The following excerpts are taken from a speech delivered to the National Association of State Treasurers' State Debt. Management Network on Sept. 10 in Orlando, Fla. The second part will appear next Monday and their part on Nov. 16.
There are numerous instances of new approaches to accomplish public finance objectives, in order to achieve ether lower cost of capital or to improve the efficiency or prospects for government finance capability. In this connection, I will discuss the various applications of interest rate swaps. Some are worth noting now:
* Greater flexibility in refunding certain debt obligations that would otherwise be restricted by private-activity functions.
* An easier system of moving to variable-rate interest obligations from a fixed-rate mode.
* An arrangement that allows for financial gains to the borrower as a result of changes in the interest rate environment.
* Adjustments in the payment schedule of debt obligations, permitting governments to limit exposure during more difficult times and increasing debt service payments when finances are much better.
The one area I would like to discuss initially at greater length involves secondary market derivatives and embedded derivatives. Because the institutional market has dominated the public finance marketplace, it is not surprising that we find a greater tailoring of individual products for institutional acceptance and investment. There are a series of examples of this closer relationship that have impacted the functions and operations of the securities market.
One such product has become known as inverted floaters. In some quarters and among investment bankers, the products may be known as RIB/SAVRs, Pars and Inflows, Floaters, and Shortrites. Generally, they accomplish the same thing -- that is, the bifurcation of debt service streams by a borrower into two securities. One [stream] is subject to a short-term auction, with the remaining stream of payment being a separate marketed debt obligation -- the so-called inverse floater -- reflecting the remaining rate level after the auction rate has been established.
There is only one reason for an issuer to consider this type of debt investment, that being, of course, lower debt service costs. The use of the instrument can be achieved only in the right set of circumstances. First, there must be a sufficient amount of bonds auctioned each time for a true auction to occur on one portion of the bifurcated security. Normally, there needs to be no less that $20 million of auctionable securities for this structure to work; this amount usually limits the use f the structure to term bonds.
Second, not all indentures envision and allow for the arrangements; thus, most of the issuers that have employed this new structure have done so utilizing a new trust agreement that sets forth the authority for the division of the stream of payments and the related role and appropriate functions for the trustee.
Third, importantly, how can one confirm that the savings are actually there as represented? The argument goes that an issuer can pick up as much as 20 to 25 basis points in lower yield on term securities utilizing this bifurcated security arrangement. We would suggest that it may be suitable for an issuer to utilize a little creative tension in determining the extent to which reduced yields are available with this structure.
For example, assuming that the trust agreement did anticipate and allow the process, then it may be best to give responsibility for the special bifurcated part of the offering to a co-manager. At the time that the issue is priced preliminarily, including the term bonds being priced as though the term bonds would not be bifurcated, then the co-manager responsible for the new structure would be asked to price that portion of the issue.
Frequently, the senior manager will complain that this process can interfere with the pricing for a conventionally priced issue. I don't think there is considerable violence done to the conventional pricing mode as a result of my suggestion. Through the creative tension, you should be able to determine the extent to which there will be a real price advantage by incorporating this structure into the bond sale.
It is our belief that this new structure warrants considerable attention in the right set of circumstances and could result in important debt service savings in an unusual and responsive context. It may be an advantage to you, and I would not discard it out of hand. Still, it should be emphasized that this product is appealing only to a few investors and will not substitute for the array of investors, both institutional and retail, that would normally support your debt obligations, although some sponsors are starting to open up this product to retail investors as well.
A note of caution should be stated at this point. To the extent that tailored securities for individual or a small number of investors become the wave, while there may be marginal or short-term benefits for a few borrowers over time, there is less marketability instilled in the credit markets as a result. For example, the reason that the Treasury market is so marketable is the commonality of securities that is available to investors. Carried to a more fully extensive measure, this new type of security can reduce liquidity of normal tax-exempt notes and bonds, and this is a point to consider.
As much to the point of this discussion of new products and approaches involves the application of what has recently become known as embedded derivatives, which can operate in many different ways. Let me give you one example.
Purchasers have the option, in some instances, of buying securities, to convert, at various points over the first several years of holding the debt obligations, the holdings into a swap instrument.
If the institutional investor bought the securities as a fixed-rate stream of payments, then in accordance with the agreement made at the time of purchase, the investor could swap the investment into a floating-rate debt instrument. Of course, there are payment prerequisites in order for the investor to have the ability to be beneficiary of the more flexible security. The opposite arrangement could be provided as well, that is, from floating-rate to fixed-rate debt payments.
There are a number of variations that can apply to embedded derivatives based upon the investment desires of the purchaser. This program purchasing is another example of the capability of institutional investors to formulate products that most clearly match the portfolio requirements that these purchasers have and the influence of the institutional investor that has been and can be exerted.
One concern implicit in my comments is that I believe that there remains a need for an increasing demand for tax-exempt debt. I realize that there have been many state and local government borrowers who have lobbied for Federal legislation leading to more demand -- such as an increase in the amount of tax-exempt debt that commercial banks can purchase, and receive the advantage of deductibility on the carrying charges.
Others have proposed making tax-exempt interest more attractive for insurance companies. Still others have proposed the elimination of alternative minimum tax provisions for corporations and even individuals who must now limit their nontaxable income, including Social Security benefits and income from local and state governmental debt.
To the extent that less demand exists for state and local securities, we can expect fewer buyers to have more impact on our market, which ultimately, as specialized products are developed, will create less marketability for conventional products, leading to relatively higher interest costs for most state and local borrowers.
Johnson is the chairman of Government Finance Associates Inc. in New York City.