Lower debt costs sound nice, but many issuers find derivatives a little rich for their blood.
More than one-third of municipal issuers are interested in using derivatives, according to a recent survey by the Government Finance Officers Association. At the same time, many others say the deals look risky and complicated.
Profits aren't a motive for public officials, which encourages staying put. "The public sector is conservative by nature and very risk averse," said Tony Gelderman, chief of staff to Louisiana Treasurer Mary L. Landrieu. In recent years, Louisiana has looked at derivatives and decided against using them.
Corporate America has provided treasurers with more than a few cautionary tales of derivatives gone wrong in 1994 -- take Procter & Gamble Co. "They have vast expertise and they got burned," said an aide to one state treasurer. "We have a few underpaid analysts. We can see pretty clearly where we don't belong."
Others see the corporate losses as a yellow light instead of a red one.
"I think that really points out that it should be a deliberate move to use derivatives, rather than something you embrace without giving it a lot of thought," said Harlan E. Boyles, state treasurer of North Carolina.
Finance officials familiar with derivatives say that few if any municipal derivatives users enter transactions similar to those that burned Procter & Gamble -- a swap based on German and U.S. interest rates that was highly leveraged to create big profits, or losses, from small changes in rates.
Pitfalls and Safeguards
By contrast, most municipalities use derivatives in combination with bond issues or other liabilities as hedging tools. Some have purchased derivatives for cash management accounts or pension funds.
But a few that bought mortgage-backed securities have been burned as badly as any of the corporate users. Last November, Ohio officials audited the investment portfolios of 18 municipalities and found losses totaling $8 million caused by mortgage derivatives.
Some states have strict policies limiting derivatives investments. In California, for example, the treasurer's office buys structured notes, but will not buy a security that does not return 100% of principal. They also shun variable-rate securities based on formulas that may pay zero interest in some periods.
The treasurer's office manages $26 billion of state and local funds and offers daily liquidity.
"We always maintain a rate of reference based on the current market direction," said William Sherwood, chief of the state's investment division. Instead of using derivatives to pick up yield when rates decline, "we try and keep it real straightforward. If rates come down, our rates will come down. And if rates go up, our rates will go up."
The state fund is prohibited from investing in futures and options.
Sherwood has no complaints about the liquidity of structured notes. "Quite frankly, we try to stay away from anything that might give you that type of problem," he said.
But for most treasurers, the derivatives action is related to bond issues.
So far this year, issuance of bonds with embedded derivatives is way down, even taking into account the steep slide in overall issuance. Through the first five months of the year, volume totaled $2.4 billion, compared with $5.2 billion for the first half of 1993, according to MuniView.
Derivatives professionals and municipal finance officials say a variety of factors have created the slowdown from last year's heady pace.
For one, the majority of last year's new volume consisted of refunding issues. Issuers generally establish strict savings targets to justify the expense of advance refunding outstanding bonds. After accounting for negative arbitrage, underwriting fees, and other costs, an issuer sometimes saw the market slip away from its savings target by just a few basis points. Derivatives could be used to recover 10 or more basis points, making the deal economically viable once again.
But on new-money deals, issuers generally have more relaxed standards for acceptable yield levels. With rates still relatively low by historical standards, some issuers see little reason to include derivatives.
"We can get very low rates on [non-derivative] issues. Why not just fix down at a low rate?" a finance official said. "Though swaps and derivatives may be more attractive to us in a higher interest rate environment."
Worries About Savings
Other issuers are concerned about price. In Massachusetts, for example, recent derivatives pitches have offered savings of five to 10 basis points.
"It used to be that bankers would come in and promise 15 to 20 basis points of savings, whispering that 25 was possible," recalled Ken Olshansky, assistant treasurer for the state. Now savings estimates are lower, he said.
"Our participation is viewed as something investors have to pay a fee for, like the takedown," he said. At current levels, "it doesn't seem to bear any relationship to what benefits are being created."
In Texas, the amount of savings is also a concern, according to assistant deputy treasurer John Bell. But he anticipates that the state will be able to garner significant savings in the future.
"They can save states some money, and I think we'll probably use them again," Bell said. The state is considering a swap structure for an upcoming note deal, he said.
Another factor depressing derivatives issuance is investors' diminished appetite for derivatives. With rates rising instead of falling, as they did for the past few years, investors are much less interested in the inverse floater, for example. Derivatives professionals have yet to hit upon an equally popular product for a bearish market climate.
And some mutual funds have been burned by derivatives, although mainly by mortgage market products. Portfolio managers, reacting in part to growing public uneasiness, have cut back on derivatives holdings.
Trying Out Forwards
The changing yield curve has encouraged some issuers to opt for forward derivatives transactions.
In a forward deal, the issuer agrees today to sell variable-rate bonds and enter a swap on a future date. But the rate is locked in today, using forward rates derived from the yield curve.
Because the yield curve has flattened, forward rates have not risen as dramatically as current, or spot, rates. Thus, the premium between forward and spot rates has declined.
Some issuers view derivatives as more useful for their investments than for bond issues.
In North Carolina, the law prohibits the state from investing in most derivatives. But state Treasurer Harlan Boyles says it may be time to try a more flexible approach.
"Our statutes have a defined list of securities that we can invest in, versus the 'prudent man' rule that some have," he said.
New York State is also considering changing its laws relating to derivatives, although state officials are focused on debt issuance. In January, the state Assembly's Ways and Means Committee held a hearing to discuss updating the state's laws governing finance.
John Hull, deputy comptroller for the division of investments and cash management, testified at the hearing in favor of limited derivatives legislation.
The comptroller's office has "requested legislation to permit the use of derivatives, and we also think that other large public authorities should be similarly empowered," Hull said. "We think that explicit legal authorization is both helpful and necessary. We would caution, however, expansion of the authorization beyond very large and frequent issuers of local debt."
Washington State adopted such legislation last year, for example. Passed in April with the strong support of the state treasurer's office, the law permits state agencies, public utility districts, cities, counties, and other entities to use swaps. But an issuer must have outstanding debt of $100 million or annual revenues of $100 million to qualify.
