Policies for Interest Rate Management Agreements
The following policies have been created by the Texas Bond Review Board to standardize and rationalize the use and management of interest rate management agreements, primarily interest rate swaps by issuers of state securities. As used herein, the term “swaps” includes swaps, caps, floors, collars, options and other derivative financial products used in conjunction with the issuance and management of debt obligations.
These policies are meant to be guidelines for general use and allow flexibility for issuers to be able to respond to changing market conditions. However, all issuers should develop and maintain their own swap policies based on their unique goals and programs. Additionally, regular review and updates for an issuer’s swap policies can be an important tool to help ensure that its policies remain consistent with those goals and programs.
The primary objective of these policies is to establish conditions for the use of swaps and to create procedures and policies that encourage an optimum balance between risk and reward, provide credit protection and maintain full and complete financial disclosure and reporting. Another objective of these swap policies is to stimulate discussion and broaden appreciation of the issues involved in the use of swaps.
Policy 1: Legal Authority
State issuers should establish and state the basis of the legal authority that permits them to enter into the use of swaps. In most cases, Chapter 1371 of the Texas Government Code provides a statutory framework for the use of swaps. Prior to entering into any specific swap transaction, an issuer should secure an opinion from qualified legal counsel that the transaction has proper legal authority. Similarly, the issuer should obtain an opinion from the swap provider’s counsel that the swap provider’s obligations under the swap agreement are valid, binding and enforceable.
Policy 2: Procedure
Prior to entering into a swap, issuers should define procedures for evaluating and approving swap use. The procedures should include:
- a financial analysis of the swap transaction and the risks and rewards it presents, including sensitivity analysis for how the swap and its associated structure might perform in stressful market environments;
- a review of the swap’s potential impact on the issuer’s credit rating, credit costs and mix of fixed and floating-rate debt;
- an estimate of any added administrative burden; and,
- an authorization of the officials who will have responsibility and authority for authorizing the size, terms and pricing of the swap.
Policy 3: Risk Evaluation and Mitigation
In preparation for entering into a swap, an issuer should evaluate and seek to mitigate all relevant risks, including:
- Counterparty Risk: The risk of a failure of a counterparty to perform as required under its swap contract with an issuer.
- Termination Risk: The risk that a swap may be terminated prior to its scheduled maturity due to factors outside the issuer’s control.
- Collateral Posting Risk: The risk that an issuer will be required to post collateral in the event of a credit downgrade or a market change.
- Interest Rate Risk: The risk that the issuer’s costs associated with variable-rate exposure increase and negatively affect budgets, coverage ratios and cash flow margins. Variable-rate exposure may be created by a fixed-to-floating rate swap or a swap that otherwise creates some type of floating-rate liability such as a basis swap. The interest rate risk presented by such a swap may increase as interest rates increase generally, as intra-market relationships change or because of credit concerns relating to the issuer or a credit-enhancer.
- Basis Risk: The risk in a synthetic fixed-rate structure that the floating-rate on the swap fails to offset the floating-rate on the underlying liability. Because swaps are generally based on a floating-rate index, the chosen index should correlate closely with the floating-rate on the underlying instrument but may not correlate exactly. A common type of basis risk on swaps used in conjunction with synthetic fixed-rate structures is often referred to as “tax risk”, or the risk of a mismatch between the floating-rate on the tax-exempt debt of the issuer and a swap index such as one based on a taxable index like LIBOR. The correlation between the LIBOR-based rate and the floating-rate on the debt may change based on changes in tax law or other market events. The degree of risks should be evaluated in comparison with degree of benefit provided.
- Amortization Risk: The risk presented by a mismatch between the term of the swap or the notional principal amortization schedule of the swap and the term or principal amortization schedule of the underlying liability of the issuer being hedged by the swap. This risk increases when the amortization schedule of the underlying liability is uncertain as occurs with the debt of certain forms of issuers like housing agencies.
- Bank Facility Rollover Risk: When a swap is used in conjunction with underlying puttable floating-rate debt, bank facility rollover risk exists if the term of a needed liquidity or credit facility on the debt is shorter than the term of the swap. In this case the issuer is at risk as to both the availability and the price of successive bank facilities.
- Pricing Risk: The risk that the swap may not be priced appropriately in comparison to the market for comparable swap transactions. This risk is magnified in the swap market because of the complexity of the structures and the lack of readily available comparable price information.
Policy 4: Documentation
To insure standardization, better pricing and greater transparency, swaps should be documented using the standard forms developed by the International Swap and Derivatives Association, Inc. (“ISDA”). Within that framework, swap documentation should seek to provide:
- Credit protection with downgrade and collateralization provisions reflective of the relative credit strength of the issuing entity in comparison with the swap provider. This comparison should give weight to the prevailing greater credit strength of public sector entities as compared with private sector financial institutions.
- Flexibility for the issuer to terminate a swap at “market” at any time over the term of the corresponding agreement at its option without necessarily granting the swap provider a similar right.
Policy 5: Purposes
As market developments evolve and are tested, the reasons for using swaps may change over time. As a general matter, swaps should be used to achieve one or more of the following purposes:
- Managing the issuer’s exposure to floating and fixed interest rates;
- Hedging floating-rate risk with caps, collars, basis swaps and other instruments;
- Locking-in fixed-rates in current markets for use at a later date through the use of forward swaps, swaptions, rate locks, options and forward delivery products;
- Reducing the cost of fixed or floating-rate debt through swaps and related products to create “synthetic” fixed or floating-rate debt;
- Accessing the capital markets more rapidly than may be possible with conventional debt instruments;
- Managing exposure to the risk of changes in the legal and regulatory treatment of tax-exempt bonds including changes in federal marginal tax rates and other changes in tax laws that may affect the value of tax-exempt bonds relative to other investment alternatives;
- Managing credit exposure to financial institutions and other entities through the use of offsetting swaps and other credit management products; and,
- Accessing other applications that enable the issuer to increase income, lower costs or strengthen its balance sheet.
Policy 6: Savings
When a swap is used rather than the issuance of conventional bonds to produce interest rate savings such as in a forward or advanced refunding context, the level of savings should exceed the three percent (3%) refunding savings target for a refunding using conventional fixed-rate bonds to compensate for the added risks of using a swap. If the swap risks have been eliminated or significantly mitigated, the savings threshold could be the same as for conventional bonds.
Policy 7: Non-Speculation
While swaps may be used to increase or decrease the amount and type of variable-rate exposure on an issuer’s balance sheet, swaps should not be entered into for purely speculative purposes such as generating trading profits.
Policy 8: Protection from Counterparty Credit Risk
Unlike conventional bonds, swaps can create a continuing exposure to the creditworthiness of financial institutions that serve as counterparties. To protect the issuer’s interests in the event of a counterparty credit problem, issuers should take certain precautions, including:
- Use highly-rated counterparties: Differing standards may be employed depending on the term, size and interest-rate sensitivity of a transaction and types of counterparty used. As a general rule, transactions should be entered into only with counterparties whose obligations are rated at least double-A by one nationally recognized rating agency. In cases where the counterparty’s obligations are rated based on a guarantee or specialized structure to achieve the required credit rating, the issuer should review the nature and legal framework of the guarantee or structure in order to determine that it is satisfactory.
- Collateralization on downgrade: If a counterparty’s credit rating weakens or swap exposure becomes large, the swap documentation should provide added protection by requiring the posting of collateral. The standard document to allow for collateral posting is a Credit Support Annex. The Credit Support Annex may allow either counterparty to post collateral, as appropriate.
- Termination provisions: If a counterparty’s credit weakens beyond an acceptable level, even with collateralization, the swap documentation should provide the issuer with a right to terminate the transaction prior to its scheduled termination date on preferential terms. The key preferential term is to allow the issuer to trigger a termination on the side of the bid-offered spread which is most beneficial to the issuer. By using the favorable side of the bid-offered spread for calculating the termination payment, the issuer may be able to replace the downgraded swap provider with another suitable counterparty at little or no out-of-pocket cost. This credit-based termination should be in addition to a normal optional termination that allows the issuer to terminate a swap prior to its scheduled termination date on a discretionary basis (i.e., regardless of counterparty credit rating) with the cost of such termination based on a standard market methodology.
- Notice of downgrade: An issuer my require swap counterparties to provide notice in the event a credit agency takes negative action with regard to the counterparty’s credit rating including both an actual downgrading of the credit rating as well as the publication of a notice by a rating agency that the counterparty’s rating is in jeopardy of a downgrading (i.e., being placed on Standard & Poor’s Credit Watch or being assigned a negative outlook by Moody’s or other comparable action by another rating agency).
- Diversification: In order to limit counterparty risk, issuers should avoid excessive concentration of exposure to a single counterparty or guarantor by diversifying counterparty exposure over time. Exposure to any counterparty should be measured based on the termination value of any swap contracts entered into with the particular counterparty as well as such other measurements as “reasonable worst case” or “peak exposure”. Issuers should track termination values at least semi-annually based on a mark-to-market calculation of the cost of terminating each swap contract given the market conditions on the valuation date. Aggregate swap termination value for each counterparty should take into account netting of offsetting transactions (i.e., fixed-to-floating vs. floating-to-fixed). As a matter of general principle, issuers may require counterparties to regularly provide mark-to-market valuations of swaps they have entered into and may also seek independent valuations from third party professionals.
Policy 9: Competitive Procurement
Issuers may choose swap counterparties on either a negotiated or competitive basis. A competitive selection process is merited if the product is relatively standard, if it can be broken down into standard components, if two or more providers have proposed a similar product to the issuing entity or if competition will not create market pricing effects that would be detrimental to the issuing entity’s interests. The award of a competitive bid should be based on the lowest fixed interest rate to be paid, or the highest fixed interest rate to be received or other similar objective standard as is appropriate to the transaction.
Policy 10: Negotiated Procurement
Negotiated procurement should be considered under the following circumstances:
- if a swap provider has proposed original or proprietary products or original ideas for applying a specified swap product to a particular issuer’s needs;
- to avoid market pricing effects that would be detrimental to the issuing entity’s interests (for example, if the size or complexity of the swap has the potential to move market pricing in a detrimental manner); or,
- on a discretionary basis in conjunction with other business purposes. To provide safeguards on negotiated transactions, the issuer should secure outside professional advice to assist in the process of structuring, documenting and pricing the transaction as well as to provide a written certification that a fair, on-market price was obtained.
Policy 11: Hybrid Procurement
Issuers may employ a hybrid structure to reward unique ideas or special effort by including with a competitive process a provision reserving a specified percentage of the swap to a swap provider on the condition that the firm match or improve upon the best bid.
Policy 12: Reporting and Financial Disclosure
The state is committed to full and complete financial disclosure and to cooperating fully with rating agencies, institutional and individual investors, state departments and agencies, other levels of government and the general public to share clear, comprehensible and accurate financial information. The state is also committed to meeting secondary disclosure requirements on a timely and comprehensive basis.
Official statements accompanying debt issues, Comprehensive Annual Financial Reports and continuing disclosure statements will strive to meet the minimum standards (to the extent applicable to each debt issue) promulgated by regulatory bodies and professional organizations such as the Securities and Exchange Commission (SEC), Municipal Securities Rulemaking Board (MSRB), the Governmental Accounting Standards Board (GASB) and follow Generally Accepted Accounting Principles (GAAP).
Issuers that enter into a swap may also provide a regular report to their governing bodies and the public on the financial implications of the swaps they have entered into. Such reports may include:
- A summary of key terms of the swaps including notional amounts, interest rates, maturity and method of procurement including any changes to swap agreements since the last reporting period;
- The mark-to-market value (termination value) of the applicable swaps as measured by the economic cost or benefit of terminating outstanding contracts at specified intervals;
- The amount of exposure that the issuer has to each specific counterparty as measured by an aggregate mark-to-market value netted for offsetting transactions;
- The credit ratings of each counterparty (or guarantor, if applicable) and any changes in the credit rating since the last reporting period;
- Any collateral posting as a result of swap agreement requirements;
- The actual debt-service requirements or the underlying liabilities versus the amount of debt-service that was projected at the time each swap transaction was entered into; and for swaps used as part of a refunding, the actual cumulative savings versus the projected savings at the time the swap was entered into;
- An updated contingency plan to replace a terminated swap or fund a termination payment in the event that an outstanding swap is terminated; and,
- The status of any liquidity support used in connection with floating-rate bonds associated with a swap including the remaining term and current fee.