The Treasury Department should clarify the qualified hedge rules for municipal bond-related derivatives because their practical application can be cumbersome and restrictive, bond lawyers said this week.
In comments sent to the department, the National Association of Bond Lawyers said that within the qualified hedge rules, there are “current issues that need clarification on the technical level; common troublesome areas where there’s a lack of guidance,” according to NABL president Carol L. Lew.
The Treasury Department has been reviewing different elements of the arbitrage regulations contained in Section 148 of the tax code, which restrict the amount of earnings on investments of tax-exempt bond proceeds that municipal issuers can receive and retain.
Those rules cover interest rate swaps and other derivative products often used to hedge interest rate risk on municipal bonds. The qualified hedge rules apply to the integration of interest rate swaps with underlying bonds. Eight conditions must be met in order for a swap to be a qualified hedge and thereby have terms that may be integrated with those of the bonds for yield calculations.
The rules relating to qualified hedges generally have been a great success, but certain aspects of derivatives transactions “are done over and over again, and the market needs clarification,” said Lew, a partner with Stradling Yocca Carlson & Rauth in Newport Beach, Calif. NABL “tried to isolate very common transactions and issues, and provide technical suggestions” in its comments, sent Tuesday to Treasury, she said.
To that end, NABL addressed existing regulations such as the “primary purpose” rule, which stipulates that qualified hedges, such as interest rate swaps, as well as caps, futures contracts, forward contracts, or options, must be entered into “primarily to modify the issuer’s risk of interest rate changes with respect to a bond.”
Bond counsel have been uncertain whether basis swaps, in which issuers agree to make payments based on one floating rate index in return for receiving payments based on another floating rate index, meet the primary purpose rule. The swaps effectively convert a stream of floating-rate cash flows into a different floating-rate stream, and are utilized in a variety of ways, NABL said. The association recommended Treasury clarify that, where a basis swap is entered into for the purpose of hedging the interest rate changes on a bond subject to a qualified hedge, the transaction meets the primary purpose rule.
Additionally, qualified hedges cannot contain a “significant investment element,” which exists when a “significant portion of any payment by one party relates to a conditional or unconditional obligation by the other party to make a payment on a different date,” according to the current regulations. Applying those rules to the swap market creates several issues, according to NABL.
In the existing market, payments on interest rate caps are customarily made in single, upfront payments, which are deemed impermissible “significant investment elements” and disqualify caps from integration with bond yield in most cases. The rules should be changed to allow commercially customary caps with upfront premiums to be treated as qualified hedges, according to the association.
NABL also recommended that the acquisition of an offsetting hedge not be treated as a deemed termination when a hedge ceases to be qualified, and that Treasury provide that a hedge will be considered “interest-based” if all non-fixed payments are based on a formula that would be a qualified floating rate under the regulations.
Other related NABL comment projects are in the works and will address disclosure and state law issues as they relate to derivatives, Lew said.
