When selling derivatives with interest rate swaps, additional savings may bring additional risks. But issuers may already be exposed to similar risks without using swaps. Paradoxically, the so-called riskier swap could lower an issuer's total risk profile in that case.
Underwriters generally distinguish between two types of derivative transactions involving swaps. Embedded swaps accompany derivative products that are structured to meet investors' desires. The issuer passes along to investors the changing payout from the swap.
The other type of swap transaction uses the swap to create synthetic interest costs to meet issuers' needs. The swap allows the issuer to alter its mix of assets and liabilities and better manage its balance sheet.
An issuer seeking lower cost, fixed-rate debt service, for example, would sell floating-rate bonds and use a swap to reverse the liability. The synthetic fixed rate would be lower than the rate the issuer would have received if it had sold ordinary fixed-rate bonds.
Issuers can also create synthetic floating-rate exposure using this type of swap transaction. Issuers with substantial cash balances invested at short-term floating rates are already exposed to interest rate risk. If the issuer sells only fixed-rate bonds and rates fall, the interest it is collecting on its cash will decline but its debt service will not.
To better match assets and liabilities, the issuer could sell floating-rate debt. But selling ordinary floating-rate bonds may require that an issuer obtain credit enhancement - a letter of credit or standby purchase agreement, for example. That can be expensive and, in some cases, unobtainable.
In isolation, the second type of swap transaction - the balance sheet swap - creates more risks for the issuer. The payment the issuer receives from the swap counterparty may not cover the rate on the issuer's floating-rate bonds. This is called basis risk.
If the swap counterparty defaults on the swap, the issuer generally has to pay the full variable rate. The default would expose the issuer's credit risk on the swap.
On an embedded swap transaction, there is no basis risk. The floating rate component of the swap is generally identical to the rate offered on the derivative bond.
And if the swap counterparty defaults, the issuer usually is only required to make one interest payment on the derivative based on the embedded derivative formula. After that, the derivative reverts to a fixed rate.
As a futher credit plug, some underwriters offer issuers additional default protection on swaps used in embedded swap derivatives. Merrill Lynch & Co., for example, will use its triple-A rated swap subsidiary, Merrill Lynch Financial Products, as a swap counterparty if the swap is part of an embedded transaction.
The swap subsidiary is separately capitalized and rated triple-A. Even if Merrill Lynch had a financial crisis and had to default on swap contracts, the firm could not recapture the capital it placed in the subsidiary. And with its own capital base, the sub could stay solvent and not default on its swap contracts.
According to one swap professional, savings to issuers on embedded transactions when the embedded swap is with a triple-A rated counter-party are close to the savings on nonswap derivatives - only 10 to 15 basis points.
But embedded swaps can offer greater savings. New York City saved 25 basis points on a derivatives deal in August which included an embedded swap for inverse floating-rate notes.
Issuers get the greatest savings, sometimes in excess of 50 basis points, from balance sheet transactions, swap professionals say. And if the risks on the transaction are viewed in the context of the issuer's entire balance sheet, the swap may be a risk reducer.
