Government Related Financings Synthetic Fixed and Variable Debt Structures

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Government Related FinancingsSynthetic Fixed and
Variable Debt Structures
Presented to the
Maryland GFOA Conference Turf Valley Country
Club 215P 400P
Presented by Jeffrey Klein, Principal Bank of
America 704-386-0219
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Overview
Funding Considerations

• The prioritization of funding needs, expected
  return on capital, identification of other
  sources of funding and a borrowers desire to
  maintain or enhance current rating levels are
  important considerations in developing a
  comprehensive financing plan.
• TYPE OF PROJECT
• DEBT CAPACITY
• CREDIT ENHANCEMENT
• COST OF CAPITAL FOR VARIOUS FIXED FLOATING RATE
  FINANCING ALTERNATIVES
• RATING AGENCY STRATEGY
• OPTIMAL INTEREST RATE MIX
• FLEXIBILITY
• The items above typically impact a borrowers
  decision related to the type of financing that
  will be used. This session will focus on
  synthetic fixed and floating applications and how
  they contrast to traditional funding structures.

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Financing Modes - Traditional
Traditional Structures
NATURAL FIXED RATE BONDS
FIXED
NATURAL VARIABLE RATE DEMAND BONDS
VARIABLE
AUCTION RATE SECURITIES
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Financing Modes - Traditional Synthetic
Traditional Structures
Synthetic Structures
NATURAL FIXED RATE BONDS
NATURAL VARIABLE or AUCTION RATE COMBINED WITH
A SWAP
FIXED
NATURAL VARIABLE RATE DEMAND BONDS
NATURAL FIXED RATE BONDS COMBINED WITH
A SWAP
VARIABLE
AUCTION RATE SECURITIES
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Comparison Traditional Fixed vs Synthetic Fixed
Issuing Fixed Rate Debt vs. Issuing Floating Debt
with a Swap Overlay

• By using the swap market, issuers have obtained
  their desired financing at a lower cost than
  issuing the desired debt directly. For example,
  if a borrower wants to issue fixed-rate debt, it
  has two choices
• Issue the fixed rate debt directly,
• Issue floating rate debt with a swap agreement
  resulting in synthetic fixed rate debt.

Funding Comparison
Fixed Rate
Swap Agreement
Fixed Rate Debt
Floating Index
Bond Coupon 4.26 Other Costs 0.07 4.33
VRDN Rate
4.33
OR
Floating Rate Debt with a Swap Overlay
Swap Coupon 3.31 Other Costs 0.06 Remarketing
0.10 Liquidity 0.18 3.65
Floating Obligation
Fixed Obligation
For Illustrative purposes only, as of 9/29/04..
Swap Coupon based on 67 of 1-M LIBOR Schedule
is a 30-Year Final, Level Annual Debt
Service Each financing will have different
assumptions.
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The BMA Swap Curve is attractive vs. Cash Market
Bond Yields
The tax-exempt bond curve is currently very
steep. Issuers can lock-in low synthetic fixed
rate funding at the long-end of the yield
curve Cash market fixed rates at the short end of
the curve are currently more attractive than BMA
swap rates, however, at the long-end of the curve
the swap market is more attractive
Fixed BMA swap rates after 10 years are currently
10 to 51 bps lower than cash market bond rates
Based on market conditions as of September 27,
2004 bond rates reflect a generic AAA insured
credit rating, etc. Swap rates are for
indicative purposes only. Fixed BMA swap rates do
not reflect the all-in synthetic fixed interest
cost (remarketing agent fees, etc.)
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Tax-Exempt Bonds are expensive relative to
Treasury Bonds

• Municipal bonds are currently trading at a
  historically high percentage relative to
  Treasuries.
• This is creating additional negative arbitrage
  (in addition to the steep yield curve) for
  refunding escrows, construction/acquisition
  accounts and reserve funds.

Source Bloomberg as of September 16, 2004
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Reducing the Cost of Funding
Issuing Fixed Rate Debt vs. Issuing Floating with
a Swap Overlay

• Changing the index associated with the swap
  agreement will change the all-in yield
  differential between the different funding
  alternatives

Funding Comparison
Fixed Rate Debt
Bond Coupon 4.26 Other Costs 0.07 4.33
Floating Rate Debt with a Swap Overlay
Bond Rate BMA Index 67 of LIBOR
Swap Rate 3.99 3.79 3.31
Issuance Costs 0.06
0.06 0.06 Remarketing 0.10
0.10 0.10 Liquidity 0.18
0.18 0.18 4.33 4.13 3.65
Funding Differential 0 bps 20
bps 68 bps PV Difference1 - 0
2,306,667 7,842,665
For Illustrative purposes only, as of 9/29/04..
Schedule is a 30-Year Final, Level Annual Debt
Service PAR amount of 100MM
1 Assumes Index Coupon on Debt
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Floating Index for Rate Swap
An issuer has three distinctive types of interest
rate swaps available to hedge the risks
associated with VRDBs. Typically, the fewer
risks hedged by the swap, the less expensive the
cost of the hedge. The redline demonstrates the
risks the issuer hedges when using certain a
index.
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BMA vs. 1M LIBOR Historical Trading Relationship

• Theoretically BMA should equal one minus the
  marginal tax rate, (1-35) 65
• Since 1990, BMA / 1-Month LIBOR has averaged
  70.3
• In 2002, the BMA / 1-Month LIBOR ratio was higher
  than average at 78.5 in 2003, the ratio has
  averaged 85.2.
• Factors possibly effecting the BMA/LIBOR ratio
  include
• With short-term rates as low as they currently
  are, spreads in general have been severely
  compressed
• Ratios tend to increase late in the year due to
  investors raising cash to pay out year-end
  expenses as well as portfolio managers converting
  a percentage of Funds to cash due to portfolio
  guidelines
• Seasonal spikes did not account for historically
  high ratios that have occurred since July of 2002
• Marginal tax rates, seasonal factors including
  tax season, monthly outflows, municipal bond
  coupon payments
• Tax and securities law changes affecting
  tax-exempts attractiveness to investors

Avg Represents average for each
year Since Represents average since specific
time period to present
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Comparison Advantages Disadvantages
Detailed Advantages Disadvantages of Fixed Rate
Financing Strategies

• ADVANTAGES
• Current low interest rates offer borrowers the
  opportunity to lock-in fixed rates at historic
  low levels
• Committed funding, which traditionally has less
  risk to borrower as the cost of capital is known
  until the final maturity
• No interest rate risk once issued
• No tax risk once issued
• No put risk
• Usually lower cost of funds vs fixed bonds
• Lower issuance cost
• Flexibility to unwind
• Ability to incorporate optionality
• Diversification of investor base
• Ability to lock-in rates on a forward basis

Natural Fixed Rate
Bonds Synthetic Fixed Rate Debt

• DISADVANTAGES
• Higher cost of capital
• Bonds are typically non-callable for a certain
  time period, typically 10-Years, which only
  allows the bonds to be refunded during that
  period
• Limited to one advance refunding
• More continuing disclosure requirements
• Rate is typically locked-in a few weeks before
  the closing
• Borrower bears all risk associated with natural
  floating rate debt (ie. Put risk, Remarketing
  Performance, Liquidity or Enhancement Renewal,
  Tax Risk)
• Basis risk between bond rate and swap index
• Swap Counterparty Risk

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Termination Sensitivity
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Comparison Traditional Floating vs Synthetic
Floating
Issuing Floating Rate Debt vs. Issuing Fixed Debt
with a Swap Overlay

• By using the swap market, issuers can achieve
  floating rate exposure while avoiding the
  disadvantages associated with traditional
  floating rate financing
• Put Risk, Remarketing Risk, Tax Risk, Credit
  Risk
• Time and cost of negotiating and renewing
  liquidity or credit enhancement

Funding Comparison
Fixed Rate
Swap Agreement
Floating Rate Debt
BMA Index
Bond Coupon VRDN Rate Other Costs 0.06 Remarketi
ng 0.10 Liquidity 0.18 VRDN 0.34
VRDN Rate
4.33
OR
Fixed Rate Debt with a Swap Overlay
Fixed Obligation
VRDN Obligation
Bond Cost 4.33 Receive on Swap 3.69 Pay on
Swap BMA BMA 0.64
For Illustrative purposes only, as of 9/29/04..
Swap Coupon based on BMA Schedule is a 30-Year
Final, Level Annual Debt Service Each financing
will have different assumptions.
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Comparison Advantages Disadvantages
Detailed Advantages Disadvantages of Floating
Rate Financing Strategies

• ADVANTAGES
• Historically lower cost of funding
• Significant call flexibility
• Flexibility to change between modes
• No tax risk once issued
• No put risk
• Less credit risk due to elimination of put,
  downgrade, and renewal risk
• Considered committed funding
• Elimination of the time and cost of negotiating
  liquidity or credit enhancement
• No put risk or remarketing risk
• No exposure to credit spreads
• Elimination of the time and cost of negotiating
  liquidity or credit enhancement
• Can easily be restructured

Natural Variable Rate
Bonds Auction Rate Securities Synthetic
Floating Rate Debt

• DISADVANTAGES
• Bonds are subject to put risk (uncommitted
  funding)
• A tax code change, industry shock or credit
  erosion may affect the funding costs
• Typically liquidity or credit enhancement must be
  renewed and renegotiated

• Typically a higher cost than VRDBs
• Potential risk of a failed auction
• Possibility that auction paper is no longer
  considered a preferred investment option with
  investors

• Higher cost than natural floating rate debt under
  most market conditions
• Swap counterparty credit risk

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Comparison Traditional Floating vs Synthetic
Floating
Issuing Floating Rate Debt vs. Issuing Fixed Debt
with a Swap Overlay

• Long-term rates in the capital markets will
  continue to move even after a fixed rate bond has
  been issued. As swap rates rise, a borrower will
  notice that the synthetic floating rate economics
  change.
• Borrower originally issued fixed rate bonds at a
  4.33 funding cost that could swap to BMA 0.64
• Subsequently, BMA swap rates rise by 71 bps to
  4.40 resulting in a synthetic BMA minus 7 bps.

Funding Comparison
Floating Rate Debt
Bond Coupon VRDN Rate Other Costs 0.06 Remarketi
ng 0.10 Liquidity 0.18 VRDN 0.34
Fixed Rate Debt with a Swap Overlay
Bond Yield 4.33 Receive on Swap 4.40 (May
2004) Pay on Swap BMA BMA - 0.07
For Illustrative purposes only, as of 9/29/04..
Swap Coupon based on BMA Schedule is a 30-Year
Final, Level Annual Debt Service Each financing
will have different assumptions.
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Disclaimer