Since its inception in the early 1990s, the tax-exempt swap market has allowed issuers to execute synthetic pay-fixed interest rate swaps to produce interest-cost savings relative to traditional fixed-rate bonds.
Since 2001, the average synthetic pay-fixed interest rate swap savings has been about 52 basis points for double-A-minus rated municipal issuers (not including credit enhancement, remarketing fees and variable-rate trading spreads). Issuers were rewarded by this strategy until the first half of 2008, the approximate onset of the credit crunch, and the September 2008 collapse of Lehman Brothers, which abruptly closed all credit markets.
As synthetic pay-fixed interest rate swaps are dependent on liquidity and credit enhancement to work effectively (i.e., investors are available to buy auction-rate securities or bank credit to support variable-rate demand notes), the credit crunch and the associated collapse of liquidity and credit are the ultimate cause of issuers increased costs for carrying swaps.
Understanding that interest rate swaps carry real risks to issuers is the first step in managing the risks inherent in swap portfolios.
With traditional fixed-rate bonds, most risks are transferred to investors at the time of sale. Thus, issuers could forget about the traditional fixed-rate bond and associated risks after the original sale date because the many changing capital market relationships did not affect the issuers’ financial statements.
However, synthetic pay-fixed interest rate swaps expose the issuer to potentially significant swap risks and changing capital markets relationships. These affect the issuers’ liquidity (either by collateral calls or an increase in interest expense), income statement (higher than anticipated variable rate, negative swap carry and credit enhancement costs), and balance sheet (large swap termination values).
Prior to the credit crunch, many issuers treated synthetic pay-fixed interest rate swaps just like traditional fixed-rate bonds — the risks were assumed away and forgotten after the original execution date of the swap. But the crisis highlighted the negative effects that can come from ignoring the risks of swaps. These risks are real and are affected by everyday capital-market relationship realignments and, as we have learned, severe market dislocations.
As a result of the credit crunch and the increased cost of carrying swaps, some issuers panicked, expediently terminated swaps, and sold fixed-rate bonds to fund the swap termination and variable-rate bond take-outs.
Many of these decisions were reactionary, based solely on recent increased swap costs, political pressures, and bankers’ recommendations to convert all swaps to fixed, regardless of a sound economic rationale. In too many instances, there was no forward-looking methodology or qualified independent advice to aid the issuer in the decision-making process.
The hundreds of millions of dollars lost by issuers in unnecessary swap terminations and underwriting fees for associated new bond issues suggest the need for new, objective standards in issuer-swap portfolio management. There is a need for techniques that focus on forward-looking decision matrices and allow issuers to be proactive about avoiding swap losses.
For example, issuers can employ portfolio analysis that measures the efficacy of their swaps. To determine the benefit of keeping or terminating a swap, issuers can use one such analysis to compare the cost of carrying the swap versus the cost of converting to fixed-rate bonds.
As a case study, assume that a hypothetical double-A-minus rated municipality has two outstanding $25 million pay-fixed swaps and that the issuer:
• Currently pays 3.75% versus the SIFMA index on the two swaps that mature in 2015 and 2028.
• Can sell tax-exempt municipal bonds at 2.14% (2015 maturity) and 4.44% (2028 maturity).
• Can renew liquidity at 65 basis points in today’s market, pay remarketing fees of 12 basis points per year, and the VRDNs trade at SIFMA less 10 basis points.
Now compare the cost of carrying the swap to the cost of converting the swap to fixed-rate bonds:
• The cost of carrying the swap is equal to any deviance from the SIMFA index or the break-even that maintains the original swap economics. It is the sum of the cost of current or renewal credit enhancement (65 basis points per year), VRDN trading spreads to the SIFMA index (less 10 basis points per year) and remarketing fees (12 basis points per year). Thus, the total cost of carrying the swap is 67 basis points per year.
• The cost of converting to fixed-rate bonds is the difference between the swap rate and the new uninsured bond rate, the swap termination amount, and the cost of issuing the new bonds. Thus, the cost of converting to fixed-rate bonds for each swap maturity is:
• For 2015: negative 161, 167, and 31 basis points per year equals 37 basis points per year.
• For 2018: 69, 48 and 13 basis points per year equals 130 basis points per year.
The summary of results of this swap portfolio analysis is as follows:
The most important decision-making point is how long the swap can remain outstanding at 67 basis points per year before the cost of carrying the swap is equal to the cost of converting to fixed-rate bonds in today’s market, or the break-even point.
The break-even for the 2015 maturity is 2.56 years and suggests that this swap maturity should be converted to a fixed-rate bond today because the swap loses money if it remains outstanding beyond 2.56 years and 30 basis points of interest costs will be saved.
Specifically, a lengthy liquidity renewal contract that extends beyond the break-even will guarantee a loss on the swap versus converting the swap to fixed-rate bonds today.
On the other hand, the break-even for the 2028 swap maturity is equal to the maturity date, so it makes more sense to leave it outstanding, as there is time for capital market relationships to improve before considering a conversion to fixed-rate bonds.
As the capital market relationships associated with swap risk management constantly change and realign, the swap portfolio should be monitored on a frequent basis.
We believe that liquidity and credit enhancement will substantially return to the market, the market dislocation will be forgotten, and issuers will once again consider the use of synthetic pay-fixed interest rate swaps.
As such, issuers should embrace the use of forward-looking swap portfolio management techniques to minimize their interest costs. Issuers also should consider the cost benefits of structuring their swaps in better ways to avoid the problems highlighted by the recent market dislocation, including:
• Incorporate call options that eliminate the issuer’s requirement to post collateral or renew credit enhancement. Calls should be at least as frequent as the ongoing credit enhancement renewal.
• Shorten the final maturity date of the synthetic pay-fixed interest rate swap.
• Consider indexed floaters without put options by the investor to the issuer.
• Structure maximum rates on the variable-rate bonds not at 20%, but at rates that reflect current market conditions, like one-month Libor plus 100 basis points.
• Consider consultant compensation on a retainer basis, in contrast to a transactional basis, to eliminate the conflicts of interest associated with “success fees.”
• Hire experienced, independent and ethical swap advisers to represent the issuer’s best interests.
Scott G. Fairclough is a managing director at Topstone Capital Advisors Inc. Topstone senior analyst Tara McDaniel and managing director Robert Smith contributed to this article.