Although derivatives have become an increasingly accepted way for municipal issuers to sell debt, some of the same concerns that arose at the start of the derivatives boom several years ago still nag at the market.
While the tremendous growth in derivatives has allayed the fears of many of the largest issuers about using them, it has also spawned apprehension among a new crop of issuers.
Primary market disclosure and debt portfolio exposure to derivatives and other types of variable-rate debt are hot topics among the latest issuers looking to take advantage of the interest saving opportunities of derivatives products.
Meanwhile, investors have concerns about liquidity and limited secondary market disclosure, and they are busy speculating about what will happen to their derivatives purchases if the market suddenly turns sour and interest rates soar.
Rating agency executives caution that there are many risk factors to consider, especially for lower-rated municipalities or infrequent issuers, before jumping into the derivatives market.
The potenial perils, however, haven't slowed the expansion of the municipal derivatives market. According to Standard & Poor's Corp. analysts, the market has grown from about $2 billion in 1988 to about $28 billion in 1992.
In 1993 so far, more than 170 derivatives issues totaling approximately $7.6 billion have been sold, according to MuniView, a database affiliated with The Bond Buyer.
Disclosure Issues Abound
In their simplest forms, derivatives are securities that derive their value from the performance of another security or market index.
Commonly used derivatives in the primary municipal market include swap-based inverse floaters, auction-based inverse floaters, and embedded cap bonds, which are often used by portfolio managers to hedge or reduce interest rate risk. Some market players also consider short-term variable-rate notes, created by restructuring long-term bonds, as derivatives.
Issuers have turned to interest rate swaps to lower borrowing costs and better match their assets and liabilities.
Public finance executives at investment banks tend to create proprietary derivative products. Seeking to distinguish their products from the wares of competitors, the films tinker with minor features.
One result is a myriad of disclosure questions for issuers and their bond counsel.
"The level of complexity has grown," said Richard Hissocks, a partner with Orrick, Herrington & Sutcliffe in San Francisco. "With certain investment houses, there can be 24 different types of investment products you could use.
"It put issuers and bond counsel at a quandary as to how much information to provide" in offering statements, Hissocks told a group of issuers and portfolio managers at a public finance conference in Napa, Calif., in late September. The conference was sponsored by Grigsby Brandford & Co.
While Hissocks said the safest route for issuers is to provide as much disclosure as possible, the outcome could be that "the official statements would probably be twice as large."
Decide on Derivative at Sale
Some issuers have suggested that certain details regarding derivatives could be omitted in preliminary offering statements, similar to how bond prices appear only in final official statements.
"If you're considering [derivatives], you have to include the appropriate disclosure," said Leslie V. Porter, treasurer of the Los Angeles County Metropolitan Transportation Authority.
Porter said issuers should decide prior to an offering what type of derivative product to use. This would eliminate the need to include disclosure in the preliminary offering statement on a large number of derivative options.
"I wouldn't want to see our [preliminary] official statement twice as large," Porter said.
Portfolio managers and rating agency officials agree that issuers must thoroughly understand the product before authorizing the issuance of derivatives debt.
"It's up to the issuer to be educated up to speed," so they need good underwriters and good financial advisers, said David MacEwen, a senior portfolio manager at Benham Capital Management.
"I certainly wouldn't want to use a derivative if I didn't have a financial adviser and a financial adviser who is involved in underwriting," said Tom Friery, treasurer of Sacramento, Calif.
A Riverside County, Calif., official at the Grigsby Brandford conference questioned whether issuers should be concerned about how much of their outstanding debt is comprised of swaps or other derivative products.
Issuers should have a sense of how much variable-rate debt to hold in their debt portfolio, said Amy Doppelt, a senior vice president at Fitch Investors Service.
At Standard & Poor's Corp., officials say they have no set percentages of how much of an issuer's debt portfolio should be comprised of derivatives.
"There's no magic number on that. I really think it's issuer specific," said Emete Hassan, associate director and derivatives coordinator in the municipal finance department at Standard & Poor's in New York City. "We have to look at the overall portfolio and the overall credit.
"When we hear the word derivative, we don't think negative," Hassan said. "These products make sense; that's why they're around."
Standard & Poor's queries issuers on the availability of revenues and the type of contingency plans in place in case a swap unwinds unexpectedly. A terminated swap could force an issuer to pay a hefty settlement fee.
The rating agency also wants to know about the issuer's natural risk and overall debt profiles, liquidity, existing derivative portfolio, and extent to which it understands the risks of the products.
Analysts at Moody's Investors Service take a similar view.
"Yes there are credit consequences," said Katherine S. McManus, vice president and manager in the public finance department at Moody's.
However, derivatives can be good tools "if properly managed, and understood and implemented," said McManus, who also heads the rating agency's legal analysis unit.
The risks of using derivatives can vary depending on the type of issuer, said Michael Johnston, vice president and manager of Northeast regional ratings at Moody's.
Derivatives may be less risky for municipalities with prudent fiscal management that are frequent issuers, Johnston said.
But issuers with limited cash resources that are less sophisticated about managing their capital programs may be open to more risks, Johnston said.
In making rating decisions regarding derivatives Moody's analyzes an issuer's management expertise and why officials want to use derivatives, McManus said. The rating agency also considers whether the issuer understands how derivatives will fit into its overall borrowing strategy and how it can manage risk over the life of the product.
Another important issue is whether an issuer can legally use derivatives, as some state statues are sketchy about their use. Moody's also is concerned about their potential impact on the issuer's credit and liquidity, especially if a problem arises, and whether an issuer has thoroughly investigated the credit standing of the prospective counterparty in a swap agreement, McManus said.
"An understanding of the risks on the part of the issuer is important," Johnston said.
For issuers who come to market and wish to use derivatives "we discuss it with them a great deal," McManus said.