Understanding municipal derivatives.

The derivatives market for municipal market borrowers has been steadily growing since the market's inception in the mid-1980s. A significant number of state and local governments, ranging from many of the major cities, states, and statewide issuers to smaller, single-purpose governmental entities, have executed derivative transactions. Derivatives have become a key tool for reducing borrowing costs, hedging existing assets and liabilities, improving the strategic timing for market access, optimizing capital market risks in debt and investment portfolios, and enhancing investment returns.

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.

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