WASHINGTON -- While entering into interest-rate swap transactions can be a useful debt and asset management tool, the risks involved can hurt an issuer's creditworthiness, Standard & Poor's Corp. told municipal issuers yesterday.
"We're not saying municipal issuers should not use derivatives. We are saying they should be very careful about how they structure them," said G. Kris Rao, a director in the rating agency's municipal finance area.
The rating agency said in this week's edition of CreditWeek Municipal that if a swap transaction is not structured properly or is done without understanding, "it can lead to a rating downgrade."
Since the late 1980s, municipal issuers have been using derivative products based on interest-rate swaps more and more.
The derivative products are being used by issuers to save interest costs, increase financial flexibility, synthetically advance refund bond issues, and gain access to different investor markets, Standard & Poor's said.
However, interest-rate swap transactions can expose issuers to a number of risks, including counterparty credit risk, floating-rate risk, and the risk of termination.
"If used to speculate on the direction of interest rates, or if they are not structured properly, swaps can reduce an issuer's ability to pay debt service on time, thereby hurting its credit quality," the rating agency said.
Issuers with limited financial flexibility should avoid or limit their use of derivatives to a small percentage of their outstanding debt, Standard & Poor's said.
"Financial flexibility and access to liquidity resources are very important factors to examine before entering into interest-rate swaps," the rating agency said.
"Typically, we would like them to limit their exposure to 15% to 20%," Rao said.
The rating agency's warning comes a week after its analysts said they would be taking a closer look at derivatives investments in municipal portfolios.
Standard & Poor's last week said that if an issuer's portfolio includes derivatives, the agency will regularly examine the book value and market value of the securities and ask treasurers why they had invested in them.
"Exposure to derivatives need not be a cause for concern; however, for a municipality to invest a significant percentage of its portfolio in derivatives without a thorough understanding of the attendant risks is a cause of concern," Standard & Poor's said.
The rating agency did note, however, that the municipal issuers that faced the most severe losses from derivatives investments, based as much as 90% of their portfolio on derivatives.
