Matching swaps according to life of a bond issue as principal ebbs.

Interest rate swaps are customizable, allowing an issuer to match the terms of a swap to the commonly used serial bond structure.

A swap is an exchange of interest payments based on a set amount of principal, also known as the notional amount, which is not exchanged. On a typical swap, the notional amount is fixed for the life of the swap. An issuer, for example, might agree to pay its swap counterparty a fixed rate of 5.50% on a notional amount of $100 million. In return, the counterparty agrees to pay the issuer a rate based on the Public Securities Association's municipal swap index on an identical notional amount for the same term.

But a typical municipal bond deal is broken up into numerous maturities of serial bonds. An issue with a final maturity of 2010 might include bonds due every year from 1995 to 2010. And the principal is not distributed evenly among the maturities.

Underwriters, whose aim is to sell the entire deal at the lowest interest cost to the issuer, may find they can lower that cost by putting more of the principal in bonds due in 2005 to 2010 and less in the 1995 to 2000 maturities, for example.

Issuers may want to lower their overall debt service cost by using a swap in combination with variable-rate bonds instead of a fixed-rate bond issue. The combination can result in a fixed debt service cost 25 basis points or more below the cost of a fixed-rate bond issue.

Using a typical swap with the typical serial bond structure, however, creates a mismatch.

Each year, the principal amount of bonds an issuer has outstanding shrinks as one series of bonds matures, but the notional amount of the typical swap is fixed. In other words, the issuer would be paying a fixed rate of interest -- and receiving a floating rate of interest -- on a larger national amount than the issuer needs. For example, after five years the outstanding amount of principal in a $100 million bond deal might be only $80 million.

To fix the mismatch, the terms of a swap a can be customized to amortize along with the bond issue. Each year, as the principal amount of bonds shrinks, the swap's notional value can be structured to shrink by an equal amount.

Such amortizing swaps should not be confused with so-called index amortizing swaps.

The notional amount of an amortizing swap shrinks on a set schedule and directly corresponds with a bond issue.

An index amortizing swap is more of an investment play. Instead of shrinking by a scheduled amount, the swap's notional value fluctuates in accordance with a market index.

The notional amount of the index amortizing swap in the future is uncertain -- it depends on the course of future interest rates. The notional amount of the amortizing swap used by municipal issuers is generally known in advance.

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