Investors aren't the only ones
who can benefit from
customizing derivatives. Creative issuers
can combine various products to
better meet their needs, too.
A basic interest rate swap, for
example, has a stated maturity
when the
exchange
of interest
payments
concludes.
Either
side can
terminate
the swap
before
maturity,
but that
requires a termination payment
that cannot be predicted in
advance.
An issuer using such a swap in
combination with variable-rate
bonds generates debt service
savings compared with a fixed-rate
bond issue. But the issuer loses
one of the basic benefits of
issuing ordinary debt: the ability to
call the bonds early.
If rates decline after bonds are
issued, a typical issuer can
refund or advance refund bonds.
Even if rates later rise, the issuer
has locked in lower debt service
with the refinancing deal.
But issuers that use a swap and
variable-rate bonds cannot lower
debt service without terminating
the swap early, and that can be
costly.
For example, an issuer might
sell 30-year, floating-rate bonds
that pay an initial rate of interest
linked to the Public Securities
Association's municipal swap
index, about 2.45% this week. The
issuer enters a swap and pays a
fixed rate of 6.00%. The swap
counterparty pays the issuer a
floating rate based on the PSA
index.
But if there is a decline in
interest rates, including the PSA
rate, the 6.00% rate paid by the
issuer is now above-market.
Even if the issuer can call the
bonds, it still must pay the fixed
rate on the swap. And because
the issuer is paying an
abovemarket rate to the swap
counterparty, it probably would have to
make a substantial termination
payment to escape.
Instead, the issuer could use a
modified swap that includes a
call provision. On a callable
swap, the issuer can terminate
the transaction early without
having to compensate the
counterparty.
But in return for granting the
issuer a call right, the swap
counterparty might require an
upfront payment or a higher fixed
rate. And since the issuer is
comparing the cost of the swap
transaction with the cost of a fixed-rate
bond deal, the added expense may
make the swap uneconomical.
The cost of the call option varies
according to a number of market
factors. Volatility is a significant
component of the price. The value of
options generally rises as volatility
increases.
In a calm market, the cost of
including the option would usually be
lower than in a volatile market.
