Every government finance officer who uses derivatives faces the challenge of explaining the transaction to a variety of constituents, including the politicians on their governing board and the media. The task can grow considerably more difficult if the transaction results in the issuer making a termination payment to its dealer counterparty. There are those who have assumed that a termination payment made by an issuer represents a loss to the taxpayers on some sort of a bad bet. In the overwhelming majority of cases, nothing could be further from the truth. A termination payment, in and of itself, has nothing to do with a real economic loss to taxpayers or with profit for the bank. Termination payments are an inherent part of prudent use of derivatives and are often made on transactions that achieve significant savings for taxpayers.
Let us consider the most basic case of an “anticipatory hedge.” Suppose an issuer intends to issue $100 million in 30-year fixed-rate bonds. The bond sale is to take place in 12 months. The issuer is subject to debt service limitations and would like to lock in today’s interest rates in order to produce budget certainty. To accomplish this, the issuer enters into a swap, payments on which are scheduled to start in 12 months. In the swap, the issuer will pay a fixed rate to the dealer in exchange for receiving a floating rate. In 12 months, the issuer intends to sell the fixed-rate bonds and to terminate the swap before the scheduled payments on the swap are due to start. The swap is sized such that the issuer expects that the change in the swap’s mark-to-market value due to market movements will closely approximate the change in the amount of proceeds that the issuer will receive from its fixed-rate bond issue (with the amount of debt service kept constant).
For example, suppose that over the course of the next 12 months, interest rates fall. The issuer makes a $5 million payment to the swap dealer to terminate the swap. The issuer is then able, because of lower rates, to fund the termination payment with bond proceeds while keeping overall debt service at originally projected levels. The issuer ends up with net $100 million of proceeds for projects and the same debt service as budgeted — just as intended.
Has this issuer made a “bad bet”? No. No one can predict where interest rates will move in the future. If rates had risen, the issuer would have collected a termination payment - say $5 million -to add to the $95 million in proceeds that they would have received from the bond issuance. By executing the anticipatory hedge, the issuer did what hundreds of corporations do when they hedge their future bond sales in the swap market.
Creating certainty with respect to interest rates is the opposite of a bet. One can argue that not entering into a hedge and subjecting taxpayers to interest rate fluctuations would be more akin to gambling. No one can predict which way the termination payment will go on a given trade, but if the issuer does make a payment to the dealer, it should not be surprising or troubling. In fact, issuers have been making the same market hedging decisions with respect to refinancings for decades — in advance refundings, a staple of the municipal market.
In addition to anticipatory hedges, issuers often make termination payments on swaps that they intended to keep to maturity, if an opportunity arises to extract additional savings by terminating. In such cases, the taxpayers enjoy a net economic benefit even as the issuer makes a termination payment to the bank.
For example, say an issuer can sell conventional long-term fixed-rate bonds with a rate of 5.00%. Alternatively, the issuer can sell variable-rate bonds and enter into a variable-to-fixed swap, achieving a synthetic fixed rate of 4.80%. Suppose the issuer chooses to enter into the swap. A year later, market rates for conventional fixed-rate bonds may have declined further than swap rates (as has indeed happened in a number of historical periods). For instance, the rate for conventional fixed-rate bonds has declined to 4.20%, an 80 basis point decrease, while the market swap rate went down only to 4.30%, a 50 basis point decrease.
The issuer can unwind the swap, paying the dealer the present value of 50 basis points (the difference between the existing swap rate of 4.80% and the current market swap rate of 4.30%). The issuer can then refinance the floating-rate bonds at a fixed rate of 4.20%, thereby lowering the all-in cost to 4.70%. The issuer saves 10 basis points — potentially tens of thousands of dollars per year — versus the prior synthetic fixed rate of 4.80%, in addition to the 20 basis points saved by the swap in the initial financing. The economic benefit to the issuer from both the swap and the termination is clear, in spite of the termination payment to the dealer. This type of transaction is only executed at the option of the issuer and the issuer is otherwise not obligated to cancel the swap or pay a termination fee.
Perhaps, the negative attention occasionally given to termination payments is due to the misconception that a termination payment received by the dealer is indicative of the dealer’s profit. This, of course, is false. Every swap a dealer does with an issuer forms part of the dealer’s swap book, along with thousands of other transactions, all of which are re-valued daily based on changes in market rates. The dealer attempts to keep its book hedged — any increase in the mark-to-market value of one transaction is offset by the decrease in the value of others.
In order for the dealer to make a profit on termination of a swap, the termination payment received by the bank needs to be greater than the current mark-to-market of the transaction. It is entirely possible for the bank to receive a large termination payment from an issuer but to record a loss. For instance, if a dealer receives a termination payment of $10 million on a transaction whose mark-to-market on the dealer’s books is a positive $10.5 million, the dealer will record a loss of $500,000 — and even more once the bank’s cost of re-hedging is included. Conversely, a bank can show a profit even while paying a termination payment to the issuer. For instance, if a transaction’s mark-to-market value on the dealer’s books is a negative $10.5 million, and the bank pays the issuer $10 million to terminate, the bank will record a $500,000 profit (less re-hedging costs).
The fact that an issuer pays a large swap termination amount to a dealer has nothing to do whatsoever with the dealer’s profit. It also says nothing about the real economics to the issuer, as we saw above. Any attempt to present a termination payment as a proof of a transaction’s failure for the issuer is misleading and wrong. We would encourage those who analyze municipal swap transactions to understand each transaction in its entirety. Looking at the termination payment alone is simply not enough.
This commentary was written by The Bond Market Association’s Municipal Financial Products Committee. The committee consists principally of dealers in the market for derivatives in which the end-user is a borrower of the proceeds or an issuer of tax-exempt debt. This is the first in a series aimed at enhancing the understanding and awareness of derivatives as a financial risk management tool.
The Bond Market Association represents securities firms, banks, and asset managers that underwrite, invest, trade, and sell debt securities and other financial products globally.
