Derivatives in the Municipal Market Place

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Derivatives in the Municipal Market Place

• Presentation to

UNIVERSITY OF COLORADO BOULDER
Prepared by P. Jonathan Heroux Managing
Director April 14, 2005
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Presentation Outline

• Municipal Finance Overview
• Fixed Rate Obligations
• Variable Rate Obligations
• Municipal Derivatives
• Interest Rate Swaps
• Swap Options (Swaptions)
• Knockout Swaps
• Forward Delivery Contracts
• Interest Rate Locks
• Caps, Floors and Collars

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Municipal Finance Overview

• Size of Market
• Over 1.5 Trillion in tax-exempt debt outstanding
• In 2004 there were 13,400 new issues totaling
  over 360 Billion
• Diverse Issuers
• State and Local Governments
• Government Agencies
• K-12, Higher Ed.
• Diverse Projects
• Airports
• Hospitals
• Water Systems
• Housing
• Urban Renewal

Issuers of Municipal Bonds 2004 By Par Issued
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Fixed Rate Obligations
Fixed Rate Bonds

• Bonds are issued as Serial or Term bonds.
• Serial Bonds
• Most common fixed rate bonds.
• Serial bonds pay a stated fixed interest and
  principal payment at regular intervals (one
  principal payment per year).
• Each separate maturity has a distinct and stated
  interest rate.
• Allow issuer to borrow across the yield curve.
• Example of a Serial Bond

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Fixed Rate Obligations (cont.)
Fixed Rate Bonds

• Bonds are issued as Serial or Term bonds.
• Term Bonds
• Term may extend for any period, typically 2 to 25
  years.
• Principal paid at maturity.
• Term bonds have one interest rate for the entire
  term.
• Example of a Term Bond

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Variable Rate Obligations
Variable Rate Demand Obligations (VRDOs)

• Variable rate bonds have floating interest
  rates.
• The interest rate on the bonds is reset to
  current market rates at predetermined time
  intervals.
• The periodic reset of interest rates allows the
  issuer to borrow at the short end of the yield
  curve, thus initially lowering the cost of debt.
• One unique feature of variable rate bonds is that
  investors are able to sell back, or put their
  bonds to the remarketing agent when the rates are
  reset.
• Issuer must purchase a Letter of Credit from a
  bank. The LOC provides liquidity for the bonds.
  
• Example savings If an issuer can lower the
  interest rate by 10 bps on a 20MM 20 year loan,
  it will save over 260,000 in total interest
  costs.

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Interest Rate Comparison
Fixed vs Variable Interest Rates Last 10-Years
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Swap Market

• Size and Swap Providers
• Current size approximately 150 Billion in
  notional amount.
• Some major Swap providers are
• J.P. Morgan, Bank of America, Morgan Stanley,
  Merrill Lynch, Piper Jaffray, Citigroup, Goldman
  Sachs
• Who Uses Swaps and Financial Derivatives
• 501(C)3 non-profits (hospitals, private colleges,
  YMCAs, Museums/ performing arts).
• Public universities.
• Cities, counties, and state governments.
• Municipal enterprises (tolling authorities,
  utilities).

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Interest Rate Swaps

• Interest rate swaps allow an issuer to exchange
  fixed rate payments for variable rate payments or
  vice versa.
• Interest Rate Swaps Have Four Basic
  Characteristics
• 1. Agreement is between two parties to exchange
  payments.
• 2. Each party agrees to make a fixed/floating
  payment in exchange for receiving a
  floating/fixed payment over a predetermined
  period.
• 3. Payments are based on a notional amount.
• 4. No principal is exchanged.

Notional Amount
Fixed
Party A
Party B
Floating
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Interest Rate Swaps (cont.)
Floating-to-Fixed Rate Swaps
The floating-to-fixed rate swap allows an issuer
to convert a portion or all of an outstanding
variable rate issue to a fixed rate payment
structure. Issuer receives variable payments from
the swap provider and pays a fixed rate of
interest to the provider. The funds received
from the provider are then used to pay interest
on the outstanding variable rate bonds. Synthetic
Fixed Swaps act as hedge against interest rate
risk.
Fixed Rate
Issuer
Swap Provider
Variable Rate (BMA or Percentage of Libor Index)
Variable Rate
Variable RateBond Holders
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Interest Rate Swaps (cont.)
Fixed-to-Floating Rate Swaps
The fixed-to-floating rate swap allows an issuer
to convert a portion or all of an outstanding
fixed rate issue to a variable rate payment
structure. Issuer receives fixed payments from
the swap provider and pays a variable rate of
interest to the provider. This transaction
allows the issuer to use variable rate financing
(historically lower cost) with out requiring a
remarketing agent and liquidity provider.
Variable Rate (BMA or Percentage of Libor Index)
Issuer
Swap Provider
Fixed Rate
Fixed Rate
Fixed RateBond Holders
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Swap Options
What is a Swaption?
A Swaption is an option that gives the buyer the
right, but not the obligation, to enter into a
swap at a specific date in the future.

• The option buyer pays the issuer a premium upon
  execution of the swaption agreement.
• If the swaption is exercised, the swap begins.
• If the swaption is not exercised, the issuer
  keeps the premium and has no additional
  obligation to the swaption buyer.

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Swap Options (cont.)
Mechanics of a Swap Option Swaption
Swap Option

• Today
• Swap provider pays issuer for the one time right
  to direct Issuer to enter into a Swap on the call
  date.
• Call Date
• Option Exercised the Issuer and swap provider
  enter into swap and begin exchanging variable and
  fixed rate payments.
• Option Not Exercised - the Issuer retains the
  up-front payment and the ability to refund bonds
  in the future.

Fixed Rate
Issuer
Swap Provider
Variable Rate
Variable Rate
Bond Holders
Assume for this example the swap is a fixed
payor swap
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Interest Rate Swaps and Swap Options
The Value of Interest Rate Swaps and Swap Options

• Advantages
• Change Payment Characteristics issuer is able
  to change payments on fixed rate issue to
  resemble payments on variable rate issues and
  vice versa.
• Cost Savings the swap procedure usually
  provides lower borrowing costs.
• Disadvantages
• Counter Party Risk
• The risk that the party on the other side of a
  swap transaction does not fulfill its obligation
  under the swap. If the counter party defaults on
  its payment to the issuer then the issuer is left
  with un-hedged variable rate payments.

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Interest Rate Swaps and Swap Options (cont.)

• Disadvantages (cont.)
• Basis Risk
• (1) the degree to which the difference between
  two prices fluctuates (2) the residual risk that
  remains after a hedge has been placed (3) the
  risk from receiving one floating rate, such as
  BMA or a percentage of LIBOR and paying another,
  such as the interest rate on your own
  obligations.
• Example Average Index (68 of LIBOR) is
  1.50 Average cost of variable rate debt
  is 1.40 Difference
  .10Difference of .10 is Basis Risk. In this
  example the issuer receives 1.50 but only pays
  1.40. This basis differential could also be a
  negative amount in which case the issuer would
  pay more than it received, thus increasing its
  cost of borrowing.

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Interest Rate Swaps and Swap Options (cont.)

• Disadvantages (cont.)
• Tax Risk
• The risk that a change in Federal or State tax
  law changes the issuers borrowing cost.
• In Swaps, the risk can be identified and shared
  between Provider/Issuer .
• Any change in tax law may impact borrowing cost.
  An Issuer takes Tax Risk on variable rate bonds
  even when a Swap is not contemplated. As
  marginal tax rates DECREASE, floating rates on
  tax-free bonds will increase.

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Knockout Swaps

• The knockout swap is a swap which is terminated
  periodically or permanently if the variable
  interest rate moves above or below an agreed upon
  level based on a specified floating rate index,
  generally Libor or BMA.
• Advantages
• Lowers Cost when the issuer sells this option
  it receives a lower swap rate or an upfront
  premium.
• Increased Financial Flexibility Option can be
  repurchased if market conditions are favorable.
• Disadvantages
• Uncertainty if knockout rate is exceeded then
  issuer is back to un-hedged variable rate
  payments.
• Higher Interest Costs if swap is canceled the
  variable rate may be higher than the swap rate.

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Knockout Swaps (cont.)
Mechanics of a Knockout Swap
Knockout Swap

• Today
• Swap provider pays issuer or offers a lower swap
  rate for the option of canceling the swap if
  variable rate rises above a certain knockout
  rate.
• Knockout rate exceeded
• The swap is canceled. The issuer pays the
  variable rate to the bond holders and no payments
  are exchanged between the bond holders and swap
  provider.

Fixed Rate
No Payments Exchanged
Swap Provider
Issuer
Variable Rate
Bond Holders
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Forward Delivery Contracts
Forward Delivery Contracts are fixed rate debt
obligations with a settlement date sometime in
the future. The Issuer pays a premium over
todays market rates.

• Advantages
• Lock in Costs - issuer locks in the cost of
  borrowing today helps with future budgeting of
  interest costs.
• Hedge Interest Rate Risk - issuer locks in rates
  so it is no longer at risk if rates begin to
  rise.
• Disadvantages
• Cost of Premium - issuer must pay the forward
  premium.
• Non-Cancelable - once agreement is entered into
  by issuer, the issuer must provide the bonds or
  make a payment to the provider on the specified
  date. Thus, the issuer must be certain of the
  amount of funds it will need prior to entering
  into the Forward Delivery Contract.

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Forward Delivery Contracts (cont.)
Mechanics of Forward Delivery Contracts
Forward Delivery Bonds
Today Issuer sells bonds with extended
delivery. Delivery The Issuer delivers bonds
to bond holders in exchange for purchase price
agreed upon when purchase contract was signed
(Today). Result The Issuer locks in the
negotiated interest rate starting on the delivery
date through the maturity of the bonds.
Today
Negotiate Interest Rate
Issuer
Underwriter
Determine Purchase Price
Negotiated Interest Rate Todays Yields
Forward Premium
Delivery Date (I Year Later)
Deliver bonds Begin paying Negotiated Interest
Rate
Underwriter
Issuer
Purchase Bonds
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Interest Rate Locks

• Issuer agrees to an interest rate based on the
  current market (MMD index in municipal finance)
  plus a premium. At the settlement date a
  differential payment is exchanged between the two
  parties. The payment is based on the difference
  between the current rate and the locked rate.
  This difference is used to calculate the present
  value of some principal amount.
• Advantages
• Hedging Interest Rate Risk issuer locks in
  current rates plus premium.
• No Up-front Fees issuer may receive a payment
  on settlement date.
• Budget Planning securing current rates for
  future debt issuance also assists with planning
  future debt service payments as the cost of
  borrowing is known.
• Disadvantages
• Contract must be Executed even if bonds are not
  issued, the terms of the contract must be
  settled, which could mean a cash payment by the
  issuer.
• Political Ramifications if rates fall and
  issuer makes a payment, outsiders may view the
  transaction as speculative rather than risk
  management.

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Interest Rate Locks (cont.)

• Illustration of MMD Rate Lock

Assume that in todays market the MMD 30 year
rate is 5.10 and that the present value of a
basis point is 10,000.
Rates Fall 30bps MMD 4.80
Rates Rise 30bps MMD 5.40
Borrower
Counterparty
Counterparty
Borrower
300,000
300,000
Market Rate Bonds
Market Rate Bonds
Bond Purchasers
Bond Purchasers
Differential payment 300,000 (10,000 30 bps)
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Caps, Floors and Collars
Interest Rate Caps

• An interest rate cap is an agreement between an
  issuer and a interest rate cap provider that
  places an upper limit on the risk exposure for an
  issuers variable rate bonds.
• While the interest rate on the bonds may
  increase above the cap, the cap provider will pay
  the issuer the difference in interest cost on a
  notional principal amount any time a specified
  index (BMA, 1-month LIBOR) rises above a
  specified cap strike rate.
• To purchase a cap, the issuer pays an up-front
  premium to the cap provider.

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Caps, Floors and Collars (cont.)
Interest Rate Floors

• An interest rate floor is an agreement between an
  issuer and the purchaser of an interest rate
  floor that places a lower limit on the rate of an
  issuers variable rate bonds.
• While the rate on the bonds may drop below the
  floor strike rate, the issuer agrees to pay the
  floor purchaser the difference in interest
  payable on a notional principal amount when a
  specified index rate (e.g BMA, 1-month LIBOR,
  etc.) falls below a stipulated minimum, or floor
  strike rate.
• The Issuer receives a premium from the floor
  purchaser for this agreement.

Exposure After Floor
Unhedged Exposure
Floor
Strike
Payment to
Floor Buyer
Variable Rate
Variable Rate
Interest Expense
Interest Expense
0
2
4
6
8
10
0
2
4
6
8
10
Interest Rates
Interest Rates
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Caps, Floors and Collars (cont.)
Interest Rate Collars

• An interest rate collar combines the use of a cap
  and a floor. The collar sets an issuers
  variable rate exposure to a predetermined range.
  The payment received from the floor often is used
  to offset the premium on the cap.

Collar Exposure
Variable Rate
Interest Expense
0
2
4
6
8
10
Interest Rates
Cap Strike
Floor Strike
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Caps, Floors and Collars (cont.)
The Value of Caps, Floors and Collars

• Advantages
• Limit Risk Exposure through the use of caps,
  issuer sets the upper limit on its variable debt
  service thus setting the maximum interest rate
  payment.
• Termination of Cap or Floor issuer can sell or
  extend the contracts at any time.
• Premium from Floor issuer receives a premium
  from the floor agreement.
• Combine Cap and Floor for Collar issuer may
  limit variable rate exposure to a predetermined
  range and apply the payment from the floor to the
  premium on the cap.
• Disadvantages
• Cost of Contract issuer must pay an up-front
  premium for cap.
• Floor Limits Potential Benefit if rates fall
  below the floor strike rate, the issuer loses the
  savings benefits from lower interest payments.

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Summary

• Using Financial Derivatives is not for every
  issuer or every circumstance. Municipal Issuers
  use derivatives for hedging only and not for
  market speculation.
• Properly executed, financial derivatives can help
  municipal debt issuers lower borrowing cost and
  manage risk exposure.
• As financial derivatives have become more
  popular, many municipalities have begun using
  derivatives as part of their financial management
  strategy.
• "By far the most significant event in finance
  during the past decade has been the extraordinary
  development and expansion of financial
  derivatives.
• - Alan Greenspan, 1999

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Terms

• BMA
• The Bond Market Association Municipal Swap Index,
  produced by Municipal Market Data, is a 7 day
  high grade market index comprised of tax-exempt
  VRDOs from MMD's extensive database. This is the
  standard variable rate index for municipal
  finance.
• LIBOR
• The London Interbank Offering Rate is the rate
  that most creditworthy international banks
  dealing in Eurodollars charge each other for
  loans.
• Maturity or Maturity Date
• The date upon which the principal security
  becomes due and payable to the security holder.
• MMD
• Municipal Market Data. This companies compiles
  municipal bond market statistical information and
  publishes daily statistics.

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Terms

• Notional Amount
• The amount SWAP payment calculations are based
  on. The notional amount is usually the same or
  very close to the principal amount of the
  underlying bonds. The notional amount is a
  calculation basis only, as principal is not
  exchanged in a swap transaction.
• Swap
• A sale of security and the simultaneous purchase
  of another security, for purposes of enhancing
  the investor's holdings. The swap may be used to
  achieve desired tax results, to gain income or
  principal or to alter various features of a bond
  portfolio, including call protection,
  diversification or consolidation, and
  marketability of holdings.
• Swap Spreads
• The fixed spread (to Treasuries) on a Libor based
  fixed to floating interest rate swap. Swap
  spreads are effectively a proxy for spreads
  between Treasuries and very high-grade taxable
  non-Treasury bonds.

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• Questions?