Tax-exempt bond issuers using benchmarks from the taxable market in synthetic fixed-ratedeals should consider an alternative calculation of rates in order to compensate forrecent short-term losses, according to Peter Shapiro, managing director of SwapFinancial Group.
Shapiro, speaking yesterday to the Municipal Analysts Group of New York, said thatinstead of receiving 67% of the London Interbank Offered Rate in synthetic fixed-ratedeals, issuers should opt for 59% of Libor plus 35 basis points to guard against lossesin an environment of low interest rates. Shapiro and Fitch Ratings managing directorKatherine McManus both spoke on the proliferation of swaps in the municipal market.
"A lot of issuers are doing swaps for the first time now," Shapiro said. "That's why weprefer to nail [the benchmark] a little better," to guard against short-term losses.
Shapiro said that he is concerned that some new swap users could get turned off fromusing derivatives, despite the overall savings and long-term benefits, because of short-term losses produced by using 67% of Libor.
Among those new users are New York City and New York State and its agencies. SwapFinancial was recently picked as swap adviser to the New York City Municipal WaterFinance Authority and was the adviser on a $1 billion deal done recently by the EmpireState Development Corp.
As more issuers have turned to swaps, they have exploited lower rates derived from thetaxable market, where rates have dropped even further than in the tax-exempt market.However, at the same time, taxable and tax-exempt rates have compressed, cutting intothe savings produced by using a Libor-based benchmark.
In a standard municipal swap, the issuer sells long-term variable-rate demandobligations and alters the exposure on the debt to fixed rate through a contract with aninvestment bank. In the contract, the issuer pays a synthetic fixed rate to theinvestment bank and receives a variable-rate payment.
Long-term synthetic fixed rates in deals in which the issuer receives Libor-basedvariable-rate payments from the investment bank have fallen further than rates based onThe Bond Market Association municipal swap index, which is derived from tax-exemptvariable-rate demand obligations.
However, Shapiro said, despite the long-term trend showing 67% of Libor to be roughlyequivalent to the rate on tax-exempt VRDOs, that has not been enough to cover the costof tax-exempt variable-rate bonds in the last year or so. As a result, issuers have notreceived enough in payments from investment banks to cover their VRDOs in swap deals,adding to the cost of the synthetic fixed rate.
Using a long-term analysis of the 52-week moving average of Bond Market Association toLibor, Swap Financial calculated that 59% of Libor plus 35 basis points produces apayment from an investment bank that covers the cost of tax-exempt VRDOs and stillgenerates an attractive synthetic fixed rate.
Shapiro said issuers his company advises have used the alternative benchmark. Shapiro,in his speech, also praised Moody's Investors Service for recently introducingcorporate-equivalent ratings for the swap agreements of tax-exempt issuers. He also saidhighly rated issuers should include "asymmetrical provisions" in their swap contracts tolevel the playing field in swaps with investment banks, which have more volatile creditquality.
Also yesterday, Fitch's McManus reiterated the approach her agency is taking inconsidering the effect swaps could have on municipal credit ratings.
Fitch released a brief on its methodology last week. The agency said it is looking at anumber of factors in determining if a swap helps or harms a credit, including the basisrisk that arises when issuers use Libor-based swaps.
