California's Bakersfield Memorial Hospital has executed an unusual interest rate swap that employs a periodic auction to reset the issuer's floating-rate bonds instead of a remarketing agent.
The structure enabled the hospital to sign a swap contract for the life of the 26-year bonds, a goal sought by many issuers but offered by only a handful of swap providers.
On more typical swaps, a remarketing agent resets floating-rate bonds. The bonds include a put backed by a liquidity facility to assure investors that they will be able to dump the bonds if the rate is reset too low.
But the Bakersfield auction structure, developed by Lehman Brothers, avoids the need for a liquidity facility by eliminating the put. And the synthetic rate on the advance refunding deal saved the hospital 25 basis points over a straight, fixed-rate issue, according to Lehman Brothers, the senior manager on the transaction.
The hospital's floating-rate debt, issued late last month, will be reset every 35 days at a dutch auction. The bonds are identical to Lehman's Select Auction Variable Rate Securities, or SAVRs. which are typically sold in conjunction with Lehman's Residual Interest Bonds, or RIBs, to form an inverse floating-rate security. But no RIBs were issued on the Bakersfield deal. The bonds were insured by AMBAC Indemnity Corp.
Bonds reset by a remarketing agent are soled to money market mutual funds. To meet the funds' need for short-term securities, such bonds contain a put option allowing the holder to force the issuer or remarketing agent to buy back the bonds on any reset date.
If the remarketing agent sets the rate on the bonds too low, the holders may "put" the bonds. So the bonds are usually backed by a liquidity facility to insure that the remarketing agent will have enough cash on hand to pay back investors exercising their put right.
In a dutch auction, the rate is not subjectively set by a firm. Instead, the rate is set at the lowest rate that will cover all bids made by bondholders. The bonds cannot be put back to the issuer.
Derivatives professionals who did not work on the Bakersfield deal said that they felt more comfortable executing a swap on a remarketed floating-rate bond.
"We feel the risk is lower for us if we are the remarketing agent," one professional said. "It cushions possible losses [on the swap] if rates spike up dramatically on the bonds."
By eliminating the need for a liquidity facility, the auction structure also provides the market with a new way to issue bonds with a long maturity interest rate swap, according to Sheldon L. Sussman, senior vice president at Lehman.
The swap and the bonds have an identical maturity of 26 years, with an average life amortization of 17 years.
"This structure is an alternative for long-dated swaps, without the need for a liquidity facility," Sussman said. "We're seeing more and more issuers worried about getting and keeping liquidity facilities, but here the issuer doesn't need one."
One derivatives professional said that the major provider of long-dated municipal swaps, AIG Financial Products, seems to have decided to cut back on its business.
"The Lehman structure could be copied by firms trying to replace AIG's product without taking on the same risks AIG did," the professional said.
AIG typically provides issuers with a guarantee that locks in the price of a liquidity facility for the issuer for the life of the swap. The auction reset bonds, by contrast, do not have any liquidity enhancement.
AIG denies it is backing out of the long-dated swap market. Alan D. Marks, executive vice president at Smith Barney, Harris Upham & Co., who works frequently with AIG on such deals, said the firm's commitment is unchanged.
"We are actively pursuing transactions at the long end of the swap curve where they make sense for our municipal clients," Marks said.
The swap on the advance refunding deal allowed Bakersfield to reach its net present value savings target. Without the swap, the refunding did not make sense for the hospital.
By issuing floating-rate bonds and entering into an interest rate swap, the hospital locked in a synthetic fixed rate of 5.60%. The rate was 25 basis points below the rate the hospital would have paid on ordinary bonds, according to Lehman Brothers.
The 25 basis points boosted the net present value savings of the refunding to $2.4 million from $1.1 million, well above the hospital's target of $1.5 million.
The bonds refunded include $32.9 million issued in 1984 and $20 million issued in 1989.
Paul A. Jerdin, senior vice president for financial services at the hospital, said, "The earliest call date on the bonds we're refunding is in 1999. That means we need government bonds for five or six years."
The interest rate on Treasury notes of five-year to seven-year maturity was between 5.10% and 5.70% when the hospital was planning the refunding. The bonds being refunded carried coupons of 6.20% to 7.375%.
"With rates the way they are, that made for a lot of negative spread that had to be offset for the deal to make economic sense," Jerdin said.
Derivatives professionals said the value to issuers of locking in fixed-rate interest costs with floating-rate bonds and a swap are particularly compelling under current market conditions.
"It's a particularly compelling trade in the swap market right now," one professional who did not work on the Bakersfield deal said. "There has been some turmoil in the municipal market with all the supply coming in, but an issuer should be able to save piles of money on this trade if they can sell the bonds."
Jerdin said the hospital set a saving target of $1.5 million to insure that the transaction offset the one-time charge of about $1 million that the hospital would have to take to advance refund the outstanding bonds. The charge represented the unamortized issuance costs from the original bonds, he said.
The hospital also considered issuing other Lehman Brothers derivative products, such as inverse floating-rate bonds or bonds with embedded interest rate caps. But the swap and floating-rate issuance provided the lowest overall rate for the hospital, Jerdin said.
