WASHINGTON - The Public Securities Association has asked federal officials to modify certain hedging provisions of the arbitrage rules, saying they present "significant barriers" to the development of the municipal derivatives market.

The PSA asked for the modifications in a memorandum sent to Treasury and Internal Revenue Service officials last week.

The memorandum follows a letter and memo the PSA sent the agencies in August seeking three major changes to the IRS hedging rules. The most recent memo seeks six additional modifications to the rules.

The hedging rules dictate when municipal bond issues with derivatives can be treated as fixed-yield issues for arbitrage purposes.

Issuers and bond firms want municipal derivatives to be afforded fixed-yield treatment so that the bond yield can be easily figured for arbitrage purposes, remains constant, and accurately reflects the issuer's interest costs over the life of the bonds.

Fixed-yield treatment is especially important for derivatives used in advance refundings because the bond Yield dictates the extent to which the yield on the escrowed securities must be restricted.

One of the PSA's proposed modifications calls for the IRS to make clear that if an interest rate swap is terminated because of a counterparty default, the termination of the swap will not cause the bonds to be treated as variable-yield bonds.

Under the current rules, if a swap is terminated within five years of issuance, the bonds are to be treated as variable-rate bonds. The restriction appears aimed at ensuring that the termination of a swap will not result in a windfall for the issuer.

The PSA said, however, that there would be no windfall motive in the default of a counterparty and that issuers should not be penalized for actions of another party that are beyond their control.

The association also said the IRS should clarify that interest rate caps with periodic fee payments will not be regarded as "investment property" that would prevent issuers from receiving fixed-yield treatment.

Under the current rules, caps would be treated as investment property when the strike price of the cap - that is, the price at which the cap provider begins to make payments to the issuer - is not less than the market fixed rate for an interest rate swap on the date the cap takes effect.

But the PSA argued that if the cap fees are spread out over the term of the cap, it is not likely the cap is being used to give the holder an investment-like return.

In another proposal, the PSA asked the IRS to clarify that an upfront payment made by the counterparty to the issuer in a swap will be treated as a loan that is repaid with swap payments from the issuer that are above-market. The swap payments should be excluded from yield calculations, the PSA said.

In such cases, the upfront payments cover the present value of the future debt service savings and are, in essence, a loan from the swap provider to the issuer that is repaid over the term of the swap, the PSA said.

The IRS should make clear that the upfront payments should not disqualify the swap from fixed-yield treatment as long as, when the payment is made, the swap provider certifies what discount rate it used in calculating the present value of the savings and in determining the portion of the future swap payments that represent the "loan" repayments, the PSA said. The repayments should be excluded from all yield calculations, the association said.

"Such a procedure would allow issuers flexibility in structuring savings, while at the same time providing a policing mechanism to guard against potential abuses," the PSA said in its memo.

The PSA also proposed a modification regarding transactions in which an issuer agrees to enter into a swap in the future in return for either making an upfront payment to the counterparty now or agreeing to pay an above-market swap payment to the counterparty in the future. The excess payments would represent the increased costs of hedging, it said. The IRS should make clear that the upfront payment or above-market swap payments will not disqualify the transaction from fixed-yield treatment and will be excluded from yield calculations, the PSA said.

The PSA asked the IRS to modify the rules to make clear that if a hedge terminates with respect to some of the underlying bonds, the rest of the bonds will still be integrated, for arbitrage purposes, with any other hedges that remain in place.

In another proposal, the PSA asked the agencies to broaden the scope of the hedging rules so that non-swap hedges, such as interest rate caps, can also receive fixed-yield treatment.

The current rules provide fixed-yield treatment only for certain interest rate swaps. But the PSA said that most municipal derivative transactions contain several products to achieve maximum interest rate savings for the issuer.

"Unless there is a compelling policy reason, which there does not seem to be, for mandating such inefficiency, the case for broadening the scope of [the hedging rules] to include non-swap hedges seems overwhelming," the PSA said.

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