Q: You advocate that issuers sell longterm floating-rate debt and enter an interest rate swap to lock in a fixed rate. What are the advantages of synthetic fixed-rate debt that make it worth the effort?

Gort: It's probably the greatest opportunity for the municipal issuer to participate in savings that are available in the derivatives market - without having to take a speculative trading position as well.

Specifically, municipal bonds are very inefficient the further out on the yield curve you go, due to possible tax law change, credit deterioration, and the lack of homogeneity of credits. And then closer in on the yield curve, to weeklies and dailies and commercial paper, you have homogenizing credits with letters of credit, insurance of very highly rated institutions, a very low risk of tax law change, and a much more liquid and able market.

So you get the best benefit of the tax exemption in the floating-rate short-term [market]. And you get the highest efficiency possible in the swap market the longer the rate.

Q: Is that difference caused by the different shape of the yield curve in the municipal market and the swap market?

Gort: It's not necessary that it be a different shape. The particular thing favoring these synthetic, fixed-rate bonds today has been that there have been some unusual shapes in a very steep yield curve, and the taxable yield curve has been a lot more efficient during market moves.

For example, the municipal market has significantly lagged the bond market, and that created some great widening of savings.

The swap market is very efficient to deal with, because it doesn't have the 50,000 different municipal issuers out there to worry about, it does not have the inefficiencies in the long end that exist in the tax-exempt market, and the tax-exempt market has a unique and wonderful efficiency in the short end.

There has been a shortage of short-term municipal paper going on now for many years. So those issues are priced very aggressively, sometimes through the implied tax-exempt rate because of the shortage of paper for the bond funds.

So by taking advantage of two very efficient points in two different markets, you generate significant savings.

Q: So how does the transaction work? What's the structure?

Windisch: Basic synthetic fixed-rate structure is simply to take bonds that you would have otherwise issued as long-term fixed-rate debt, and instead issue short-term floating-rate debt. And then, in turn, to enter a floating-to-fixed interest rate swap. When we talk about synthetic fixed, we generally mean replacing long-term financing, so you're talking about swaps that extend frequently 20 or 30 years.

Q: But there are risks that could disrupt the synthetic fixed rate?

Gort: I don't want to call it risk, because really we're not talking about risk in the sense of loss, but if they're after a fixed rate, what Ron just described to them does not quite give them a fixed rate. Because they have a floating-rate index that they're being paid [on the swap side), and they have a bond that may price on, through, or above the index.

Many issuers, of course, have decided that they don't want that. They want a fixed rate. And honestly, prior to the tax law changes this spring, they had to have a fixed rate to get an integration for yield purposes.

So we have a unique creature, something that does not exist outside the municipal market, which is a rate-matched - or zero-basis risk - swap where the swap dealer agrees to pay the actual cost on the bonds.

Though that then begins to get more of a true, fixed rate, it's always subject to a series of conditions. There are credit events and rate events, both of which can lead to not having an exact match.

Q: Doesn't an issuer need some form of credit enhancement to take advantage of a synthetic fixed-rate structure?

Gort: Double-A quality municipal issuers who have a significant cash flow and cash on hand can meet requirements that the rating agencies specify to issue floating-rate debt in the highest rating categories without having a liquidity or credit provider.

Of course, they are the most able to take advantage of this market. Since they do not have to purchase liquidity, and they do a rate-match swap, they would then have, in effect, a perfectly matched and a fixed-rate obligation.

Most issuers, those who have to purchase liquidity, are always at risk that something will happen to the liquidity. Times change. The Basel [capital] standards certainly change the nature of liquidity and credit providers, both their ability and price of doing transactions.

Q: Are some firms willing to include a liquidity guarantee on the transaction, that effectively assures an issuer that liquidity support will always be provided al a set cost?

Gort: There are very few institutions who have offered a solution to that by guaranteeing liquidity over the life of the bonds as part of the transaction. It's a very, very limited number. And if you think about that, any time you have a market that has only one or two providers, that's cause to be concerned in and of itself since you obviously are not in a free market and open system. You're going to be bound by whatever terms they wish to dictate.

And secondly, you still haven't eliminated liquidity risk. Their liquidity capability could go away. They could have a credit problem with their liquidity.

Q:are there other risks issuers need to keep in mind? What about credit risk on the swap?

Gort: The third major risk, and this is a price risk again, is that your counterparty credit can change. If we look at the history of ratings of financial institutions, there's a lot of volatility. When you sign up for a counterparty, you are assuming that that counterparty will be there to make payments over the life. If they're not, you have to replace the swap.

The cost of replacing the swap is a relatively simple cost to analyze. It's whatever the current market is, the difference in payments over the life brought down to a present value at their, or the issuer's, cost of funds.

By far the fairest, most equitable transaction is a mutually collateralized, bilateral collateral agreement. When you are exposed above the comfort level, you bring your exposure back to zero, and when you get back up above the comfort level again, you bring your exposure back to zero, by posting collateral with the other party.

Q: How does a standard collateral agreement work?

Windisch: In the context of synthetic fixed [transactions], the idea of collateral is to allow a party that has seen a default happen to go out and buy the same swap from another provider. So in the case of an issuer who's paying a fixed rate to their swap counterparty, if interest rates increase, then all things being equal, if the swap dealer defaulted, the issuer would have to pay a higher fixed rate to a replacement counterparty.

In that case, the swap dealer would give collateral to the issuer so they could then go buy a swap at the original rate. Conversely, if rates went down, then the swap dealer is receiving an above-market rate from the borrower. If the borrower defaulted, he'd have to replace those cash flows at lower rates. In that situation, the borrower would post collateral, so if he went away, the swap dealer could replace the swap or buy a swap at an equal rate.

Gort: It means that at any one time, each party is absolutely neutral as to the other party, whether something happens to them or they choose to default. That does create one significant problem, which is many municipal entities either do not have the cash on hand or do not have the legal authority to post collateral on their contracts.

Q: Does that apply to all issuers?

Gort: This is particularly a problem with constitutional issuers like states and cities and counties. It is much less of a problem with statutory issuers. And when you get into the quasipublic issuers like nonprofit organizations, hospitals, universities, it's very much not a problem. Most of them do in fact have cash on hand, particularly the ones that are interested in this marketplace.

Q: How else can you reassure an issuer about credit risk?

Gort: We have demonstrated to several issuers that there is a lot of comfort because of the fact that you are constantly moving down the yield curve. Five years from now your exposure will be significantly less than it is today, because you will have a shorter remaining term. Therefore you're on a shorter yield curve, and more importantly, you'll have a shorter remaining exposure.

With interest rates low but threatening to reverse course, issuers have already refinanced a record volume of debt this year. Some have refunded bonds paying 9% or more with fixed-rate debt paying just 5.50%.

Others have refinanced by issuing so-called synthetic fixe-rate debt. The issuer sells variable-rate debt and enters an interest rate swap to lock in a fixed rate for the life of the swap. Issuers have saved 20 to 40 basis points on ysnthetic fixed-rate transactions.

But there are times when a syntheic fixed-rate transaction can unexpectedly turn into a floating rate.

Staff reporter Aaron Pressman spoke with Micheal Gort, a principal in public finance at Morgan Stanley & Co., and Ron Windsich, an associate, last month about the risks and benefits of sysnthetic fixed-rate issues.

Gort and Windisch said many issuers could take advantage of a swap or forward transaction to lower the cost of their debt service.

"The forward swap transaction is no different from the concept of synthetic fixed-rate debt. You are still taking bonds that you would have done as fixed-rate bonds and doing a swap instead," Gort said.

Although terms of the swap are negotiated right away, the swap does not begin for several years.

Forward transactions do require the issuer to pay a slight premium over current rates, however, "You really use it in instances where you don't have the option of issuing fixed-rate bonds," Gort said.

Issuers must demonstrate that they have the legal authority to engage in swap. "We certainly have turned down circumstances where we could not be assured," Gort said.

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