Orange County yesterday agreed to pay $1.769 million for an interest rate cap that will protect the county against a significant rise in interest rates between now and the planned sale of $720 million of recovery bonds at the end of June.
In a deal described by several market observers as the first of its kind, the county chose Goldman, Sachs & Co. to supply the cap - effectively an insurance policy - in competitive bidding.
The contract will protect against any increase in municipal bond yields of more than 75 basis points between pricing yesterday and June 30.
In what derivatives market players said was an unusual structure - some called it unprecedented - the cap was broken down into 30 individual portions, giving Orange County protection for each of the serial maturities it plans to sell.
Caps have generally been against a single index, derivatives market sources said. But they added that such an arrangement does not protect against changes in the shape of the yield curve that could lead to the county having to pay higher interest rates if the curve, for example, flattens without changing in overall level.
The county entered into the derivative contract in connection with its sale of $720 million of recovery certificates of participation, scheduled to come to market before June 30 as part of the bankruptcy recovery plan.
"It is very unique," said Christopher Varelas, principal at Salomon Brothers Inc., which is serving as financial adviser to Orange County. "We wanted to structure a cap that protected the county from various types of interest rate exposure, both an increase in rates and also a rotational shift or flattening of the yield curve."
To achieve this, the cap is linked to the levels of the Municipal Market Data's triple-A insured yield curve. If the yield at each maturity on June 30 is more than the strike price of 75 basis points above the yield at pricing yesterday, Goldman will have to pay out the excess interest cost on that maturity.
Explaining why the county bought the cap, Varelas added: "Purchasing the cap eliminates the one variable beyond the county's control and ensures that the county's available revenues will be sufficient to pay off the obligations needed to emerge from bankruptcy."
Four firms bid on the deal, having qualified after going through a selection process. In addition to Goldman, they were: Bank of America, Lehman Brothers, and J.P. Morgan Securities Inc.
Asked to suggest how the deal should be executed, Andrew Garvey - senior vice president and marketing manager in Lehman's municipal swaps and investment products group - said his firm had suggested the 30-part cap structure on Monday because it more closely matches the bonds Orange County will issue.
"The key is, it's a more precisely tailored hedge to make sure they were protected from all interest rate movements," he explained.
His colleague, senior vice president Rob Taylor, added that the large number of Municipal Market Data scales available made it possible to choose the one which best matched the expected pricing of the bonds across the entire yield curve. In addition, he said, the MMD scales are one of the most accurate.
Another derivatives market player, who asked not to be named, said it was the first structure of this kind he had seen.
However, he said the use of caps to protect against interest rate movements in this way is a growing market, even though it is more common to use a single figure for pricing such as the PSA index or the London Interbank Offered Rate.
Bidders on the deal, he added, needed a lot of technical skills because of the deal's complexity, the "outsize" $720 million notional amount, and $600,000 cost of a one basis point change if the strike price is exceeded.
Tom Nichols, general manager of Municipal Market Data, a sister company to The American Banker-Bond Buyer, said the adoption of MMD's index was confirmation of its accuracy as a benchmark.
Goldman declined to comment on the deal.
