WASHINGTON - The Internal Revenue Service has asked industry officials for detailed information about embedded cap and inverse-floater bonds amid concerns that the new arbitrage rules may hamper or halt the way these products are currently structured, sources said this week.

IRS officials asked members of the Public Securities Association's municipal derivatives committee and their lawyers to provide the information after meeting with them last Friday to discuss their concerns about the rules, said the sources, who were knowledgeable about the meeting.

Embedded cap and inverse-floater bonds are hedged with interest rate caps or interest rate swaps. They typically bear variable rates for a period of time before converting to a fixed rate when the hedge terminates or when bondholders, if they have a rate conversion right, convert to a fixed rate.

The new rules would treat these bonds as variable -- rather than fixed-rate -- making compliance with arbitrage requirements difficult and possibly very costly. The rules would take effect after Aug. 15 for issuers who opt to continue using existing rules until then.

At the meeting, IRS officials mostly listened to the industry concerns and did not express many views or say whether they might be able to provide regulatory relief, sources said.

PSA committee members and their lawyers were reluctant to talk about the meeting after being told by IRS officials not to talk to the press.

The IRS officials, the sources said, indicated that they would not want to make wholesale changes to the arbitrage rules' hedging provisions, and that if any relief were provided it would probably be through private letter-rulings or revenue rulings.

"They're uncomfortable making broad changes to the arbitrage rules that could allow all kinds of hedges to be done, because it could open the door to abuse," one source said.

"I think if there are going to be changes, it's going to be done through revenue rulings or revenue procedures, or maybe even private-letter rulings," another source said.

The hedging provisions of the new arbitrage rulesgive the IRS commissioner broad authority to determine the arbitrage treatment of derivatives products through revenue rulings or revenue procedures.

The IRS officials indicated that they could not address the concerns raised by the industry officials or the effect of the rules on specific products until they obtained more information about the products.

"They were friendly, but noncommittal about what they could do. They mostly listened and said, 'Let's keep talking,' " one source said.

The concerns about the arbitrage rules stem from hedging provisions that would allow issuers of embedded cap and inverse-floater bonds to take net cap or swap payments into account in determining bond yield, but would treat these bonds as variable-rate rather than fixed-rate instruments.

Industry officials generally want bonds in derivatives transactions to be treated as fixed-rate bonds, whose yields are determined once at the time of issue and reflect the yield over the entire term of the issue.

The yields for variable-rate bonds, in contrast, must be figured and refigured every five years, in what are in effect five-year snapshots. For variable-rate bond issues containing serial and long-term bonds, the yield in the first five-year period would be artificially low and would not reflect the issuer's average interest costs over the life of the bonds.

This would create major problems for embedded cap or inverse-floater bonds that are used to advance refund previously issued bonds, because the initial low five-year shapshot yield would have to be used to determine the yield of the securities escrowed to pay the prior bonds.

The rules contain three provisions under which embedded cap or inverse-floater bonds would be treated as variable rate.

Under one provision, bonds would only be treated as fixed-rate if they were hedged with interest rate swaps. This provision excludes embedded cap bonds from being fixed-rate.

Under another provision, bonds would be treated as fixed-rate if issuers receive floating-rate payments and make fixed-rate payments. This provision would exclude inverse-floater bonds as being fixed-rate because issuers typically would receive fixed-rate payments and make floating-rate payments in transactions involving those bonds.

A third provision says that bonds would be treated as variable-rate if a swap is terminated within five years of issuance. This provision would affect most inverse-floater bonds because they typically have interest rate conversion features that allow issuers to convert to a fixed rate if the market moves against them.

The rules do not cover products such as residual interest bonds/select auction variable-rate bonds, or RIBS/SAVRS, and therefore provide no assurance that these bonds would be treated as fixed-rate bonds. These are inverse-floater bonds in which variable rates are reset through dutch auctions.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.