Although interest rate swaps frequently present issuers with the opportunity for significant savings, issuers should be aware of the risks.

One important factor is basis risk, which can turn a synthetic fixed rate into an unforeseen floating rate under some circum stances.

In a synthetic fixed-rate transaction, the issuer agrees to pay the swap counterparty a fixed rate, and the swap counterparty agrees to pay the issuer a floating rate. The floating rate that the issuer receives is supposed to cover the issuer's obligation on its floating-rate bonds.

But there are a variety of situations where a mismatch can occur. The potential mismatch is referred to as basis risk.

In some cases, the swap counterparty agrees to pay the issuer the exact floating rate due on the bonds. But in other cases, the will pay the issuer a counterparty will pay the issuer a floating rate based on a market index, while the issuer's bonds will pay interest based on a remarketing or auction. There is no guarantee that the two floating rates will match.

Several years ago, Philadelphia had an unpleasant experience with a swap, partly due to basis risk exposure. In 1990, the city issued $148 million of floating-rate debt and entered a swap. The counterparty, Merrill Lynch & Co., agreed to pay the city a floating rate based on the J.J. Kenny high-grade index. The city agreed to pay Merrill a fixed rate of 6.85%.

Unfortunately for the city, a fiscal crisis developed later that year, leading to credit downgrades. Merrill was unable to remarket the floating-rate bonds, so the rate on the bonds rose to the so-called bank bond rate, at the time about 12%.

The city was still receiving payments on the swap based on the Kenny Index and paying 6.85%. Merrill's payments were well below the 12% bank bond rate due on the bonds. The city's basis risk exposure emerged, creating enormous losses.

On swaps in which the counterparty agrees to pay the issuer's actual cost of funds, the floating-rate swap payment is not based on a market index, but instead on the floating rate set on the bonds. Some underwriters call this structure a "zero basis risk" swap.

Despite the name, the risk is not completely eliminated.

Theoretically. the issuer should receive a floating rate on the swap that matches the floating rate it owes on its bonds.

But under certain circumstances, the swap counterparty is freed of its obligation to pay the exact floating rate on the bonds.

Generally, if a remarketing of the floating-rate bonds fails, and the rate on the bonds automatically jumps to the bank bond rate, the floating rate on the swap reverts to a market index.

In that case. the issuer would have to pay the difference between the bank bonds rate owed on its bonds and the market index rate it was receiving on its swap, and would still have to pay the fixed rate on the swap.

In some cases, if the issuer is downgraded below a preset level, the floating rate on the swap again reverts to a market index.

Although Philadelphia did not enter a zero basis risk swap, such a structure would not have protected the city. After being downgraded to CCC. and after a failed remarketing for its bonds, the city's swap would have reverted to the Kenny index rate even if the original swap paid the bonds' rate.

So an issuer considering entering a swap should weigh not only the credit strength of its swap counterparty, but also its own credit strength. An issuer with declining credit quality is more likely to run into basis risk problems.

As Philadelphia Treasurer Kathryn Engebretson says, the moral of the story is that issuers "shouldn't enter a swap if their credit is declining."

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