WASHINGTON - The IRS' recently issued revisions to its arbitrage rules are mostly favorable for municipal derivatives, but contain proposed restrictions on interest rate caps that are troublesome, market participants said yesterday.

The so-called technical corrections, most of which the Internal Revenue Service issued on May 6 in proposed and temporary form, are "tremendously responsive" in addressing the Public Securities Association's concerns about the final arbitrage rules that were published last June, said Robert Sharp, a lawyer with Rogers & Wells in New York City.

The association had complained that the arbitrage rules were overly restrictive because they treated as fixed-yield only interest rate swaps in which the issuer makes fixed-rate payments and receives floating-rate payments.

The technical corrections would expand the existing rules to allow more tax-exempt bonds with derivatives, including forwards, to be treated as fixed-yield bonds as long as the issuers' costs are fixed, said Sharp and John Cross, a lawyer for Hawkins, Delafield & Wood in Washington, D.C.

"For the most part, they were very constructive changes," Cross said.

The proposed and temporary technical corrections take effect for bonds sold after June 6, but are still subject to public comment and possible revision.

But most derivatives market participants said they are concerned about the technical corrections the IRS proposed for interest rate caps because they would severely limit leveraging.

"Embedded cap bonds are often leveraged because investors want to obtain a cheaper hedge," said bond lawyer who did not want to be identified.

It is not uncommon to see embedded cap bonds that contain an interest rate formula in which there is a leverage factor of two or three times a floating-rate index, market participants said.

Leveraging is used to reduce investors' costs of purchasing an interest rate cap. Such caps are costly, investment bankers said. They provide investors with protection against increases in short-term interest rates rather than with above-market yields. Interest rate caps do not provide investors with returns unless they are triggered by rising rates.

An investor who wants to hedge $10 million of inverse floating-rate bonds may buy $5 million of embedded cap bonds with a leverage factor of two times a floating-rate index. The investor is able to buy less bonds than the amount it is trying to hedge but gets twice as much protection from the cap through leveraging.

Under the proposed rule, which would not take effect until adopted in final form, bonds with interest rate cap would not be treated as a "qualified hedge," and would instead be considered "investment-type property" that is subject to arbitrage restrictions, unless three criteria are met.

One is that the cap would have to be used to hedge a bond that is defined as a variable-rate bond under the IRS' final rules on original issue discount. Under the definition, the cap could not have an interest rate formula with a leverage factor of more than 1.35 times a floating-rate index.

Derivatives market participants are concerned about the link between the hedging provisions in the arbitrage rules and the final rules on original issue discount.

"The link to the rules on original issue discount, in and o itself, is not that drastic," Cross said. "But it does raise the question of whether Treasury and the IRS will pursue this standard in future rules that deal with the issue of whether tax-exempt bonds that have derivatives or exotic interest rate formulas generate a return that is still tax-exempt interest."

Sharp said the arbitrage and original issue discount rules should not be linked because they have "different policy aims." The policy aim of the original issue discount rules is to match income and expense over time for obligations that have irregular payouts, he said.

Sharp also said that it does not make sense for the IRS to revise the arbitrage rules' hedging provisions to cover non-swap hedges and then to propose to restrict interest rate caps, the primary non-swap hedge used in the municipal bond market.

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