Issuers often use floating-rate debt in conjunction with a swap to lower their debt service costs.

Sometimes, the floating-rate debt is reset by a remarketing agent or at a periodic Dutch auction. In other transactions, the debt is tied to a market index. The two most common indexes, the JJ Kenny high-grade index and the Public Securities Association's municipal swap index, reflect rates on short-term, tax-exempt securities.

But some tax-exempt, index-linked, floating-rate debt is tied to taxable market indexes, such as the constant maturity Treasury rate or the London interbank offered rate.

California, for example, sold some floating-rate revenue anticipation notes last week that will pay 72% of the one-month Libor rate.

Why would a tax-exempt issuer sell floating-rate debt tied to a taxable market index? The answer lies in the vagaries of the swap market.

Although the tax-exempt derivatives market is growing, the volume of swaps denominated in tax-exempt indexes is tiny compared with the volume of swaps linked to taxable indexes. So an issuer can choose from a wider array of swap dealers if it enters a swap based on a taxable market index.

Issuers can still select from 10 to 20 firms providing swaps based on tax-exempt indexes, but there is another reason for using taxable index swaps: saying money.

Most swap dealers hedge their tax-exempt swaps using taxable swaps or futures contracts on taxable market indexes.

They are then exposed to a new risk and must add another layer of hedges because at times the taxable market does not move in unison with the tax-exempt market, which could upset the hedges.

For example, this week the PSA swap index is at 2.90% While three-month Treasury bills are yielding 4.28% -- a ratio of about 67.8%. But last week, the PSA index was at 2.83% and the Treasury bill was at 4.50% -- a ratio of 62.9%.

So the dealer must use the MOB spread -- the difference between the Treasury bond futures contract and the municipal bond futures contract -- or other tactics to hedge against a change in tax-exempt rates that does not affect their taxable hedge transactions.

This added layer of hedging is reflected in the cost of a tax-exempt swap. By inflating the bid-ask spread, a dealer usually charges more for a PSA swap than for an identical swap based on a taxable market index.

To avoid taking on that risk, the dealer can offer a swap based on a taxable market index.

Instead of offering a floating-rate security that pays a rate exactly equal to a tax-exempt market index, the issuer's debt pays a proportion of a higher, taxable market index.

The issuer then enters a swap based on the 'proportion, or enters a swap with a lower notional value than the amount of debt sold.

For instance, if an issuer sold $100 million of notes paying 72% of one-month Libor, the issuer could enter a swap based on the same index with a notional value of just $72 million.

The risks from changes in the ratio of taxable and tax-exempt rates now reside with the security holder.

If the ratio of one-month Libor to similar tax-exempt securities rises from 72% to 75%, the holder of the tax-exempt 72% Libor floater loses out. The holder is still receiving only 72% of one-month Libor, while ordinary tax-exempt floaters have risen to 75% of Libor.

If the ratio declines from 72% to 68%, however, the holder is a winner. While ordinary- tax-exempt floaters are paying only 68% of Libor, the holder of the Libor floater still receives 72%.

And there is one other reason for tax-exempt issuers to use taxable market swaps. The issuer is using the swap to lock in a fixed rate lower than the rate it would pay if it issued fixed-rate debt.

Sometimes the rate on a swap is cheaper than the rate on fixed-rate debt, but not always. Swaps linked to different indexes may offer lower rates.

If an issuer cannot save money with a PSA index-linked swap, savings might still be available on a Libor swap.

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