Interest Rate Swap:

An interest rate swap is a contract between two parties to exchange a series of fixed rate and floating rate interest payments over a predefined period of time, without exchanging the underlying principal amount referred to as a “notional” principal amount. Interest rate swaps are used to convert interest rate basis (e.g., from floating to fixed or fixed to floating) to enable issuers to lower their costs of borrowing.

The counterparties exchange interest payments on specific dates, according to a predetermined formula. The floating rate resets are generally based on LIBOR or BMA index. Other floating rate benchmarks include actual bond rate or cost of funds and BMA/LIBOR index baskets.

LIBOR: London Interbank Offered Rate. This interest rate is the standard rate for quoting interbank lendings of Eurodollar deposits. It is the customary rate for plain vanilla taxable interest rate swaps. Municipal issuers generally enter into swaps at a percentage of LIBOR that best mimics their tax-exempt rates.

BMA: The Bond Market Association index is the standard rate for tax-exempt swaps. The index is published weekly and rates are effective from Thursday thorough the following Wednesday.

The two most common types of swap are fixed-to-floating swaps and floating-to-fixed swaps.

Fixed-to-Floating Swaps: The issuer makes floating rate interest payments (BMA or percent of LIBOR) to a counterparty in exchange for fixed interest payments made by the counterparty. A fixed-to-floating swap enables an issuer to structure a synthetic floating rate liability by securing a floating rate obligation without having to purchase a lien or letter of credit as liquidity or credit support or pay any remarketing fees.

Floating-to-Fixed Swaps: The issuer makes fixed interest payments to a counterparty in exchange for floating rate interest payments (BMA or percent of LIBOR) made by the counterparty. A floating-to-fixed swap enables an issuer to structure a synthetic fixed rate liability.

Forward Starting Swap:

A synthetic advance refunding, combines an interest rate swap (the swap actually begins on the date the old bonds are called) which is executed today, at today's prevailing interest rates, with the issuance of variable rate refunding bonds, which occurs at the call date of the old bonds.

For example, the Issuer executes a forward interest rate swap contract today. The Issuer agrees to pay a fixed rate of interest on the current call date and will be entitles to receipt of a floating rate of interest on the current call date. Note that the payment of fixed rate amounts will commence on the current call date, the date on which the old Bonds will have been refunded. Under this scenario, the Issuer can structure the swap contract so that it can take payments (at a variable) prior to the call date on the outstanding Bonds. The Issuer would then use this cashflow to offset a portion of the existing outstanding Bonds debt service requirement. As a result, according to the Issuer's preferences, it could realize none, some, or all of the economic benefits of the transaction between the present time and current call date depending on the structure of the payment arrangements in the swap.

At the current call date the Issuer (1) issues its variable rate refunding bonds (at then prevailing rates); (2) call the outstanding bonds; and (3) begins making a fixed rate payment to its swap counterparty. The combined transactions create a "synthetic" fixed rate debt through the mechanism of the swap contract.

There are several considerations to take into account in such an arrangement. First, the counterparty to the swap must be of particularly strong credit quality. Next, the Issuer must determine the basis on which it will take variable rate swap payments and on which it will pay its own variable rate debt after the call date. For example, it is common for municipal issuers to use indices like BMA or a percentage of LIBOR in the calculation of interest on their debt. Another consideration is basis risk, which is the possible non-convergent numerical relationship between the two indices.

Terms and structure of this type of transaction are easy to "customize" to individual situations. The swap market is both active and relatively efficient. The documentation is straightforward, as far as these transactions go.

Swaptions:

An additional variation to an interest rate swap is the inclusion of an “option” for the Provider to compel the Issuer to enter into a synthetic fixed rate refunding during an option period.  This option period can be a specific date, a list of dates (usually interest payment dates on the related bonds) or open-ended, giving the Provider the option on or after a specific date.  For this option, the Provider will pay the Issuer a sum, determined at the time of execution of the swaption and payable at any time.  If the option is not exercised, the Issuer would be able to refund its bonds on a current basis with no obligation to return the option payment received for selling the swaption.

Basis Swaps:

A basis swap is a contract between two parties where, for a specified period of time one party pays a floating rate of interest on a notional amount using one index (e.g. 1-month LIBOR), and the other party pays a floating rate of interest on the same notional amount using a different index (e.g. BMA). A basis swap can be used to transform the nature of a floating rate exposure.

The structure of a basis swap consists of a counterparty exchanging interest payments on specific dates, according to a predetermined formula. Only the net payment amount is exchanged. The customary variable rate indices exchanged under a basis swap are BMA and LIBOR, isolating tax risk. The entity receiving the LIBOR based payments is taking tax risk whereas the entity receiving BMA is transferring tax risk.

Considerations for Basis Swaps:

1. Absolute Interest Rate Risk – The Level of Rates

Let’s use an example of a basis swap under which the issuer receives 77% of 1-Month LIBOR and pays BMA.

Whenever the BMA/1-Month LIBOR percentage is less than 77% (in our example), the issuer will be receiving funds from the swap dealer. It is important to note that historically BMA/1-Month LIBOR percentage has averaged at around 68%. Hence, based on historical data the issuer is capturing 10% of 1-Month LIBOR as long as the historical averages hold. As rates increase the issuer receives 10% of a higher number, than if rates decrease. For example if 1-Month LIBOR is at 7%, the issuer has picked up 70 basis points whereas if 1-Month LIBOR was at 2%, the issuer receives only 2 basis points

Interest Rate Cap:

An interest rate cap provides protection against rising interest rates by placing a maximum value (“strike rate”) on the underlying floating rate index for the entire term of the cap for an up-front fee (“premium”).

The strike rate, notional amount, term and choice of floating rate index determines the premium or cost of the cap. If during the term of the cap the floating rate index exceeds the strike on the reset date for any floating rate period, the issuer would receive an amount equal to the difference between the strike level and the index based on the notional amount for that period. It should be noted that the cap sets a maximum exposure as it relates to the index and not the actual bond rate. There may be potential basis risk between the actual bond rate and the index. Hence, the issuer’s exposure is limited to:

1. Payments up to the strike rate plus any basis differential

2. Cost of the cap

The most liquid sector of the market is from 1 month to 5 years, although longer transactions can be executed. The effective date, cap payment dates, and maturity date of the cap are specified prior to execution. The underlying floating rate index for most municipal caps is BMA or LIBOR. The cost of purchasing an interest rate cap is paid by the issuer as a one time up front payment. In some cases, caps are paid for in annual installments to the cap swap dealer.

Interest Rate Collar:

A collar is a combination of a cap and a floor. Similar to caps and floors the customer selects the floating rate index, term, notional and the strike rates for both the cap and the floor. However, unlike a cap or a floor, an up-front premium may or may not be required, depending upon where the strikes are set. In either scenario the issuer is the buyer of one product and the seller of the other.

The strike rate, notional amount, term and choice of floating rate index are determined for both the cap and the floor. If during the term of the collar the floating rate index exceeds the cap strike or falls below the floor strike on the reset date for any floating rate period, the issuer would receive or pay an amount equal to the difference between the strike level and the index based on the notional amount for that period.

Hence collars protect the issuer against rising interest rates, but limit the benefit of falling rates by the floor strike rate. Since the issuer would be selling the cap or the floor and buying the other product, the cost of a collar is generally lower than just a cap or floor, since the cost of one is offset by the premium received on the second. In the instance where based on the strike rates of the cap and the floor they have equal value, the cost of one would completely offset the premium received on the other resulting in no premium payment. This structure is often referred to as a “costless” collar.  The most liquid sector of the market is from 1 month to 5 years, although longer transactions can be executed. The effective date, payment dates, and maturity date of the collars are specified prior to execution.  The underlying floating rate index for most municipal collars is BMA or LIBOR.

Interest Rate Floor:

An interest rate floor sets a minimum value (“strike rate”) on the underlying floating rate index for the entire term of the floor for an up-front fee (“premium”)

The strike rate, notional amount, term and choice of floating rate index determines the premium or cost of the floor. If during the term of the floor the floating rate index falls below the strike on the reset date for any floating rate period, the issuer would receive an amount equal to the difference between the strike level and the index based on the notional amount for that period. It should be noted that the floor sets a minimum rate as it relates to the index and not the actual bond rate. There may be potential basis risk between the actual bond rate and the index.

The most liquid sector of the market is from 1 month to 5 years, although longer transactions can be executed. The effective date, floor payment dates, and maturity date of the floor are specified prior to execution. The underlying floating rate index for most municipal floors is BMA or LIBOR. The cost of purchasing an interest rate floor is paid by the issuer as a one time up front payment. In some cases, floors are paid for in annual installments to the floor swap dealer.

Knockout Swaps:

Definition: A knock-out swap is terminated periodically or permanently if interest rate levels exceed a predetermined benchmark level for a specified floating rate index. When an issuer sells this option to the swap dealer, it allows the issuer to enter into a fixed pay swap at a lower rate, however the issuer assumes the risk of having the hedge cancelled if the floating rate exceeds the predetermined barrier. There may in some instances be an initial lock-out period.

Structure:

Example: The issuer enters into a 70% of Libor knock-out swap at 3.15%, which would terminate if 70% of Libor resets at or above 6.00%. Since the swap reverts back once the rate falls below the index barrier, this swap is also referred to as a “periodic reversion swap.”

If 70% of Libor resets below 6.00%, the swap payout would be as follows:

Documentation:

Interest rate swap agreements are documented by executing generic International Securities Dealer Association (“ISDA”) Master Agreements. Amendments or additions to the Master Agreement are specified under the Schedule to the Master Agreement. The terms and conditions of the trade are outlined using a Trade Confirmation. Below is a description of each of the commonly used documents when entering into an interest rate swap agreement:

• Master ISDA Swap Agreement: defines obligations of counterparties for all future transactions.
  
  
• Schedule: Modification of Terms set forth in Master ISDA Swap Agreement for counterparty specific issues security and source of payment, options selected under the Master Agreement.
  
  
• Credit Support Annex: an addendum to the Master Agreement relating to collateral terms.
  
  
• Enforceability Opinions: counsel opinions that counterparties have executed valid and binding contracts under applicable law.
  
  
• Confirms: define specifics of each individual transaction (notional amount, amortization schedule, fixed rate, swap index, payment dates, etc.).