Under the right set of circumstances, municipal interest rate swaps can be very effective instruments for state and local government debt management and investment programs. Increasingly, as financial adviser to these governments, we are being asked to suggest and evaluate alternative interest rate swap approaches. If designed properly, reliance on interest rate swaps can outweigh the risks, which are often rather minimal, attendant to this product.
The application of swaps can be quite varied. For example, swaps represent a debt management tool that can be used for diversifying a borrower's standard practices, including an adjustment in fixed-rate debt by increasing the amount of floating-rate indebtedness: often, this adjustment can be achieved more easily and simply through swaps than through the direct issuance of variable-rate debt.
In addition, swaps can be employed, on a delayed swap basis, to accomplish the refunding goals of a particular borrower that would otherwise be lost. In this respect, swaps are most often less expensive than simple forward, interest rate commitments available at the first call date; while the cost of forward, interest rate commitments has declined significantly over time, they still tend, based on our evaluations, to be more expensive than swaps to accomplish the same purpose.
Other ways interest rate swaps have been employed include, among others, the hedging of investment programs, an increase in current cash flow, and an adjustment in the payment program for a debt service schedule.
[Mr. Johnson has chosen tow examples to demonstrate the issues his firm has confronted in evaluating the possible use of interest rate swaps. The first appears this week.]
Fixed-to-Floating Deal
Government A owned, operated, and has financial responsibility for a public enterprise, which receives cost reimbursements from other users, including governmental entities. Government A had previously sold fixed-rate debt and established the capital cost reimbursement levels from other users, based on the long-term fixed rate received on the previous borrowings.
All of Government A's debt was in long-term fixed-rate bonds. To diversify its indebtedness composition, Government A chose to swap less than 20% of its fixed-rate debt roughly equivalent to the amount of the principal amount of debt represented by the enterprise activity, into variable-rate debt.
This transaction was concluded over the last two years, over which time the steep yield curve provided significant low rates on the variable-rate piece. In this respect, Government A received reimbursement for the capital cost component, based on the fixed-rate debt, while the swap allowed Government A to actually pay, over the intervening period, a much lower, variable interest-rate cost than through the fixed, interest-rate payment.
Also, Government A was able to hedge its variable interest-rate exposure through an investment pool in taxable, short-term securities that was approximately equivalent to the notional amount of the swap. Because this investment pool of short-term securities was roughly equal to the notional amount of the swap, as interest rates rose on a variable basis, the investment return to Government A from the pool also increased, so that the interest-rate exposure was capped by aligning the investment program with the swap structure.
This transaction caused Government A to address a series of key factors related to interest-rate swaps. If these were not adequately handled, the risks to Government A of the swap could have outweighed the benefits.
* Counterparty Risk: Depending on the terms and provider of the master interest swap agreement, this risk can be more or less significant; in any case, the risk can be economically damaging if not addressed properly.
For example, if the counterparty were to go bankrupt or disappear in the midst of the swap, Government A would have been responsible for certain additional debt service payments. In this case, Government A's and the provider's credit ratings balanced each other, and there were sufficient protections built into the transaction so that the counterparty risk was addressed; in other swap transactions, this risk can become very substantial to the government.
* Rating Agency Perspective: Government A had numerous meetings with the ratings agencies to describe the benefits/risks of the swap program. The agencies focused on the variable-rate risk aspect of the swap, and as long as Government A came within certain guidelines as to tolerable levels of variable-rate exposure, then when the overall structure was determined by the agencies to be sound, the agencies signed off on the transaction.
* Leveraging: In this instance, we decided to leverage the swap by 30% to relate the swap to the investment pool held by Government A. In other words, the securities held by Government A were taxable obligations, so that in order to balance the swap, which was paid in tax-exempt rates, we leveraged the swap up by the rough equivalent of tax-exempt rates to taxable rates, that is, by 30% above the notional amount.
One could question whether every participant should take this step, but because of the extraordinary underlying asset of the taxable investment pool equivalent to the leverage notional amount, Government A did not believe that an undue risk was being absorbed, and when the rating agencies evaluated the swap, they were not discomforted by this leveraged feature.
* Proper Index: At a time, the two indices that could have been applied to the transaction, that is, the variable-rate index on which Government A would base its payments, were the Libor or J.J. Kenny index.
We chose the J.J. Kenny index because we concluded that it was most reflective of the tax-exempt market per se; while transactions have been concluded using the Libor index, relying on a percentage of its taxable levels, we have found that the Kenny index is more derivative of the tax-exempt market itself, without reliance on a baseline taxable rate.
Of course, a new index is now being promoted for relating even more directly to the prevailing short-term, tax-exempt market, and in fact, we would now be examining it for any new swap transactions - that is, the index being distributed by the Public Securities Association.
* Break-Even Rate: Government A established a goal of achieving a high break-even related to the fixed rate on the enterprise transaction. In other words, Government A wished to take necessary precautions so that it did not pay as amount on its variable-rate debt near to or above the debt service charges applied to its fixed-rate obligations.
Ultimately, the break-even rate for Government A was well above the average rate of the J.J. Kenny index for the last decade. Combining this high break-even rate with the security of the investment pool, Government A concluded that this aspect of the risk analysis was adequately addressed.
* Length of Swap: As financial adviser, we have concerns about the extension of swap life beyond 10-year period for normal transactions.
Because the swap market is not as deep as the conventional municipal bond market, to identify precise market prices for swap transactions is more difficult and uncertain; thus, our review of the swap market suggest that the more variable portion of the swap market consists of the 10-year or lesser period. In fact, because of the higher marketability and activity in the 10-year range, together with the government's desire not to incur a contractual obligation of a long duration, Government A limited its exposure to a 10-year swap.
It should also be emphasized that the fixed-rate bonds were callable in 10 years, which would have altered the precise goals of the government if we had extended the swap beyond the 10-year period.
J. Chester Johnson, president of Government Finance Associates Inc., recently presented a speech at the Institute for International Research in New York City from which the following excerpts have been taken.
The theme of the presentation was the risks that governments can face in municipal interest rate swaps. Because of the growing importance that derivatives. particularly municipal swaps, have assumed in the public finance area, we have included those parts of the speech that may be of most significance to The Bond Buyer's readership.
The excerpts will be published in two parts: in today's issue and next Monday's.
