WASHINGTON -- The new arbitrage rules may hinder or halt the use of some of the municipal derivative products that have become commonplace in the market, industry officials and lawyers said this week.
"They threaten some structures that have become very common," said George Wolf, a lawyer with Orrick, Herrington & Sutcliffe in San Francisco.
The products affected include embedded cap and inverse floater bonds.
Embedded cap bonds are hedged with interest rate caps, while inverse floater bonds are hedged with interest rate swaps. Typically both kinds of bonds bear variable rates for a period of time, but convert to a fixed rate when the hedge terminates or, in the case of a bondholder conversion right, when the bondholder opts to convert to a fixed rate.
Bond firms and issuers traditionally have treated these bonds as fixed-rate, since the interest rate paid by the issuer, when integrated with the hedge payments, is always fixed.
However, the hedging provisions of the would treat these as variablerate bonds, making compliance with the arbitrage rules extremely difficult and potentially economically disastrous, industry officials and lawyers said.
The problem arises because while the yields for fixed-rate bonds generally are determined once -- when they are issued -- based on the issue price and debt service payments, the yields for variable-rate bonds must be figured and refigured every five years, in what amounts to ever-changing, five-year snapshots.
For most variable-rate bond issues, especially those containing serial and term bonds, the yield in the first five-year period would be artificially low and would not reflect the issuer's average interest costs over the life of the bonds.
Some bond firm officials and lawyers say the rules, which probably will affect only deals done after Aug. 15, would make embedded cap and inverse floater deals difficult to do.
"I don't think there's any reason to panic." said Shelly Sussman, a senior vice president at Lehman Brothers in New York City. While the rules "definitely hurt" some structures, "they don't mean we can't do them; they would only make them more difficult to do," he said.
But other lawyers said the rules could make such deals too costly. "It could make a lot of the derivatives deals that are being done in the market now useless in the future," said Carol Lew, a lawyer with Stradling, Yocca, Carlson & Rauth in Newport Beach, Calif.
Members of the Public Securities Association's municipal derivatives committee plan to meet with Internal Revenue Service and Treasury officials tomorrow to discuss their concerns about the new rules.
Most market participants say that the adverse effects of the rules were unintended, and they hope the IRS will correct them.
But a few lawyers, such as Dale Collinson of Willkie, Farr & Gallagher in New York, believe that the arbitrage rules can be read so that the adverse hedging provisions would not apply to derivative products such as embedded cap and inverse floater bonds.
"If you're achieved a structure that gives you certainty about the yield, you ought to be able to apply the rules for fixed-yield bonds," Collinson said.
One of the problems with the arbitrage rules' hedging provisions, the lawyers and industry officials say, it that only bonds hedged with interest rate swaps will be treated as fixed-rate bonds. This would mean a bond issue that contained embedded cap bonds would be treated as a variable-rate issue.
Another concern comes because the provisions say that if a swap is terminated within five years of issuance, the hedged bonds are to be treated as variable-rate bonds. In other words, if a bondholder in an inverse floater bond deal with a rate conversion feature converts to fixed rates within five years of issuance, the bonds would become variable-rate bonds.
Some lawyers say the rules can even be read as thwarting all new inverse floater bond deals.
Industry officials are also concerned that the rules do not cover products such as RIBS/SAVRS (residual interest bonds/select auction variable-rate bonds) and, therefore, provide no assurance that these bonds would be treated as fixed-rate bonds. These transactions involve inverse floater bonds in which variable rates are reset through dutch auctions.
Bond firms and issuers generally want tax-exempt bonds in derivative transactions to be trated as fixed-rate so that they can easily determine a bond yield that will remain constant and will accurately reflect the issuer's interest costs over the life of the bonds.
They especially want advance refunding bonds to be fixed-rate because the bond yield determines the yield at which the securities escrowed to pay the prior bonds can be invested.
Industry officials report that embedded cap and inverse floater bonds are often used in advance refundings because they give issuers more interest rate savings than traditional refundings.
Under the arbitrage rules, however, these refunding bonds would be treated as variable-rate, and the bond yield from the first five-year snapshot period would have to be used to determine the investment rate of the escrowed securities. That first five-year snapshot bond yield would be low, particularly if the issue contained serial bonds, so that the deal might no longer be economically feasible.