In cases where federal law rules out advance refunding, an issuer can try two other techniques for taking advantage of the current low interest rates: a forward transaction or a forward swap transaction.
In an ordinary forward transaction, the issuer locks in the rate and terms of bonds to be delivered later on. Investors receive a forward contract, which obliges them to buy the bonds when they are delivered.
To compensate the investor for waiting, the locked-in rate is higher than the rate the issuer would pay if the bonds were delivered today. The difference between the two is called the forward premium, and it is shaped by such factors as the level of long-term and short term rates and the shape of the yield curve.
Many market participants consider the forward contract a derivative because its value derives from the value of the bond to be delivered. For example, an +issuer could sell forwards for noncallable, 15-year bonds to be delivered one year in the future. If the issuer priced similar bonds for immediate delivery, the bonds would yield 5%. So the forward bonds will yield 5% plus a premium.
The premium compensates the investor for the lost opportunity of receiving interest on the investment for the period before the bonds are delivered. A small portion of the premium may also be compensation for the illiquid nature of the forward contract compared with an ordinary bond.
What is the value of the lost opportunity? if an ordinary bond had been purchased, the investor would receive 5% for the first year. Instead, the investor could buy a one-year security and receive less than half that rate. The Bond Buyer's one-year note index was at 2.28% on Dec. 23.
After the first year, the buyer of the ordinary bond continues to receive 5% interest. What rate should the forward buyer receive to garner an equivalent return?
One measure used to compare the relative return on cash flows is known as the internal rate of return. The internal rate of return is the discount rate at which the present value of the future cash flows equals the amount paid upfront.
The internal rate of return on the ordinary bond, held to maturity, is 5%.
To achieve an internal rate of return on the forward transaction of 5%, after receiving just 2.28% for the first. year, the forward bond would have to yield about 5.28%.
The forward bond's rate premium might be higher or lower to account for illiquidity, supply and demand, or other factors.
When a forward transaction is used instead of an advance refunding the issuer must consider the cost of leaving its current high coupon debt outstanding until the call date, against the costs of the forward transaction.
The issuer's interest costs will generally be higher on a forward transaction than on a simple advance refunding.
The forward swap transaction attempts to meld the advance refunding elements of a forward issue with the additional savings provided by synthetic swap-based issues.
Next week: how the forward swap transaction works.
