WASHINGTON -- The Public Securities Association is urging the Internal Revenue Service to make three revisions to the new arbitrage rules, saying the changes "are essential to the continued growth of the municipal market."

The industry trade group recently sent the IRS a letter and memorandum outlining the proposed changes that would allow certain embedded interest rate swap, embedded cap, and matching floater and inverse floater bond transactions to be treated as fixed-yield issues for arbitrage purposes.

"I think what we're saying is that when products give rise to a fixed economic yield for the issuer and there is no possibility of a windfall or arbitrage abuse, they should be treated as fixed-yield issues under the arbitrage rules," said Robert K. Sharp, a lawyer with Rogers & Wells in New York City, which is working with the association on derivatives issues.

Issuers and bond firms want municipal bond issues with derivatives to be treated as fixed-yield issues. That way, the bond yield can be easily determined for arbitrage purposes, and will remain constant and accurately reflect the issuer's interest costs over the life of the bonds.

Fixed-yield treatment is deemed particularly important for those derivatives used in advance refundings because the bond yield dictates the yield of the securities escrowed to redeem or defease the bonds.

The new arbitrage rules, which took effect for bonds issued after Aug. 14, only treat bonds as fixed-yield issues if they are hedged with interest rate swaps in which the issuer pays fixed rates and receives floating rates.

The PSA praised the IRS for including the hedging provisions in the arbitrage rules but said the provisions are so narrow that they do not provide fixed-yield treatment to some commonly used derivatives products. These include matched floating and inverse floating rate bonds, embedded caps, and caps and interest rate swaps in which the bondholder has the right to convert to fixed rates within five years.

One PSA concern is that under the new rules, if an issue is hedged with a swap and the swap is terminated within five years, the hedged bonds are to be treated as variable rate.

The restriction appears aimed at ensuring that the termination of a swap will not result in an issuer windfall that is not subject to arbitrage requirements.

But, the PSA said in its memo, almost all bond transactions with embedded swaps or caps permit bondholders to convert to a fixed rate, and when rate conversion takes place there is a partial termination of the swap or cap.

The termination of the swap has no economic impact on the issuer, the PSA said, because any termination payments made to the issuer are offset by adjustments in the bonds' interest rate.

The association asked the IRS to revise the rules so that bond issues with swaps that are terminated within five years of issuance will be treated as fixed-yield issues if the fixed yield paid by the issuer does not change as a result of the termination.

The PSA also asked that the rules be revised so that transactions with embedded caps are treated as fixed yield as long as the issuer pays periodic fees to the cap provider in exchange for receiving payments if a specified floating rate index exceeds a predetermined fixed rate.

The current rules appear to exclude caps from fixed-yield treatment because of concern that the issuer could pay a cap fee up front and then receive a series of payments from the cap provider that, over time, would be greater than the up-front cap fee.

But the PSA said that almost all municipal derivatives transactions with embedded caps call for the issuer to pay periodic fees and that such fees are made in exchange for payments from the cap provider if the cap is exceeded.

In addition, the PSA asked the IRS to revise the rules so that transactions with matched floating and inverse floating rate bonds, such as RIBS/SAVRS, or residual interest bonds/select auction variable rate bonds, will be treated as fixed-yield issues. The association said these transactions are structured so that the issuer's yield is always fixed.

IRS officials have said they did not cover these transactions in the arbitrage rules' hedging provisions because they are not hedging transactions. But the PSA pointed out that since the two sets of bonds each bear variable rates, the whole transaction could be treated as variable yield under the arbitrage rules.

IRS officials said earlier this month, after publishing 31 technical corrections to the arbitrage rules, that they are considering issuing further guidance on derivatives.

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