter. The Federal Reserve Bank of New York coordinated the preparation of the Principles, with the help of representatives of the Foreign Exchange Committee of the Federal Reserve Bank of New York, the Emerging Markets Traders Association, the International Swaps and Derivatives Association, the New York Clearing House Association, the Association (formerly known as the Public Securities Association), and the Securities Industry Association.
DAVID L. TAUB is a partner at the law firm of McDermott Will & Emery LLP.
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|Author:||Taub, David L.|
|Publication:||Government Finance Review|
|Date:||Aug 1, 2005|
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