PART 2.2.1 CONTINUED UNDERSTANDING MUNICIPAL FINANCE (35% OF EXAM) Flashcards
General Obligation Bonds
-Secured by full faith, credit, and taxing power of an issuer (bonds are NOT secured by any assets)
-P&I is guaranteed by revenues raised by the issuer (primarily from its taxing authority)
-Traditionally “unlimited”
GO Bonds become debt obligations of the taxpayers within the issuing municipality as they must pay the taxes that are levied so the issuer can pay P&I
Can GO Bonds be “limited tax bonds” - why or why not
Yes, when security is limited by the local government’s constitution or statutes
*State and local municipalities that issue GO bonds usually levy income taxes or sales taxes to pay principal and interest
-Various types of fees such as license fees can also provide backing for GO bonds
GO Bonds are used to raise funds for non-revenue producing long term capital projects
-Typically fund projects and infrastructure improvements that will serve the entire community
-Common projects
-Roads
-Parks
-Government Buildings
-School Buildings
GO Bonds - Most issuers also rely on various AD Valorem Taxes for backing GO bond issues
-Taxes are based on the value of private homes and business holding within the municipality
-Property and real estate taxes are the most common types of ad valorem taxes used to pay debt service on and redeem GO bond issues
-Example - If a school district creates a bond issue to fund a new school building, it may increase the property tax rate in the district to ensure sufficient income to meets its principal and interest obligations
Unlimited Tax GO Bonds
Are backed by the total taxing power of the issuer
-May use property taxes, special taxes and other sources of income to repay interest and principal
Limited Tax GO Bonds
Backed by specific, narrowly defined taxing authority
-Example - City might issues bonds to build a bridge that is funded by a one cent increase in sales tax generated within the city for the next 10 years to pay principal and interest to bondholders
Generally a unlimited tax pledge is considered stronger than a limited tax pledge from the perspective of credit analysts and investors
-Perception of safety can allow an issuer to sell bonds at a lower int rate, saving taxpayer money
Ad Valorem (according to value) tax
One that can be raised or lowered by a local governing body without the sanction of superior levels of government
What happens in the event of default on GO bonds?
The holders of GO bonds have the right to compel a tax levy or legislative appropriation.
Nationally, how are GO bonds approved?
By referendum
Revenue Bonds
-Payable from a specific source of revenue and to which the full faith and credit of an issuer with taxing power is NOT pledged
-Paid from identified sources
-Doesn’t permit bondholders to compel taxation or legislative appropriations of funds
-Pledged revenues may be derived from the operation of the project, grants and excise taxes, and other specified non-ad-valorem taxes (e.g., income taxes)
-May include covenants to assure the adequacy of the pledged revenue sources
RevBonds
*Revenue bonds are backed by a specific source of revenue associated with the project for which the financing has been secured for
-Example - Revenue bonds are issued to build a convention center the fees collected from persons that use the facility, attend concerts, meetings or sporting events will pay the expenses of building and maintenance along with ongoing principal and interest owed to bond holders
*Revenue bonds do not rely on general funds of an issuing authority or depend on raising additional taxes
-The principal and interest payments to revenue bond holders are made by the stream of income that is generated by the project
-Issues of a revenue bond is not obligated to pay principal and int on the bonds it issues from any source other than those revenues specifically pledged to debt service
-In some cases revenue bonds can be backed by
-Sales tax
-Fuel tax
-Hotel occupancy taxes
-User fees
-Sometimes called special tax bonds
*An agency that provides free services cannot issue revenue bonds
-Public schools
-Revenue source is limited to tax dollars or government funding
RevBond Purposes
*Fund public authorities and support essential public services, most commonly
*Transportation systems
-Reliant on public funding and passenger fees for its construction and maintenance
*Toll revenue for building and improving highways
*Airports are constructed by a variety of municipalities
*Levy fees on airlines, terminal stores, parking garages, and tickets for payment of debt services
*Power systems
-Collect bills on a monthly basis
-Fund principal and int payments
*Sewer
-Bonds are issued by municipalities to build water lines, sewage treatment facilities
-Bonds are repaid with usage fees such as water collection bills
*Water
-Issue revenue bonds that are guaranteed by revenues collected from monthly bills
-Collections pay for use of water and treatments to ensure quality control and health standards are met
*Non profit organizations (501©)
*Private sector corporations such as hospitals
*New Housing Authority
*Education
-Funding for public education comes from taxation and general obligations bond issues
-Certain aspects of education rely heavily on revenue bonds
-Construction of an improvements to residence halls and dorms and student loans are often funded through conduit revenue bonds
*Healthcare
-Construct or expand public hospitals
*Industrial Revenue Bonds (IDRs)
-Public parking garages
-Factories
-Industrial parks
-Stadiums
-Backed by specific revenue streams generated by the facility
-Immediate benefits belongs to the private entity
GO vs RevBonds
Special Tax Bond
A bond secured by revenues derived from one or more designated taxes other than ad valorem taxes
What taxes secure a Special Tax Bond?
Bonds for a particular purpose might be supported by sales, cigarette, fuel or business license taxes
What is an example of a Special Tax Bond?
City may issue a special tax bond to build a new admin building for a community college that is backed by a new excise tax on alcoholic beverages sold within the city
Special Assessment Bonds
-Obligation payable from a special assessment
What is a Special Assessment
-A charge imposed against a property in a particular locality because that property receives a special benefit from some public improvement that is separate from the benefit enjoyed by the public at large
-May be apportioned according to the value of the benefit received, rather than the cost of the improvement
-Part of one of the most rapidly growing areas of tax-backed financings
-Properties located within a defined district will benefit from an improvement instead of the public at large
-Property owners are typically assessed a share of the cost of these improvements
-P&I on these bonds is paid from the assessments charge to benefiting property
Example of a Special Assessment Bond
Properties within a area may receive direct benefit from improvements to water lines, streets, sidewalks, or sewers
Moral Obligation Bond
A bond that, in addition to its primary source of security, is also secured by a non-binding covenant that any amount necessary to make up any deficiency in debt service will be included in the budget recommendation made to the governing body, which may appropriate funds to make up the shortfall.
-The governing body, however, is not legally obligated to make such an appropriation
-Issued by a state or agency and features an additional measure of security if there are any deficiencies in funds to pay debt service
-Moral Obligation Bond is based on a non-binding covenant and does not have the issuers full faith and credit pledge no voter approval is required
*Transportation projects
*Parks and rec projects
*Public improvements and energy projects
Double-barreled Bond
*A bond secured by both a defined source of revenue (other than property taxes) and the full faith and credit or taxing power of an issuer that has taxing powers.
*Are a type of general obligation bonds that include a second form of backing from a defined source of revenue
*Viewed as some of the safest municipal bonds
*These bonds have a legal obligation to make up a shortfall of revenue while moral obligation bonds do not
Example of a Double-barreled Bond
A municipality may issue bonds to build a toll road that are backed by toll revenues but also by the full faith and credit of the municipality
Capital Appreciation Bonds (CABs)
*Are municipal zero coupon bonds
*Are issued at a discount and pay no periodic interest
*At a CABs maturity the holder receives the par value
*Diff between purchase price and par value represents the appreciation earned by the investor
*CABs are attractive as a funding alternative for long term projects that will yield no cash for a number of years
*No reinvestment risk since investors receive no regular coupon payments
*Not suitable for investors who rely on bonds to provide a stream of income payments
*May be tendered to the issuer for redemption but an int payment penalty applies
*Backed by municipal gov
Tax Increment/Allocation Financing
-Payable from the incremental increase in tax revenues realized from any increase in property value resulting from capital improvements benefitting the properties that are financed with bond proceeds
-A method of financing the public costs associated with a private development project
*Property tax collections will increase from successful development and can be allocated to repay the public infrastructure investments
-TIF relies on future gains in taxes to subsidize current improvements
*To ensure an increase in taxes above standard yearly increases
*The area targeted for improvement (the tif district) usually includes a substantial area beyond the original project site
-Amount issuer can borrow is calculated by summing all normal annual real estate tax increases from every parcel in the TIF district for a period of 20-25 years or more, along with the tax revenue anticipated to come from the project
*TIF was designed to channel funding toward improvements in destressed underdevelopment parts of a jurisdiction
What type of bond/financing is often used to finance the development of blighted areas?
Tax Increment/Allocation Financing
Taxable Municipal Securities
*Taxable municipal issues are currently one of the fastest growing sectors in public finance
*Investors have many more options to choose from and find them attractive because of the availability of higher yields without the need to take too much credit risk
*Build America Bonds
Build America Bonds (BABs)
*Long term bond
*Issued to deliver economic stimulus
*Interest income is fully taxable to investors at the federal, state and local levels
*Issuers of the direct payments BABs are subsidized by the fed gov, which pays 35% of the interest owed to investors
*Example - f a BAB was issued with a 6% coupon rate, the gov pays 2.1% of the interest (35%) while the issuer would pay the remaining 3.9% of the interest (65%)
*Allows the issuers to offer higher int rates to attract investors
*Are not guaranteed against default by the fed gov
*Were popular with instructional investors that used them to improve portfolio diversification and earn higher yields
*BABS may either be GO or revenue Bonds
*The capital projects these bonds fund include
*Maintenance on public buildings
*Courthouses
*Schools
*Transportation infrastructure
*Gov hospitals
*Public safety facilities and equipment’s
*Water and sewer projects and public utility projects
*American Recovery and Reinvestment Act of 2009 (ARRA)
*Increase state and local funding for capital projects and to put Americans back to work while rebuilding aging infrastructure
Build America Bonds (BABs)
-Taxable municipal securities issued through December 31, 2010 under the American Recovery and Reinvestment Act of 2009 (ARRA). –BABs may be direct pay subsidy bonds or tax credit bonds.
Private Purpose Bonds
o Referred to as private activity bonds
o Issued for the benefit of a non-public entity
Examples of projects funded by taxable private purpose bonds
o Sports stadiums
o Pension plans refunding
o Investor led housing projects
Recovery Zone Economic Development Bonds (RZEDBs)
-A category of taxable Build America Bonds to fund infrastructure and facility improvement in areas of significant unemployment and poverty.
-RZEDBs are direct pay subsidy bonds that provide a higher subsidy rate than other direct pay subsidy BABs.
Taxable Credit Bonds
Municipal securities that entitle the bondholder to receive, in lieu of interest payments, a credit against federal income tax.
Tax Credit Bonds
*Are a type of BAB that provide investors with a federal tax credit equal to 35% of the interest
*Projects that can be funded by these
*School district using money to expand or upgrade facilities
*Projects developing renewable energy sources
*Public infrastructure projects
*Energy conservations programs
Variable Rate Demand Obligations (VRDOs)
Debt securities that bear interest at a floating, or variable, rate adjusted at specified intervals (daily, weekly, or monthly) according to a specific index or through a remarketing process. The investor has the option to put the bond back to the tender agent at any time with specified notice (e.g., seven days). The put price is par plus accrued interest. These securities typically are supported by a liquidity facility, (i.e., letter of credit, standby bond purchase credit or self-liquidity), which assists in making these securities money market fund eligible.
Variable Rate Demand Obligations (VRDOs)
*Long Term bonds
*Are variable rate securities that are issued by state and local gov as either general obligation or revenue bonds
*Interest rates that float and are reset on a periodic basis
*Typically issued with maturities of 20-30 years
*Considered short term securities because their holders have the right to sell them back to the issuer at par on any of the periodic reset dates
-Called a put feature or tender feature
*Backed by a bank letter of credit or by bond issuance, helping to create liquidity
*Investors purchase VRDOs at par in 100,000 increments
*When security is put back to the issuer, the investor receivers par plus the accrued interest earned
*Returns have a low correlation with stock and bond returns
*Good source of portfolio diversification
*Tax exempt money market funds are the largest holders of VRDOs
Action Rate Securities (ARSs)
*Are long term variable rate bonds tied to short term interest rates
*For ARS the new rate is determined by an auction process
*Lowest rate at which all the bonds can be sold establishes the new interest rate also called the Clearing Rate
*All bids at or below this rate are accepted and paid the clearing rate while any bids above the clearing rate are rejected
*Greatest risk for ARS is a failed auction
*Happens when not enough demand or when they are not enough submitted bids for the securities to reset the int rate and investors are forced to hold onto their bonds
*Upon auction failure the int rate on the security typically increases to a previously set rate well above market rates
*VRDOs have a put feature they are considered more liquid than ARSs
Short Term Municipal Obligations - maturities of less than 3 years are classified as short term securities
Municipal Note
o Is a short term, high quality municipal issue that is sold by a municipality to help manage its cash flow
o Usually mature in 1 or less years
Tax Anticipation Notes (TANs)
Notes issued in anticipation of future tax receipts, such as receipts of ad valorem taxes that are due and payable at a set time of year.
Revenue Anticipation Notes (RAN)
*Issues in anticipation of receiving revenues in the future
*Sales taxes
Tax and Revenue Anticipation Notes (TARNs)
Notes issued in anticipation of receiving future tax receipts and revenues at a future date.
Bond Anticipation Notes (BANs)
o Typically issued to support capital projects and are repaid by proceeds from the issuance of long term bonds
o Provide interim financing until the bond issue can be prepared and sold
Grant Anticipation Notes
*Revenue notes that are backed by anticipated grant receipts
*Grants are usually from the fed gov and are often used for
-Transportation projects
-Highway construction or maintenance
*Risk is that there is no guarantee the state will receive the anticipated funding
Commercial Paper
*Tax Exempt Commercial Paper is a short term debt obligation issued by municipalities that matures within a 270 day period
*Backed by a line of credit with a bank
*Issuers pay maturing principal of outstanding commercial paper with newly issued commercial paper
*Known as roll over - extends the period for which the short term funds are borrowed.
*Universities commonly issue commercial paper
What is a Tax-exempt Commercial Paper?
A short-term unsecured debt where the bondholder does not pay federal, state, or local taxes on the interest payments.
Key Takeaways re: Tax-exempt Commercial Paper
-Issued with a fixed interest rate
-Has a maturity date of fewer than 270 days
-Is commonly denominated in increments of $1,000
Are interest rates on Tax-exempt Commercial Paper usually higher or lower than other short-term cash instruments? And are Tax-exempt Commercial Paper higher or lower than taxable debt?
Interest rates on tax-exempt commercial paper are typically higher than other short-term cash instruments but will be lower than taxable debt.
Tax-exempt commercial paper is usually issued to finance short-term liabilities, which provides the debt holders (bondholders) with some level of tax preference on their debt investment earnings. Tax-exempt commercial paper is issued with a fixed interest rate, has a maturity date of fewer than 270 days, and is commonly denominated in increments of $1,000.
Commercial paper is mostly a promissory note backed by the financial intuition’s health. Federal government policy does not cover losses incurred from investing in commercial paper. Furthermore, the Federal Deposit Insurance Company (FDIC) does not insure against losses from investing in tax-exempt commercial paper.
An investor’s due diligence should include checking the desired tax-exempt commercial paper’s quality ratings listed by agencies such as Standard & Poor’s or Moody’s.
Tax-exempt Commercial Paper interest rates should rise as the economy grows.
Tax-exempt commercial paper issued by the government is an indirect method of support for those specific entities as opposed to directly funding these entities. The government forgoes the collection of taxes on the interest income, but the logic is that the entity issuing the tax-exempt commercial paper will engage in activities that serve the community that will end up generating more value than the lost tax revenue. Thus, tax-exempt commercial paper can be viewed as an instrument of public policy.
Only companies with an investment-grade rating may issue commercial paper.
Institutions, such as universities and governments, typically issue tax-exempt commercial paper, while banks, mutual funds, or brokerage firms buy the tax-exempt commercial paper. The buyers may hold the commercial paper as an investment or act as an intermediary and resell the investment to their customers. There is a limited market for tax-exempt commercial paper issued directly to smaller investors. Due to the 2008 financial recession, new legislation limits the type and amount of commercial paper held in money market funds.
The Federal Reserve Board (FRB) publishes current borrowing rates on commercial paper on its website. The FRB also publishes the rates of highly rated commercial paper in a statistical release occurring each Friday.
Information relating to the total amount of outstanding paper issued is also released once per week.
Board of Governors of the Federal Reserve System. “Commercial Paper Rates and Outstanding Summary: Volume Statistics for Commercial Paper Issuance.”
The tax-exempt commercial paper is beneficial for the borrower (issuer) as they are able to access funds at lower rates than they might otherwise have to pay if they had borrowed the money from a traditional financial institution, such as a bank. Tax-exempt commercial paper can be beneficial for the lender (bond buyer) as the net rate of return may end up being higher than if they had invested in taxable commercial paper.
Municipalities and local governments may issue tax-exempt commercial paper as a way to meet short-term financial obligations, such as payroll or government expenses. They may also issue commercial paper as a way to meet expenses while pursuing longer-term capital raises.
Most commercial paper is sold in very large increments that are not available to the average retail investor. However, you can gain exposure to the commercial paper market by investing in a mutual fund or money market fund that invests in tax-exempt commercial paper.
Only governments and affiiliated bodies can issue tax-exempt commercial paper. The rules for issuance are determined by the tax code of the issuing state.
Tax-exempt commercial paper refers to short-term securities whose interest is exempt from certain state or local income taxes. This is frequently used by local and municipal governments as a way to finance their short-term debt obligations. Due to certain associated risks, the interest rates on tax-exempt commercial paper are typically higher than other short-term cash instruments.
Lease Rental, Lease Revenue, or Leasehold Revenue Bond
A bond that is secured by lease payments made by the party leasing the facilities that were financed by the bond issue. Typically,
lease rental bonds are used to finance construction of facilities (e.g., schools or office buildings) used by a state or municipality. In many cases, lease payments may be subject to annual appropriation or
will be made only from revenues associated with the facility financed. In other cases, the leasing state or municipality is obligated to appropriate funds from its general tax revenues to make lease payments as long as it utilizes the leased property
Installment Purchase Agreements
A contract where a seller will let a buyer incrementally pay for a property or asset. If the buyer cannot purchase the asset all at once, they can seek out consent from the seller to split up the payments into installments.
Certificate of Participation (COP)
An instrument evidencing a pro rata share in a specific pledged revenue stream, usually lease payments by the issuer that are typically subject to annual appropriation. The certificate generally entitles the holder to receive a share, or participation, in the
payments from a particular project. The payments are passed through the lessor to the certificate holders. The lessor typically assigns the lease and the payments to a trustee, which then distributes the payments to the certificate holders.
Certification of Participation (COP)
*Is an alternative form of bond financing used by municipal or gov entities
*Investors in the bond issue do not receive regular interest on the bonds or a guaranteed face value at the end of the project
*Instead they receive an actual share of the lease payments rather than interest and principal funded from rental payments
*COPs offer financing flexibility because projects financed with COPs are not subject to established debt limits or restrictions of the municipality
Annual Appropriation Pledge/Lease
A pledge typically found in the bond contract for lease revenue
bonds or securing a certificate of participation financing that commits the issuer or other obligor to make lease payments or other periodic debt service payments but only to the extent that funds are
budgeted and appropriated on an annual basis by the issuer’s governing body. The governing body is not legally obligated to make such appropriation in any year. An annual appropriation pledge typically is used only in connection with projects that are considered to be essential to the issuer’s operations and therefore the governing body is likely to appropriate the money needed to pay debt service on an on-going basis. In many jurisdictions, this clause permits a borrowing entity to undertake a long-term certificate of participation or other lease revenue obligation financing without technically incurring debt, thereby avoiding statutory or constitutional debt limitations and referendum requirements because the lease payments are characterized as payments for use of the facilities rather than as payments on a promise to repay bonded debt
Abatement Clause
A provision of a lease that relieves a lessee of the obligation to make lease payments in the event that the leased property cannot be utilized (e.g., because of construction delays, property damage or other causes).
Bank Loan/Direct Loan
A loan to a municipal issuer from a banking institution or another lender. The obligations my constitute municipal securities.
Bank Loans
*Alt financing method available to municipal issuers
*Potential advantages for issuers
-Lower int rates and transactions costs
-Simpler execution process
-Greater structuring flexibility
-Not requirement for a rating or offering documents
-Direct interaction with the lender instead of multiple bond holders
Reves Test
*Supreme court decisions which provides guidelines to making a determination between the difference between a bank loan and other private placements of municipal securities
*If a bank loan is classified as a security a CUSIP number must be acquired
Escrow Security Bond
This type of bond is used to protect an obligation or promise to pay from one party, the obligee, to a second party, such as a contract holder. The bond will protect the obligee if the second party fails to meet the obligation.
Escrow
Escrow is a financial arrangement where a neutral third party holds assets or funds on behalf of two parties in a transaction. The third party, called an escrow agent, releases the funds only when the parties have fulfilled their contractual obligations.
Escrow Account
A fund established to hold funds pledged and to be used solely for a designated purpose, typically to pay debt service on an outstanding issue in an advance refunding.
Escrow Deposit Agreement
An agreement that typically provides for the deposit of funds or
securities in an escrow account to refund an outstanding issue of municipal securities. The agreement sets forth the manner in which funds are to be invested (generally in eligible securities) pending their
expenditure and the schedule on which on-going debt service payments are to be made and early redemptions, if any, of securities are to occur.
Escrowed Securities
Securities that are held, typically in an escrow account, to be used solely for a designated purpose
Treasury Securities
Debt obligations of the United States Government sold by the Treasury Department in the form of bills, notes and bonds (as well as SLGS sold to issuers of municipal securities) backed by the full faith and credit of the United States Government:
-Bills – Short-term obligations that mature in one year or less and are sold on the basis of a rate of discount.
-Notes – Obligations that mature between one year and ten years.
-Bonds – Long-term obligations that mature in ten years or more.
Bills (a type of treasury security)
Short-term obligations that mature in one year or less and are sold on the basis of a rate of discount.
Notes (a type of treasury security)
Obligations that mature between one year and ten years.
Bonds (a type of treasury security)
Long-term obligations that mature in ten years or more.
Federal Agencies
-Commodity Futures Trading Commission (CFTC)
-Federal Deposit Insurance Corp (FDIC)
-Federal Reserve Board
-Office of the Comptroller of Currency (OCC)
-Securities and Exchange Commission (SEC or The Commission)
Commodity Futures Trading Commission (CFTC)
An independent federal agency charged with the regulation of commodity futures and option markets in the United States.
Federal Deposit Insurance Corporation (FDIC)
Federal agency that guarantees (within limits) funds on deposit (other than securities) in member banks and thrift institutions, and performs other functions relating to the safety and soundness of its member institutions. The FDIC also enforces MSRB rules applicable to its member banks (other than banks that are members of the Federal Reserve System) that are municipal securities dealers.
Federal Reserve Board
The Board of Governors of the Federal Reserve System, which is
the federal agency responsible for making national monetary policy and supervising and regulating certain banking institutions. In addition, the Federal Reserve Board enforces MSRB rules applicable
to the system’s member banks that are municipal securities dealers.
Office of the Comptroller of Currency (OCC)
Federal agency within the Treasury Department responsible for supervising and regulating national banks. The OCC also enforces MSRB rules applicable to bank dealers that are national banks.
Securities and Exchange Commission (SEC or The Commission)
The federal agency responsible for supervising and regulating the securities industry. Although municipal securities are exempt from the SEC’s registration requirements, municipal securities dealers and municipal advisors are subject to SEC regulation and oversight. The SEC also has responsibility for the approval of MSRB rules and enforces anti-fraud provisions of the federal securities laws in the sale and purchase of municipal securities.
Investment Contracts
-Guaranteed Investment Contracts (GICs)
-Forward Delivery Agreement
Guaranteed Investment Contracts (GICs)
An investment, secured by a contract with a financial institution, that guarantees a fixed rate of return and a fixed maturity.
Forward Delivery Agreement
A two-stage process where a bond’s price is set on a specific date, but the bonds are not issued until a later date:
-Pricing: The bonds are priced, or the interest rate is determined, at the beginning of the forward delivery arrangement.
-Issuance: The bonds are issued and the offering is closed at a future date.
Forward delivery bonds are a way for issuers to protect against interest rate increases and lock in savings when interest rates are low. They can also be used to refund tax-exempt bonds that aren’t eligible for advance or current refunding.
Issuers typically pay a premium to lock in the interest rate until the bonds are issued. They don’t recognize the bonds as an asset or liability until the offering is closed.
Money Market Instruments
-CDs
-Commercial Paper
-Interbank Loans
-Money Market Mutual Funds
-Treasury Bills
-Securities Lending and Repurchase Agreements (Repos)
Certificates of Deposit (CDs)
The most familiar money market instruments are bank deposits, which are not considered securities, even though certificates of deposit are sometimes traded like securities. Depositors, who are lending money to the bank, look to the institution’s creditworthiness, as well as to any government programs that insure bank deposits.
Commercial Paper (CP)
A promissory note (an unsecured debt) issued by highly rated banks and some large nonfinancial corporations. Because the instrument is unsecured (no more than a promise to pay, hence the name), investors look solely to the creditworthiness of the issuer for repayment of their savings. Commercial paper is issued and traded like a security. But because it is short term by nature and not purchased by retail investors, it is exempt from most securities laws. In the United States, for example, commercial paper is issued in maturities of 1 to 270 days, and in denominations that are deemed too large for retail investors (typically $1 million, but sometimes as small as $10,000).
Interbank Loans
Interbank loans are not secured by collateral, so a lender looks exclusively to a borrower’s creditworthiness to assess repayment probabilities. The most closely watched interbank market is in England, where the London interbank offered rate (LIBOR) is determined daily and represents the average price at which major banks are willing to lend to each other. That market did not prove to be a reliable source of funding during the crisis. LIBOR rates rose sharply in comparison to other money market rates once the creditworthiness of banks was called into question. Moreover, lending volume decreased significantly as banks struggled to fund their existing assets and were less interested in new lending. Emergency lending by central banks helped make up for the contraction of this funding source. Recent investigations by regulatory authorities have also called into question the integrity of the pricing process by which LIBOR is determined.
Treasury Bills
Treasury bills, which are issued by the government, are securities with maturities of less than a year. U.S. Treasury bills, sold at a discount from face value and actively bought and sold after they are issued, are the safest instrument in which to place short-term savings. The markets are deep and liquid, and trading is covered by securities laws. U.S. Treasury bills are not only savings instruments; they can be used to settle transactions. Treasury bills, which are issued electronically, can be sent through the payments system as readily as money.
Repos
Repos are an important large, but more complicated, segment of money markets. Repos offer competitive interest rates for borrowing and lending on a short-term basis—usually no more than two weeks and often overnight. A borrower sells a security it owns for cash and agrees to buy it back from the purchaser (who is in effect a lender) at a specified date and at a price that reflects the interest charge for borrowing over the period. The security at the heart of the transaction serves as collateral for the lender.
Money Market Mutual Funds
Money market mutual funds (MMMFs) are securities offered by companies that invest in other money market instruments—such as commercial paper, certificates of deposit,
Municipal Fund Securities
-Local Government Investment Pools (LGIPs)
-529 College Savings Plans
Local Government Investment Pools (LGIPs)
An investment pool established by a state or local governmental entity or instrumentality that serves as a vehicle for investing public funds of participating governmental units. Participants purchase shares or units in the pool (often formed as a trust) and assets are invested in a manner consistent with the portfolio’s stated investment objectives. The investment advisor invests in a manner consistent with the cash management needs of the governmental unit participants.
529 College Savings Plans
A program established by a state as a “qualified tuition program” pursuant to Section 529 of the Internal Revenue Code. Under a 529 savings plan, a person may make contributions to an account established for the purpose of meeting the qualified higher education expenses of the designated beneficiary of the account. Effective January 1, 2018, qualified higher education expenses include expenses for tuition at an elementary or secondary public, private, or religious school. Contributions generally are used to acquire units in a state trust, with trust assets invested in a manner consistent with the trust’s stated investment objectives. Units typically constitute municipal fund securities. Under current federal tax law, earnings from a 529 savings plan used for qualified higher education expenses of the designated beneficiary are excluded from gross income for federal income tax purposes.
Possible Financing Solutions for Municipal Issuers
-Bonds
-Notes
-Bond Proceeds Investment Strategies
-Municipal Fund Securities
-Swaps/Derivatives
Bond
(1) The written evidence of debt, which upon presentation entitles the bondholder or owner to a fixed sum of money plus interest. The debt bears a stated rate(s) of interest or states a formula for determining that rate and matures on a date certain. (2) For purposes of computations made on a “per bond” basis, a $1,000 increment of a security (no matter what the actual denominations are) (e.g. 10
bonds refers to a $10,000 investment). (3) Generally refers to debt securities with a maturity of greater than the short-term range.
Note
A short-term obligation of an issuer to repay a specified principal amount on a certain date, together with interest at a stated rate, usually payable from a defined source of anticipated revenues. Notes usually mature in one year or less, although notes of longer maturities are also issued. The following types of notes are common in the municipal market:
Types of Notes
-BAN
-Commercial Paper (CP)
-Construction Loan Notes (CLNs)
-Grant Anticipation Notes (GANs)
-Revenue Anticipation Notes (RANs)
-Tax Anticipation Notes (TANs)
-Tax and Revenue Anticipation Notes (TRANs)
BANs
Notes issued by a governmental unit, usually for capital projects,
that are repaid from the proceeds of the issuance of long-term bonds.
Commercial Paper (CP)
Short-term obligations issued by municipal entities usually backed by a line of credit with a bank that mature within 270 days. The issuer typically pays maturing principal of outstanding commercial paper with newly issued commercial paper, referred to as a “roll over,” thereby borrowing funds on a short-term basis for an extended period of time. Rate reset periods may vary from one to 270 days and different portions of a single issue of commercial paper may simultaneously have different reset periods.
Construction Loan Notes (CLNs)
Notes issued to fund construction of projects (typically housing
projects).
*Typically issued with 2-3 year maturities although some can be up to 5 years
*Repaid by the permanent financing acquired after the project is finished
New Housing authority bonds or public housing authority bonds (PHAs)
*Aim to develop affordable, sanitary, and adequately sized living arrangements for low income, disabled, or elderly citizens
*Municipal housing bonds can finance either housing or mortgages for persons with limited incomes
*Section 8 Bonds
*Issued for multi fam properties, but other types of municipal housing bonds may fund building and mortgages for single family homes
*Collected rents along with assistance provided by federal gov programs, pay the principal and int on PHA bonds
*These bonds are backed by rental income and have the backing of the federal government as well to cover any shortfall
*Certain states issue mortgage revenue bonds
-Which provide a funding source for home mortgages
Grant Application Notes (GANs)
Notes issued on the expectation of receiving grant funds, usually
from the federal government. The notes are payable from the grant funds, when received.
Revenue Anticipation Notes (RANs)
Notes issued in anticipation of receiving revenues at a future
date
Tax anticipation notes (TANs)
Notes issued in anticipation of future tax receipts, such as receipts
of ad valorem taxes that are due and payable at a set time of year.
Tax and revenue anticipation notes (TRANs)
Notes issued in anticipation of receiving future tax
receipts and revenues at a future date.
Bond Proceeds Investment Strategies
-Cash Flow Driven Accounts
-Reserves
-Investment Agreements (IAs)
-Cash Flow Driven Accounts
These accounts include capitalized interest funds, debt service funds, and project funds. Debt service and capitalized interest funds are usually more straightforward because cash needs are typically known in advance. Project funds are more dependent on factors like contractors and weather, which are harder to predict.
Reserves
These accounts are designed to be accessible if the underlying project experiences a revenue shortfall.
Investment Agreements (IAs)
IAs are contracts that allow a financial institution to lend issuer funds, which are then repaid with interest. The terms of IAs can vary significantly, but they can be an attractive way to invest bond proceeds under favorable market conditions.
When developing an investment strategy for bond proceeds, you can consider the following:
-Client objectives: Understand the client’s objectives.
-Investment vehicles: Determine what vehicles the client can invest in, based on state code and the client’s Investment Policy.
-Risk tolerances and preferences: Determine what strategy fulfills the client’s objectives within their risk tolerances and preferences.
Municipal Fund Security
A municipal security that, but for section 2(b) of the Investment
Company Act of 1940, would constitute an investment company.
Examples of Municipal Fund Securities
Interests in local government investment pools, 529 savings plans, and ABLE programs
Municipal Securities
A general term referring to a bond, note, warrant, certificate of participation or other obligation issued by a state or local government or their agencies or authorities (such as cities,
towns, villages, counties or special districts or authorities). A prime feature of most municipal securities is that interest or other investment earnings on them are generally excluded from gross income of the bondholder for federal income tax purposes. Some municipal securities are subject to federal income tax, although the issuers or bondholders may receive other federal tax advantages for certain types of taxable municipal securities.
Examples of Municipal Securities
-Build America Bonds
-Mutual Fund Securities
-Direct Pay Subsidy Bonds
Municipal Advisor
A person or entity (with certain exceptions) that (a) provides advice to or on behalf of a municipal entity or obligated person with respect to municipal financial products or the issuance of municipal securities, including advice with respect to the structure, timing, terms, and
other similar matters concerning such financial products or issues, or (b) solicits a municipal entity, for compensation, on behalf of an unaffiliated municipal securities dealer, municipal advisor, or investment adviser to engage such party in connection with municipal financial products, the issuance of municipal
securities, or investment advisory services.
Municipal Bond
A debt security issued by or on behalf of a state or its political subdivision, or an agency or instrumentality of a state, its political subdivision, or a municipal corporation. Municipal bonds, for example, may be issued by states, cities, counties, special tax districts or special agencies or authorities of state or local governments.
Municipal Entity
A state, political subdivision of a state, or municipal corporate instrumentality of a state, including (a) any agency, authority, or instrumentality of the state, political subdivision, or municipal
corporate instrumentality; (b) any plan, program, or pool of assets sponsored or established by the state, political subdivision, or municipal corporate instrumentality or any agency, authority, or instrumentality thereof; and (c) any other issuer of municipal securities.
Municipal Securities Business (aka Municipal Securities Activities)
A term generally encompassing all of the activities of municipal securities dealers in the municipal securities market.
Municipal Securities Dealer
A dealer or bank dealer engaged in the business of effecting
principal trades in municipal securities. This term is often used colloquially, and is used in this glossary (unless the context otherwise requires), as a collective term to describe all brokers, dealers and municipal securities dealers engaged in municipal securities activities.
Municipal Securities Rulemaking Board (MSRB)
A self-regulatory organization, consisting of representatives of securities firms, bank dealers, municipal advisors, issuers, investors and the public, that is charged with primary rulemaking authority over municipal securities dealers and municipal advisors in connection with their municipal securities and municipal advisory activities. MSRB rules are approved by the SEC, and enforced by the SEC, FINRA and the federal banking regulators depending on the regulated entity
Derivative
A product whose value is derived from an underlying security or other asset structured to deliver varying benefits to different market segments and participants. The term encompasses a wide range of products offered in the marketplace including interest rate swaps, caps, floors, collars and other synthetic variable rate products.
Swap
(1) A generic term used to describe a broad range of derivative products, including but not limited to interest rate swap contracts.
(2) A sale of a 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.
Collar
A swap agreement entered into by an issuer or obligor with a swap counterparty in connection with variable rate debt that combines an interest rate cap and an interest rate floor. Such arrangement is typically used to establish a minimum and maximum interest rate range that defines the payment obligations of the swap parties with respect to the swap. The obligor remains responsible for the payment of debt service on the bonds and typically will apply payments received under the collar to offset such payments
Credit Default Swap
An agreement that transfers the credit risk of a third party from the protection buyer to a protection seller in exchange for a premium.
Fixed-to-Floating Rate Swap
An agreement whereby an issuer synthetically converts fixed rate
debt into variable rate debt through an interest rate swap or similar arrangement. In this process, the issuer makes payments to the counterparty at a variable rate determined according to the terms of the swap while the counterparty pays a fixed rate also according to the terms of the swap, which may be equivalent to the rate due to bondholders as determined under the bond contract.
Floating-to-Fixed Rate Swap
An agreement whereby an issuer synthetically converts variable
rate debt to fixed rate debt through an interest rate swap or similar arrangement. In this process, the issuer makes payments to the counterparty at a fixed rate according to the terms of the swap and the counterparty makes payments on a variable rate or rates according to the terms of the swap, which may be equivalent to the rates payable to bondholders under the bond contract.
Forward Swap Agreement
An agreement whereby two parties enter into an interest rate swap
agreement to begin at a future date.
Interest Rate Swap Contract or Agreement
A specific derivative contract entered into by an issuer or obligor with a swap provider to exchange periodic interest payments. Typically, one party agrees to make payments to the other based upon a fixed rate of interest in exchange for payments based upon a variable rate. The swap contract may provide that the issuer will pay to the swap counterparty a fixed rate of interest in exchange for the counter-party making variable payments equal to the amount payable on the variable rate debt.
Swap Advisor
An advisor to a municipal entity or borrower in connection with the entity’s or borrower’s consideration of entering into an interest rate swap transaction
Swaption or Swap Option
An option held by one party that provides that party the right to
require that a counter-party enter into a swap contract on certain specified terms.
Tax Swap
The sale of a security at a loss and the simultaneous purchase of another similar security. By creating a loss, the tax swap reduces the investor’s current tax liability. The tax swap may also serve
purposes similar to those of other types of swaps. There are specific Internal Revenue Service regulations governing tax swaps
Total Return Swap (TRS)
A swap designed to transfer the credit exposure of an asset between
parties in which all investment earnings from a particular asset are exchanged for payments based on an established rate or rate-setting mechanism.
Wash Sale
A transaction in which securities are sold for the purpose of establishing a tax loss but are reacquired (or a substantially identical security is acquired) within 30 days prior to or 30 days after the
date of the sale. Under such circumstances the deduction of the loss for tax purposes would be deferred.
Swaps - Key Takeaways
-In finance, a swap is a derivative contract in which one party exchanges or swaps the values or cash flows of one asset for another.
-Of the two cash flows, one value is fixed and one is variable and based on an index price, interest rate, or currency exchange rate.
-Swaps are customized contracts traded in the over-the-counter (OTC) market privately, versus options and futures traded on a public exchange.
-Plain vanilla interest rate, equity, CDS, and currency swaps are among the most common types of swaps.
Intro to Swaps
A swap is a derivative instrument allowing counterparties to exchange (or “swap”) a series of cash flows based on a specified time horizon. Typically, one series of cash flows is considered the “fixed leg” of the agreement, while the less predictable “floating leg” includes cash flows based on interest rate benchmarks or foreign exchange rates. The swap contract, which is agreed on by both parties, specifies the terms of the swap, including the underlying values of the legs, plus payment frequency and dates. People typically enter swaps either to hedge against other positions or to speculate on the future value of the floating leg’s underlying index/currency/etc.
For speculators like hedge fund managers looking to place bets on the direction of interest rates, interest rate swaps are an ideal instrument. While one traditionally trades bonds to make such bets, entering into either side of an interest rate swap agreement gives immediate exposure to interest rate movements with virtually no initial cash outlay.
Counterparty risk is a major consideration for swap investors. Since any gains over the course of a swap agreement are considered unrealized until the next settlement date, timely payment from the counterparty determines profit. A counterparty’s failure to meet its obligation could make it difficult for swap investors to collect rightful payments.
The Swap Market
Since swaps are highly customized and not easily standardized, the swap market is considered an over-the-counter (OTC) market, meaning that swap contracts cannot typically be easily traded on an exchange. But that does not necessarily mean swaps are illiquid instruments. The swap market is one of the largest and most liquid global marketplaces, with many willing participants eager to take either side of a contract. According to the Bank for International Settlements, the notional amount outstanding in over-the-counter interest rate swaps was $5.2 trillion in April 2022.
Types of Swaps
Plain Vanilla Swaps
Plain Vanilla Swaps
Plain vanilla interest rate swaps are the most common swap instrument. They are widely used by governments, corporations, institutional investors, hedge funds, and numerous other financial entities.
In a plain vanilla swap, Party X agrees to pay Party Y a fixed amount based upon a fixed interest rate and a notional dollar amount. In the exchange, Party Y will pay Party X an amount based upon that same notional amount as well as a floating interest rate, typically based upon a short-term benchmark rate like the Fed Funds Rate or LIBOR.
The notional amount, however, is never exchanged between parties, as the next effect would be equal. At the start, the value of the swap to either party is zero. However, as interest rates fluctuate, the value of the swap fluctuates as well, with either Party X or Party Y having an equivalent unrealized gain to the other party’s unrealized loss. Upon each settlement date, if the floating rate has appreciated relative to the fixed, the floating rate payer will owe a net payment to the fixed payer.
Take the following scenario: Party X has agreed to pay a fixed rate of 4% while receiving a floating rate of LIBOR+50 bps from Party Y, on a notional amount of 1,000,000. At the time of the first settlement date, LIBOR is 4.25%, meaning that the floating rate is now 4.75% and Party Y must make a payment to Party X. The net payment would, therefore, be the difference between the two rates multiplied by the notional amount [4.75% - 4% *(1,000,000)], or $7,500.
Currency Swap
In a currency swap, two counterparties aim to exchange principal amounts and pay interest in their respective currencies. Such swap agreements let the counterparties gain both interest rate exposure and foreign exchange exposure, as all payments are made in the counterparty’s currency.
For example, say a U.S.-based firm wishes to hedge a future liability it has in the U.K., while a U.K.-based business wishes to do the same for a deal expected to close in the U.S. By entering into a currency swap, the parties can exchange an equivalent notional amount (based on the spot exchange rate) and agree to make periodic interest payments based on their domestic rates. The currency swap forces both sides to exchange payments based upon fluctuations in both domestic rates and the exchange rate between the U.S. dollar and the British pound over the life of the agreement.
Equity Swap
An equity swap is similar to an interest rate swap, but rather than one leg being the “fixed” side, it is based on the return of an equity index. For example, one party will pay the floating leg (typically linked to LIBOR) and receive the returns on a pre-agreed-upon index of stocks relative to the notional amount of the contract.
If the index traded at a value of 500 at inception on a notional amount of $1,000,000, and after three months the index is now valued at 550, the value of the swap to the index receiving party has increased by 10% (assuming LIBOR has not changed). Equity swaps can be based upon popular global indexes such as the S&P 500 or Russell 2000 or can be made up of a customized basket of securities decided upon by the counterparties.
Credit Default Swaps
A credit default swap, or CDS, acts differently than other types of swaps. A CDS can be viewed almost as a type of insurance policy, by which the purchaser makes periodic payments to the issuer in exchange for the assurance that if the underlying fixed income security goes into default, the purchaser will be reimbursed for the loss.
The payments, or premiums, are based upon the default swap spread for the underlying security (also referred to as the default swap premium).
Say a portfolio manager holds a $1 million bond (par value) and wishes to protect their portfolio from a possible default. They can seek a counterparty willing to issue them a credit default swap (typically an insurance company) and pay the annual 50 basis point swap premium to enter into the contract.
So, every year, the portfolio manager will pay the insurance company $5,000 ($1,000,000 x 0.50%) as part of the CDS agreement, for the life of the swap. If in one year the issuer of the bond defaults on its obligations and the bond’s value falls 50%, the CDS issuer is obligated to pay the portfolio manager the difference between the bond’s notional par value and its current market value, $500,000.
Swap Market Participants
-Swap dealer
-Major swap participant
-Eligible contract participant
Swap Dealer
A swap dealer is an individual or entity that serves as a swaps broker, makes markets in swaps, or enters into swaps contracts with counterparties.
-An individual who acts as the counterparty in a swap agreement for a fee called a spread. Swap dealers are the market makers for the swap market. The spread represents the difference between the wholesale price for trades and the retail price. Because swap arrangements aren’t actively traded, swap dealers allow brokers to standardize swap contracts to some extent.
Swap Dealer Key Takeaways
-A swap dealer facilitates transactions in swaps contracts, acting as principal or agent.
-Swap dealers are legally identified in the 2010 Dodd-Frank Wall Street Reform.
-The de minimus threshold for swap trading has been set at $8 billion. This means that an entity will not be considered a swap dealer unless the aggregate notional amount of its deals exceeds that figure.
Understanding Swap Dealers
A swap is a type of derivative contract whereby two parties exchange the cash flows or liabilities from a pair of different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate, or index price.
The most common kind of swap is an interest rate swap. Swaps do not trade on exchanges, and retail investors do not generally engage in swaps. Rather, swaps are over-the-counter (OTC) contracts primarily between businesses or financial institutions that are customized to the needs of both parties. Since these are OTC products, they are more opaque than exchange-traded products.
Prior to the financial crisis, swaps had been largely unregulated, taking place mainly between firms and financial institutions, in largely unregulated transactions. In 2011 the Securities and Exchange Commission (SEC) finalized proposals requiring security-based swap dealers and participants to register with the commission, as part of the Dodd-Frank legislation.
Who oversees the Swap market?
SEC and Commodity Futures Trading Commission (CFTC)
According to Section 721 of the Dodd-Frank Act, a swap dealer is an entity that:
-Holds itself out as dealer in swaps;
-Makes a market in swaps;
-Regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
-Engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps, provided, however, in no event shall an insured depository institution be considered to be a swap dealer to the extent it offers to enter into a swap with a customer in connection with originating a loan with that customer.
Major swap participant
There are three parts to the Dodd-Frank Act definition. A person that satisfies any one of them is an MSP:
-A person that maintains a “substantial position” in any of the major swap categories, excluding positions
held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans
for hedging or mitigating risks in the operation of the plan.
-A person whose outstanding swaps create “substantial counterparty exposure that could have serious
adverse effects on the financial stability of the United States banking system or financial markets.”
-Any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is
not subject to capital requirements established by an appropriate Federal banking agency” and that
maintains a “substantial position” in any of the major swap categories.
The statutory definition excludes swap dealers and certain financing affiliates.
Eligible Contract Participant (ECP)
Section 723(a)(2) of the Dodd-Frank Act added new subsection (e) to CEA section 2. Under CEA section 2(e), a person who is not an ECP cannot enter into a swap except on or subject to the rules of a designated contract market. Section 741(b)(10) of the Dodd-Frank Act also amended the ECP definition by providing that, for purposes of certain foreign exchange transactions specified in CEA sections 2(c)(2)(B) and 2(c)(2)(C) (retail forex transactions), a commodity pool is not an ECP if any participant in the pool is not itself an ECP.
What is the current value of a swap called?
Mark-to-market (MTM) value
Mark-to-market (MTM)
The current value of a swap is called the mark-to-market value. This is what the swap is worth using current market interest rates. For banks daily valuation is important. It provides profit and loss figures, shows whether hedging is effective and provides information for collateral support. And should you need to cancel or break a swap before it has matured the valuation will provide the basis of the cost you pay or the benefit you receive.
Interest Rate Swaps (IRS)
An interest rate swap is an over-the-counter derivative transaction. The two parties to the trade periodically exchange interest payments. There is no principal exchange.
One party pays a fixed rate of interest, the other pays a floating rate of interest. The fixed interest payment remains unchanged throughout the life of the deal. It is paid annually, semi-annually or quarterly in arrears.
The floating interest is paid on a three or six monthly basis. Because it is reset using the relevant Libor rate it will vary depending on short term interest rates. It too is paid in arrears
What is the longest interest rate swap you can do?
The major currencies have very liquid interest rate swap markets. Interest Rate Swaps can have maturities of between 2 and 20 years but it is possible to trade swaps that have maturities exceeding 50 years. If you intend to do long dated deals you may be asked to collateralise the transactions.
What documentation is used for interest rate swaps?
The standard documentation is the International Securities Dealers Agreement, (ISDA master agreement). This is negotiated and signed by both parties. Confirmations then cover individual transactions and refer to the master agreement.
What can interest rate swaps be used for?
Interest rate swaps can be used to manage interest rate risk, an example follows. A bond issuer can sell a fixed rate bond to an investor. The fixed funding cost of the borrower is then swapped to a floating rate using an IRS.
The investor obtains a fixed rate asset; this may suit interest rate expectations or match investment criteria. But many borrowers prefer to fund on a floating rate basis with the cost of borrowing expressed as a spread over or under Libor. By using a swap the issuer and investor can both get the interest basis they want.
The net floating rate cost of funds to the issuer, (Libor plus/minus), is dependent on the difference between the fixed cost of funding and the swap rate. If the fixed cost of funds is below the equivalent swap rate then the floating rate funding cost is Libor less a margin. If the fixed cost of funds is above the equivalent swap rate then the floating rate funding cost is Libor plus a margin.
How are interest rate swaps used for trading?
If a trader anticipates interest rates to fall he could receive fixed interest on a swap and pay floating. If rates do fall the trader will now be receiving a higher interest rate than the market rate. The interest rate swap will have a positive value. But the trader has taken risk. This could have gone wrong, rates could have risen.
Interest rate swaps can also be used to trade the shape of the yield curve. This can include the difference between the 2 year swap rate and the 5 year rate, the 2 year rate and the 10 year rate, the 5 year rate and 10 year rate and the 10 year rate and the 30 year rate. If the trader thinks the relative yields between two parts of the curve are “out of line” he can receive fixed interest in one maturity and pay fixed in the other.
The nominal amounts of the two swaps are adjusted by the duration of the swaps. (This means the nominal amount of the near dated swap is greater than that of the far dated swap). This type of trade will benefit the trader if the slope of the yield curve moves as expected. A variation on this trade takes three points on the yield curve trading the spread differential between centre point and the outside two points.
Can you lose money with interest rate swaps?
You can make and lose money with interest rate swaps. The current value of a swap is called the mark-to-market value. This is what the swap is worth using current market interest rates. For banks daily valuation is important. It provides profit and loss figures, shows whether hedging is effective and provides information for collateral support. And should you need to cancel or break a swap before it has matured the valuation will provide the basis of the cost you pay or the benefit you receive.
If it is in your favour you should receive a payment from your counterparty that equals the market value. If you are losing money on the swap you will have to pay the market value to your counterparty. This has a practical significance.
Let’s suppose you used a swap to convert floating rate funding to a fixed rate and that funding was linked to the purchase of an asset.
If you sell the asset and make money you will be left with the swap. If interest rates have fallen you will be losing money on the swap. You will have to pay your counterparty to cancel it. You need to include this cost in the realisation of your asset.
If you don’t like the cost of cancellation do not fall into the trap of leaving the interest rate swap in place hoping that it will improve. Otherwise, your hedge will become a speculative trade.
Basis Rate Swap
A type of swap in which two parties swap variable interest rates based on different money markets. This is usually done to limit interest-rate risk that a company faces as a result of having differing lending and borrowing rates.
Interest Rate Option
An investment tool whose payoff depends on the future level of interest rates. Interest rate options are both exchange traded and over-the-counter instruments.
Hedge
An investment entered into to reduce or offset the risk of adverse price movements in a security by taking an offsetting position in another investment.
Cash Flow Hedge
A hedge of the exposure to the variability of cash flow that
1. is attributable to a particular risk associated with a recognized asset or liability. Such as all or some future interest payments on variable rate debt or a highly probable forecast transaction and
2. could affect profit or loss
Future Issuance Hedge
Enable issuers to secure current market rates for future fixed-rate funding.
Treasury Lock
A hedging tool used to manage interest-rate risk by effectively securing the current day’s interest rates on federal government securities, to cover future expenses that will be financed by borrowing. Treasury locks are a type of customized derivative security that usually have a duration of one week to 12 months. They are cash settled, usually on a net basis, without the actual purchase of any Treasuries.
Basis Risk
In finance is the risk associated with imperfect hedging. It arises because of the difference between the price of the asset to be hedged and the price of the asset serving as the hedge, or because of a mismatch between the expiration date of the hedge asset and the actual selling date of the asset (calendar basis risk), or—as in energy—due to the difference in the location of the asset to be hedged and the asset serving as the hedge (locational basis risk).
Swap Termination Risk
If a swap terminates at its normal maturity date, there are no further cash flows and therefore the swap has a price of zero. If one of the counterparties decides to terminate the IRS before its term is up, the price of the swap at the time of the early termination will have to be exchanged. If interest rates have risen, the fixed counterparty makes payment to the floating, i.e. the floating counterparty is the winner. The reverse is true for falling interest rates. The amount exchanged is the net present value of the remaining netted cash flows. Should a losing counterparty choose to terminate an IRS by selling it to a third party, that counterparty will have to pay the third party the price, if any, of the swap on the date of sale.
Interest Rate Swap Collateral
Held to reduce counterparty credit exposures, see link for more detail
Counterparty Risk
A type (or sub-class) of credit risk and is the risk of default by the counterparty in many forms of derivative contracts. Link has example of counterparty risk in context of an interest rate swap.
ISDA (International Swaps and Derivatives Association) Documentation
A standard agreement used in over-the-counter derivatives transactions. The ISDA Master Agreement, published by the International Swaps and Derivatives Association (ISDA), is a document that outlines the terms applied to a derivatives transaction between two parties. Once the two parties agree to the standard terms, they do not have to renegotiate each time a new transaction is entered into.
The Dodd-Frank Act requires Swap Dealers to act in municipalities’ best interests when advising them on swaps. Please read more about the regulations at the link.
Risks associated with products
The management of market and credit risk has become an important aspect of all financial markets, including the over the counter municipal market. Investors and dealers alike have placed a greater emphasis on risk management. By measuring how many bonds are owned and how long they have been in an investment portfolio, and by layering the credit risk, investors and their advisors can quantify the risks involved in holding different bonds
Types of Risk
-Credit Risk (aka Default Risk)
-Counterparty Risk
-Interest Rate Risk
-Liquidity Risk (for variable debt)
-Market Access Risk
-Basis Risk
-Political Risk
Credit Risk (aka Default Risk)
i. Risk that interest and/or principal on the securities will not be paid on time and in full
ii. By definition, a bond that carries less credit risk will have a better rating than a bond with more credit risk (1)
iii. If the credit standing of the issue improves, the bonds may be worth more in the market
iv. If the issuer’s credit standing weakens, the bonds may fall in value
v. Investors need to know who is responsible for repayment of the securities and the financial condition of that entity to assess the credit risk and decide whether to purchase the securities
vi. Investors can work with a broker to evaluate a bond’s default risk
vii. MSRB definition – the risk that a bond issuer will be unable to make interest or principal payments as they become due. Significant events that transpired after an investor purchased a bond, such as ratings downgrades or other material events which may reflect an increased likelihood of default on the bond, may cause potential investors to value the bond at a lower value than the price paid by the investor.
Counterparty Risk
i. A type of credit risk - The risk to each party of a contract that the counterparty will not live up to its contractual obligations.
ii. Idea is often applied specifically to swap agreements in which no clearinghouse guarantees the performance of the contract
iii. Can be reduced by having an organization with extremely good credit act as an intermediary between the two parties
Interest Rate Risk
i. The rate of most municipal bonds is paid at a fixed rate. The rate does not change over the life of the bond. If interest rates in the marketplace rise, the bond you own will be paying a lower yield relative to the yield offered by newly issued bonds.
ii. Evaluating a Municipal Bond’s Interest Rate Risk (published by MSRB)
1. One of the principal risks facing municipal bond investors is interest rate risk, or the risk posed to a bond as a result of interest rate fluctuations. In general, the longer the maturity of a bond, the greater the risk. If a bond is sold prior to its maturity in any interest rate environment, whether rates are high or low, its price or market value will likely be affected by the prevailing interest rates at the time of the sale. When interest rates rise, investors attempting to sell a fixed rate bond may not receive the full par value. When interest rates fall, the same investors may receive more than the par value in a secondary market sale.
iii. MSRB definition – the risk posed to the owner of a bond as a result of interest rate fluctuations. When interest rates rise, bond prices tend to fall; conversely, when rates decline, bond prices tend to rise. Accordingly, if interest rates are higher at the time that an investor attempts to sell a municipal bond than they were when the investor initially purchased the bond, the price at which he or she will likely be able to sell the bond would be lower than the price at which the bond was originally purchased by the investor, all other factors unchange
Liquidity Risk (for variable debt)
i. Risk stemming from the lack of marketability of an investment that cannot be bought or sold quickly enough to prevent or minimize a loss.
ii. Typically reflected in unusually wide bid-ask spreads or large price movements
1. Rule of thumb – the smaller the size of the security or its issuer, the larger the liquidity risk
iii. Issuers should have a plan that specifies their actions and backup provisions should one or more guarantors to the transaction fail to perform. This also applies to a government’s ability to renew its liquidity agreements during a difficult market. (2)
iv. MSRB description– the risk that there may not be a significant market for the purchase and sale of the bond. Liquidity refers to the likelihood of finding a willing buyer for a specific bond. The risk of not finding a buyer, or the liquidity risk, is dependent on a number of factors. For example, liquidity risk may generally be greater for lower-rated bonds, bonds that were part of a small issue, bonds that have recently had their credit ratings downgraded or bonds sold by an infrequent issuer, among other factors. More liquid bonds are typically those for which there is a large trading volume and a large number of dealers that routinely buy and sell such bonds. In general, greater liquidity enhances the market value of the bond. The converse is also true. The more illiquid a bond, the more likely the bond will have a lower price in the secondary market and there may be fewer bids for the bonds. Generally, the fewer the bids, the greater the price disparity between the bids and current market levels.
Market Access Risk
i. The underlying price of a particular bond changes in response to market conditions. When interest rates fall, newly issued bonds will pay a lower yield than existing issues, which makes the older bonds more attractive. Investors who want the higher yield may be willing to pay a premium to get it. Likewise, if interest rates rise, newly issued bonds will pay a higher yield that existing issues. Investors who buy the older issues are likely to do so only if they get it at a discount. If you buy a bond and hold it until maturity, market risk is not a factor because your principal investment will be returned in full as maturity. Should you choose to sell prior to the maturity date, your gain or loss will be dictated by market conditions, and the appropriate tax consequences for capital gains or losses will apply. (3)
ii. The term given to potential price fluctuations in a bond that are caused by changes in the general level of municipal interest rates. If the level of these rates has changed since the bonds were bought, the resale value of those bonds will of course reflect that shift. Thus, if interest rates are currently higher than they were when the bonds were bought, the bonds may be worth less; conversely, if interest rates have declined, bond prices generally will have risen and the bonds may fall in value.
Basis Risk
i. The risk that offsetting investments in a hedging strategy will not experience price changes in entirely opposite directions from each other. This imperfect correlation between the two investments creates the potential for excess gains or losses in hedging strategy, thus adding risk to the position. (4)
ii. Basis risk arises when the instrument used to hedge your exposure fails to act as predicted and most frequently occurs when using future contracts. Since a hedge involves two financial instruments, basis risk refers to the possibility that the second asset or financial contract, which is referred to as the basis, will fail to exhibit the expected behavior in response to the adverse movements in the price of the original investment. In some instances, basis risk may result in the hedge providing less protection than you had expected. In extreme cases, the hedge can do more harm than good and you may lose more money as a result of the hedge than you would have without it. Example
Political Risk
i. Risk is tied to the civic climate in a state or local governmental unit, and may be reflected by tax-limitations referendums or voter rejection of bond issues. (1)
ii. A subset of credit risk as it assesses the issuer’s willingness to pay (1)
iii. If an investor’s goal is in-state tax exemption and voter referendums with negative implications for bonds have been passed in that state, that investor could be incurring more political risk than an investor with a portfolio of national names not concentrated in any one state
Issuer Risk Management - Policies, Monitoring, Metrics
A debt management policy should be designed to fit the specific needs and policy goals of the city that’s adopting it. The policy may contain provisions about:
i. What types of projects will be financed with debt.
ii. The maximum amount of debt a city will issue and how maximum debt load will be measured (e.g., total dollar amount, debt per capita, debt as a percent of total market value, debt service as a percent of budget, etc.).
iii. Whether competitive sales are generally preferred, unless circumstances warrant otherwise.
iv. When existing debt should be refunded.
v. Managing a city’s rating, if any.
vi. Designating staff responsible for managing debt-related activities.
vii. How and when debt status reports will be provided to the governing body.
viii. Post-issuance compliance activities and requirements.
ix. Rules on the use of derivatives.
x. Use of variable rate or other non-traditional debt products.
xi. Use of third-party providers with respect to managing debt obligations (paying agents, etc.).
xii. Every city, regardless of size, should consider adopting and annually reviewing a debt management policy. Besides providing important guiding principles for staff and officials, doing so helps promote regular discussion of the city’s financial picture and future needs.
Debt Limit
*Establishes the total amount of GO principal that can be outstanding at any time
*Often states as a percentage of the assessed valuation of properties within the municipality
-Low debt limit is often viewed as providing greater safety in the analysis of bond issues
-Issuers that have outstanding debt that falls below their debt limits are viewed as offering greater safety to investors
*Further contributing to the safety of GO bonds is the fact that many proposed new issues are subject to voter approval
-Example - School district may require that a bond referendum pass with 2/3 majority
*GO Bonds are valued for their relative safety as investments
-Rated similarly to US treasury securities and high grade corporate bonds I
-Because of their taxing authority and the full faith and credit backing, municipalities rarely default on GO bonds
Municipal Lease Financing
*Leases offer a financing alternative for municipal issuers because less cash is required, terms are flexible, and there are no voting requirements
Lease Purchase Agreement
*A variation of municipal leasing in which a state or local gov or political subdivision purchases real or personal property from the leaser
*Instead of paying for the asset outright, periodic lease payments are made over an time period during which the lease builds equity in the property
*Terms are stated so that the lessee gets ownership at the end of the term for $1
Tax Exempt Lease
o Is a type of lease purchase agreement that allows a government agency or another entity to obtain use and ownership of capital assets
*Tax exempt leases are structured as a series of one year renable obligations
*Each year the gov must appropriate funds for the contribution of lease payments
*Municipality is the lessee of end user of the leased equipment’s and remits periodic payments to the lessor in exchange for the use of the leased equipment’s
Nonappropriation Lease
The governmental lessee reserves the right to terminate the lease simply by not appropriating funds for payments for lease
Abatement Lease
The municipal lessee is party to a multi-year lease and can make commitment to making lease payments for the entire lease term unless the leased asset is not available for use or somehow destroyed
Neither the nonappropriation lease or the abatement lease impose an absolute and unconditional general fund obligation neither is classified as debt under municipal tax regulation
Asset Transfer Financing (aka Lease Back Financing)
*Follows the basic pattern of tax exempt lease financing
*The property that is subject to the lease (such as city hall, police station, gov buildings) is already owned by the public agency lesee
*The lessee leases or sells the property to a lessor(purchaser) and immediately leases (repurchases) the property
*Allows a public entity to meet current capital requirements by realizing cash from the value of existing debt free assets
Clean Water State Revolving Fund
*A self-perpetuating loan assistance authority for water quality improvements projects
-Administered by the environmental protection agency and state agencies
-Provides loans for the construction of municipal wastewater facilities and implementation of pollution control projects
State and Federal Appropriations
Funding may be available through fed and state gov, subject to their approval of the payments requested
Grants
*U.S Gov departments and agencies sponsor grants for municipalities to fund community, economic development, and recreational projects that will benefit the general public
*Usually has a specific clearly defined purpose, and rigid application guidelines and deadlines apply
*Process of requesting funds through a grant is called Grant Writing
*Not required to be repaid
*Fund awarded to municipal entities through fed grants are not required to be repaid
*Used for
*Constructions and renovations projects and well as infrastructure improvement
*Purchase land and equipment
Pay As You Go Funding
o Avoid additional debt
o From current revenue such as tax revenues for payment of capital expenses
o Can avoid int charges and minimize admin tasks associated with the debt managements using this type of funding
Bond Banks
*Combine the financing needs of small municipal entities to obtain funds at a lower costs and interest rates then the small entity could obtain on its own
*Bond Banks serve
*Cities
*Municipalities
*Schools
*Hospitals
*Water and sewer districts
Municipal Fund Securities
*Are investments pools that resemble mutual funds
*Primary diff is they are issued by a state or local gov entity
*Investment pools is a collection of investments from many investors
*Professional managers invest and operate the funds capital to produce capital gains and income for investors
*Are not debt securities, they are equity securities
*Subject to the rules of the MSRB
Municipal Fund Securities
-LGIPs
-Section 529 College Savings Plan
Local Government Investment Pool (LGIP)
*Are established by state or local governmental entities as trusts, and allow for investment of cash held by gov entities.
*Purpose is to provide safe, liquid, and competitive investment options for eligible local government investors
*Investors that are eligible to join LGIPs include
*Cities and towns
*Counties
*Special taxing districts
*Fed recognized tribes
*Municipal corporations
*Community and technical college and 4 year unis
Investment Objectives of LGIPs
*Money market fund with the objective of maintaining a constant net asset value (NAV) of $1 and liquidity for investors
*Other gov investments pools have investments objectives of maximizing returns
-Have a variable nav
-Invest in long term securities with potential for investments growth
-Investors are subject to market and liquidity risk
Regulation of LGIPs
*Not subject to regulation under the investment company act of 1940
*Exempt from registration with the SEC
*Do not require issuers to prepare a prospectus and statement of additional info
*Exempt from the SECs risk limiting rule
Marketing of LGIPs
*Marketed directly to potential participants
-Fees and charges
*Any investment management firm engaged by the LGIP will usually charge a fee based on the assets managed
Section 529 College Savings Plan
*Are tax advantage education savings plans authorized under Internal Revenue Code (IRC) section 529
*Allows investors to save money in an account in which the earnings grow free from federal income tax
*When money is needed for education expenses can be withdrawn federal income tax free
*Fall under def of municipal fund securities because investors purchase ownership interest in pooled funds
Investment Options of 529 Plans
*States offer age based investments options where the underlying investments become more conservative as the beneficiary gets closer to college age
*Also offer risk based investments options where the underlying investments remain in the same fund or combination of duns regardless of the beneficiary’s age.
Distribution of 529 Plans
*Securities dealers are engaged to sell this plan
*Advisor Sold Plans - when investors open an account through an authorized investment firm with the 529 plan
*Direct Sold Plans - investors choose to deal directly with the 529 plan
-Fees and charges may be lower
529 Plan Qualified Expenses
*Assets in a college savings plan may be used to cover eligible expenses and any eligible educational institution
*Qualified higher educational expenses
-Tuition
-Mandatory fees
-Books, supplies, and equipment required for enrollment or attendance
-Room and board expenses
*Up to 10,000 can be distributed annually from the plan to cover the costs associated with elementary and high school
529 Plan Tax Features
*Assets accumulate tax free and withdrawals for qualified expenses are not subject to taxation at federal level
ABLE Accounts
*Helps ease the financial strain of individuals with disabilities by permitting the opening of tax free savings accounts that can cover qualified expenses
-Education
-Housing
-Transportation
-Employment support and training
-Tech
-Health and wellness
Once a municipality begins to fund ongoing projects, the issuer and its advisors must determine the best way to invest the proceeds from these financing activities., as well as manage outstanding debt
*Public Funds- typically refers to current operating funds, special funds, interest and sinking funds, or other funds of any kind or character that belong or in the custody of
-State treasurer and agencies
-Counties, townships, cities, towns, villages,
-Schools districts, unis, community colleges
-Special districts etc
The Managers of municipal funds at any level of government are responsible for
-The investment of public funds
-Purulent investment selections
-Active cash flow management
-Protection of deposits and investments
-Sound investment policy
4.1 INVESTMENT POLICY
Investment Policy
*Municipalities are required to adopt a comprehensive, written investment policy
-Establishes the instructions for the governmental units officials and staff regarding the
*Depositing
*Investing
*Monitoring
*Controlling
*And reporting of its funds including its investments and collateral
-The written investment policy should support the 3 primary objectives of municipal investment programs
*Safety - safety and preservation of principal in the overall portfolio is the foremost investment objective
*Liquidity - maintaining the necessary liquidity to match expected liabilities is the second highest objective
*Return - obtaining a reasonable return is the 3rd most important investment objective
-Types of instruments eligible for purchase by the entity, the investment process, and the management guidelines for a portfolio should also be in the policy
-Should not be a static document, annual review is required
4.2 INVESTMENT STRATEGY
Investment Strategy
*How the plan will be accomplished
*Biggest risk public entities face is a change in interest rates
*Int rates fall there should be some short term investments that will keep paying a relatively high rate of return
*Int rate rise - short term investments can be invested at a high int rate when they come due
*Liquidity means having cash available when its needed
-Too much cash is wasted opportunity and too little forces the sale of investments at the wrong time
*Cash Flow Forecast
-Useful to provide an estimate of the amount of cash that will be available for investment during the fiscal year and on a monthly basis
-Speculation is not good
*Eligible investment options
-Investment choices are the most conservative for bond proceeds, with greater flexibility for investment of other operating funds
US Treasury Securities
*Obligations of the US government
*Such as bills, notes, or bonds
*Maturity if the instrument selected is matched to the municipality’s spending schedule
-Although most municipalities may only invest in instruments with maturities of no longer than 10 years
Obligations of US Government sponsored enterprises (GSEs)
*Notes, bonds, and guaranteed certificates of participation are issued by the Government National Mortgage Association
*Fully backup by US Gov
Money Market Securities
*These short term debt instruments typically have low risk
*Maturity of one year or less
*Pay relatively low returns
*Includes
*Repurcahse agreements
*Commercial paper
*Bankers acceptances
*Negotiable CDs
Repurchase and reverse repurchase agreements
*Involve the purchase of securities with the agreement to sell them at a higher price at a specified future date
*Used to raise short term capital
*Can involve US gov securities or other highly liquid securities
Commercial Paper
*Is a short term obligation issued by large corporation to obtain funding for a short term need
*Not backed by collateral but by the issuing corporation or banks promise to pay
*Sold at a discount from face value and usually has a max maturity of 270 days
Bankers Acceptances
*Short term debt instruments called letters of credit
*Guaranteed by commercial banks
Negotiable CDs
*Issued with a min face value of $100,000 and guaranteed by a bank
*Cannot be cashed in before maturity but can be sold prior to maturity in a highly liquid secondary market
Guaranteed Investments Contracts (GICs)
*Type of investment contract or agreement offered by banks and corporation
*Guaranteed repayment of principal and a fixed or floating interest rate for a predetermined period of time
*Can vary from 6 months to 30 years
*Provides liquidity but earn a higher rate of return than could be earned in a money market account
*Backed by the issuing company’s strength
*Can pay a fixed rate of return for a fixed term
*Has purchasing power risk fi the fixed payment will not keep pace with the rate of inflation
*They are not backed by the full faith and credit of the US Gov nor are they insured by the FDIC
Certificates of Deposit
Municipal statues require at least 3 quotes to be obtained for CD investments
Forward Deposit Agreements (FDAs)
*Allow borrowers to systematically purchase permitted investment securities at a guaranteed, agreed upon yield for the life of the fund
*Long term nature of FDAs, combined with the certainty of the deposits makes FDAs suitable for long dated debt service funds and debt service reserve funds
*Benefits of a FDAs
*Fixed guaranteed yield for the life of the fund
*Funds are 100% collateralized with cash and permitted investment securities, which matures before the next debt service payment date eliminating valuation issues
*Certainty of future investment earnings
*Simplification of the burden of investing fund proceeds
4.3 UNIQUE INVESTMENT CONSIDERATIONS FROM TRUST INDENTURES
Unique Investment Considerations from Trust Indentures
*Issuance of revenue bonds requires a bond indenture also called the trust indenture
-Part of the formal bond contract
-Trust Indenture - is a series of promises between the issuer and a trustee which is legally empowered to act in a fiduciary capacity on behalf of the bondholders
*Trustee is often a large bank
-The indenture sets forth in detail a pledge of revenues
*How revenues are obtained
*How revenues are disbursed
*Handling of the funds
*Other covenants controlling the construction and operation of the facility
-Flow of funds establishes the application of revenues, including the sequence of deposits and how the facility revenues are to be applied to the cost of operation and maintenance, debt service, reserve maintenance and contingencies
Net Revenue Pledge
Gross Revenue Pledge
*All revenues received are first used for payment of debt service
*The remaining revenues are used to pay other related costs and expenses and for allocation to surplus accounts
4.4 EARLY REDEMPTION FEATURES (AKA CALL PROVISIONS)
Early Redemption Features (aka Call Provisions)
*This feature allows the issuer to redeem the bonds prior to maturity
*In this case the investors receive the principal amount and possibly an additional premium amount to compensate them for the early redemption
*Additional incentive paid to bondholders is called a call premium
*Issuers may be limited to redeeming bonds on the int payment dates or may be permitted to redeem bonds on any date under a continuous call provision
*If the call applies to the entire outstanding amount it is an in-whole redemption
*If only a portion of the bonds are called it is a partial redemption
*Usually bonds can be called only after they have been on market for a period of time referred to as a call protection period
*Period protects investors from losing an attractive int rate for a defined period of time
-NC-2 = No call for the first 2 years
*Bondholders surrenders the bond to the issuer through an early redemption, the bond holder is said to tender the bonds
*Alternative to a call provision is a direct exchange
*Whereby the issuer can replace outstanding bonds with a different issue, rather than purchase the outstanding bonds through a call
Optional Call
*Optional Call or Optional Redemption Feature
*The issuer may choose to call bonds when its most advantageous
-Usually happens when int rates have fallen and the issuer can borrow money at a rate that is lower than the coupon rate on the outstanding bonds
-Optional redemptions can often be exercised only on or after a specified date
Mandatory Call
*Sometimes a bond contract will require an issuer to redeem bonds prior to maturity when a certain unexpected event occurs
*Extraordinary call or a mandatory redemption
Catastrophe Call
Destruction of the facility that raises the revenues to pay the bonds interest and principal
Make Whole Call
*Is to protect investors from losses resulting from the early call
*Requires the issuer to make a lump sum payment of an amount equal to the net present value of the future interest payments that will not be paid because of the early call
*Advantageous to the investors, expensive to the issuer
Sinking Fund
*In order to ensure that funds are available to redeem securities in accordance with call provisions issuers may be required to establish a special account called a sinking fund
*Enhances the safety and liquidity of the issue
4.5 Defeasance
Defeasance
A financing tool for making an outstanding bond issue void, both legally and financially
*To defease bonds issuers collateralize an outstanding issue of debt with a portfolio of risk free gov securities, usually a staggered portfolio of US Treasuries with maturities of no more than 10 years
*Cash from the municipal gov is used to buy the gov securities knows as State and Local Government Series (SLGS)
*And the principal and interest earned on the securities are used to meet the debt service obligations of principal and interest on the outstanding bonds as they become due
*SLGS are special US Treasury Securities that collateralize an outstanding debt issuance in a defeasance
*Because SLGS are RISK FREE government securities the credit quality of the outstanding debt they collateralize will jump to AAA
*They positively impact the credit quality of an issuers outstanding bond
*Defeasance allows the municipality to remove the debt from its balance sheet at the time the outstanding bonds are fully collateralized
*The process of defeasance requires an escrow agent
*Such as a hank or trust company
Advantages of Defeasance
*May enable an issuer to extinguish debt at the best possible price
*Bondholders are not penalized, instead they might benefits because the bonds are not redeemed prior to maturity and are secured by US gov securities
*Saves costs for the issuer because it can be implemented without a costly legal process
4.6 REFUNDING
Refunding
*Process of refunding involves the issuance of new bonds so that the proceeds can be used to purchase an outstanding bond issue that is expensive to service
*Issuers typically refund to reduce interest costs or to get rid of the restrictive legal obligations or covenants that have been defined by the original bond contract
*Process requires the issuance of a new refunding issue to generate proceeds to pay principal interest and or the redemption price of a prior issue of bonds
*The original bond issue is called the refunded issue
*While the new issued bonds are often called the refunding bonds
*Proceeds from the new bond issue may be deposited In an escrow account in advance of a call
*Known as advance refunding or pre refunding
*Or can be used immediately (within 90 days) to retire outstanding bonds (known as current refunding)
*Proceeds are typically invested in treasuries or agency securities removing the risk of loss of principal
*Separate escrow investment policy is often established to detail the investment objectives of the escrow account, establish investment principals for the assets and create guidelines for evaluating investment decisions
*A refunding is considered current if the proceeds from within the new bond issue are deposited into an escrow account and used within 90 days to retire the outstanding bonds
*Current refunding is allowed for all types of tax exempt municipal
Tax Cuts and Jobs Act
Greatly reduced advance refunding for municipal bonds making the interest on advance refunding bonds taxable
Net Cash Refunding
The principal interest and call premium associated with the refunded bond are paid from the proceeds and investment earnings of the new issued refunding bonds
Full Net Cash Refunding
*Proceeds from the new issue are large enough to pay both the principal and interest on the bonds that are being refunded
*Investment income from the proceeds of the refunding issue is then used to pay part of the debt service on the newly issued bonds
Key difference between net vs. full net cash refunding
Is that the investment income from the full net cash refunding is not used to cover the debt service of the refunded bonds
Crossover Refunding
*The revenue stream that secures the refunding bonds continues to be used to pay the interest and principal on the refunded bonds until they mature or are called
-At that time the pledged revenues cross over to pay the interest and principal on the refunding bonds while escrowed securities to pay the refunded bonds
High to Low Advance Refunding
*Refers to the refunding of high interest rate bonds with low interest rate bonds
-The result in savings if the rate spread between the bonds is sufficient to offset any call premiums, issuance costs and additional contributions to the escrow account
-Outstanding bonds do not need to be callable but in order to realize a savings the redemption of the refunded issue must occur prior to maturity
*Proceeds from the newly issued bonds may not be invested at a rate greater than the yield on the refunding issue
*The size of the new issue will have to be greater than that of the issue to be refunded
Low to High Advance Refunding
*Is the refunding of low interest rate bonds with higher interest rate bonds
*Issuers may pursue low to high refunding in order to get relief from an existing issue that has undesirable operating covenants
*Used to retire outstanding bonds that are not yet callable
*Used to replace lower coupon bonds with higher coupon bonds
Refunding Considerations
*Present Value Savings
-Calculation of the PV
-Present Value Savings - is a capital budgeting tool used to evaluate whether a debt refunding should occur
-If a PVS exceeds between 3-5% of the value of the refunded bonds then a refunding should occur
Forfeited Option Value
*As soon as a outstanding bon reaches its first call date the bonds embedded call option become a wasting asset
*2 reasons
-At a given market rate the PVS from refunding will decline as the callable bond approaches its maturity date and more interest is paid on the outstanding amount
-As the callable bond matures the issuer has less time to amortize the call premium
*So once the first call date is reached the value of the call option is forfeited to the extent that the issuer delays the refunding decisions
Future Value Savings
*Is the total savings that refunding will provide
-Difference between the total debt service costs of the refunded debt and the total debt service costs of the refunding debt
-Unlike present value savings, future value savings does not require discounting or compounding
4.7 SWAPS AND DERIVATIVES
Swaps and Derivatives
*Changing int rates is one of the greatest risk that municipalities face in the issuance of debt securities
*In order to protect themselves from these adverse movements in int rates and better manage their cash flows municipal issuers might use derivative products such as
-Forwards
-Futures
-Swaps
-Options
Swap Market
*Is an over the counter market for derivative products that facilitates the exchange of cash flows derived from int rates, foreign exchange rates, equity prices or commodity prices
*Commonly used to manage interest rates
*The interest rate swap market is the largest segment of the swap market
*US Swap trading now takes place on the swap execution facilities (SEFs)
*Which are electronic platforms for executing transactions that provide participants additional information such as bid and offer price
-SEFs are highly regulated by the SEC and the CFTC
Market Participants - Two counterparties to an interest rate swap
*Municipal agency enters into a interest rate swap agreement to accomplish specific financial goals
*Hedging variable rate exposure and or reducing borrowing costs
*Swap Providers/dealers
*Act as market makers or intermediaries
*Swap dealer is the actual counterparty to the municipal issuer
*Major swap providers/dealers
*Commercial banks
*Investments banks
*Insurance companies
Other Participants in the swap process
*Financial Advisor
-provide a review and analysis of financing alternatives and coordinate the efforts of team members and the delivery of pricing analysis
*Swap Advisor
-review and analyze swap alternatives and assist in swap procurements including conducting competitive bids
-Continually monitor swap market conditions, provide advice or rates and structures and participates in reviewing the closing documents
*Legal Counsel
-Ensures compliance with current bond resolution and legal statutes and prepares and reviews closing documents
*Swap Insurers
-provide insurance for schedules swap payments from the municipal issuer to the swap counterparty
Swap Documentation
*International Swaps and Derivatives Association (ISDA) is the global trade association for the derivatives industry
*The ISDA master agreement governs all swaps
*Swaps are supported by the following standard ISDA documentation
*ISDA Master Agreement
-Standardized legal form that describes general terms that apply in any swap transaction
*ISDA Schedule
-Used by the parties to make negotiated amendments to the terms of the master agreement
-Might set thresholds relating to certain events of default as well as payment measures and methods
*Credit Support Annex
-Included when collateral or some other form of credit support is provided by one of the parties
-CSA may require a party that is out of the money above a certain threshold to post collateral as an alternative to termination of the contract from a credit downgrade
*Include
*Thresholds at which collateralization is required and the types of collateral permitted
*This depends on the long term unsecured debt rating of the out of the money party at the time
*Transactions Confirmation
-Provide details for each specific transaction including dates rates and amounts
*Swap providers often require legal opinions stating that an user has the legal authority to enter into the swap
*Considered prudent to have legal counsel and or a swap advisor review all swap documentation to confirm compliance with applicable regulations
Suitability and Use of Swap Advisors
*MSRB defines a Swap Advisor
*As an advisor to a municipal entity in connection with the entity’s consideration of entering into a swap transaction
*Dodd Frank requires a
*Swap Dealer
-Who recommends a swap to any counter party other than another swap dealer to have reasonable basis to believe that recommendation is suitable for the counterparty
*Swap Dealers often act as swap advisors
*Under Dodd Frank
-A swap dealer acts as an advisor to a municipal entity when the dealer recommends a swap transaction or strategy that is customized for the municipal issuers investments objectives
*A swap dealer that acts as an advisor must
-Make a reasonable determination that any swap or swap trading strategy recommended by the dealer is in the best interest of the municipal entity
-Reasonable effort to obtain relevant information to ensure that the recommendations is in the best interest of the municipal entity and whether or not the municipal entity has the financial capabilities to withstand changes in market conditions during the term of the swap
4.8 TYPE AND STRUCTURES OF DERIVATIVE PRODUCTS
Derivative Products
-Forward Rate Agreements (FRAs)
-Interest Rate Swaps
-Vanilla Interest Rate Swaps)
Forward Rate Agreements (FRAs)
*Municipal borrowers use FRAs to hedge interest rate risk on future short term borrowing needs
*If for ex rates are low today and the municipality requires a loan in the future, an FRA could be used to protect against an interim rise in rates
*An FRA locks in an interest rate today on a specified principal amount to be borrowed on a future date
*The performance of an FRA is based on its comparison to a benchmark rate traditionally the London interbank offered rate (LIBOR)
-If LIBOR is higher than the contract rate the FRA buyer receives the payment
-IF LIBOR is lower than the contract rate the FRA seller receives the payment
FRAs
FRAs
Interest Rate Swaps
*Contract has two counterparties
*Whereby counterparty A is required to make payments to counterparty B based on a fixed interest rate
*While counterparty B is obligated to make payments to counter party A that are based on a specific variable interest rate
*Most interest rate swaps have a fixed rate, a variable reference rate and a principal amount
*Unlike an FRA however swaps have a series of settlement dates and are used to manage long term debt obligations
*Int rate swaps are commonlyt used to synthetically convert variable rate debt into fixed rate debt and vice versa
-In order to manage interest rate exposure
Interest Rate Swap Agreement includes the
*Fixed Rate
-Which is usually applied to the payments over the term of the swap
*Variable Rate Index
-(LIBOR) - also called the underlying which is used to compute the variable payment
*Notional Amount
-A hypothetical underlying principal upon which payment obligations are computed
*Reset Dates
-Dates upon which variable rates are set and cash flows are exchanged
*Termination Events
-Conditions that lead to optional and mandatory termination of the contract
*Termination Date
-Which defines the term (tenor) of the contract
Vanilla Interest Rate Swaps
*Use this to transform their variable rate debt into fixed rate debt or vice versa
*In order to lower their net debt service costs
Types of Vanilla Interest Rate Swaps
-Synthetic Fixed Rate Debt
Synthetic Fixed Rate Debt (a type of vanilla interest rate swap)
*Alternative to issuing fixed rate bonds a municipality can sell floating rate bonds and simultaneously enter a vanilla swap
*The creation of a synthetic fixed rate debt is illustrated below using the cash flows for a floating to fixed vanilla interest rate swap
*A municipality with variable rate debt outstanding can create synthetic fixed rate debt by entering into a floating -to-fixed interest rate swap
*Here the municipality will pay a fixed rate to the swap counterparty in return for a floating rate payment
Float to Fixed Rate Swap
Vanilla Rate Swaps
*A municipal issuer with variable rate bonds outstanding is the pay fixed counterparty to the swap
*The pay floating counterparty is a financial institution (swap dealer) that has agreed to make payments based on a variable rate index such as LIBOR OR SIFMA (Securities Industries and Financial Markets Association
*In exchange for payments based on the swaps fixed rate
*Payments made by the pay fixed counterparty are normally based on a spread over US treasury bonds with maturity or tenor than coincides with the tenor of the swap contract
*Typically between 1-15 years
*Goal is to select a formula and index that will provide the best hedge for the issuers interest payments
*Ideally the variable rate payments received from the swap will match the variable rate interest payments on the agency’s bonds so that they offset and the issue is left with the fixed rate obligation
Synthetic Variable Debt Rate
Int rate swaps and cash flow management
*Int rate swaps give municipal issuers the ability to structure their asset and liability mix to better reflect the timing of cash flow requirements for capital projects and investments
*As cash flow needs change, int rate swaps allow the issuer to adjust the timing and level of net payments associated with existing bonds without going through the time, expense, and regulatory activities associated with issuing new debt or refunding existing debt
Swap Accounting
-When a swap contract starts the swap has 0 value
*Value rises and falls based on changes in the reference int rate on which the swap is based
-Accounting for swaps requires a fair value method
*Means that the asset must be recorded on the balance sheet at the price at which it can currently be sold
-Current price is based on the PV of cash flows of each leg of the transaction
-In an Interest rate swap
*The fixed leg is fairly straight forward since the cash flows are specified by the coupon rate set at the time of the agreement
*Pricing the floating leg is more complex since the cash flows change with future changes in interest rates
-Determining the current fair value of the swap for financial reporting is called Mark to the Market (MTM) accounting
*MTM is the value that should be used to determine the value of the payment that the swap counterparties will pay or receive in the event that a swap is terminated before it matures
-If the swaps variable rate is currently below the swaps fixed rate and this condition is expected to persist until expiration the swap will have a negative MTM value
*Therefore the agency will be required to make a payment to the counterparty to cancel the contract
-The swap at its current mark to market value is recorded on the balance sheet as either an asset (gain) or liability ( loss
-Cash flows of a int rate swap, which are the interest payments made or received on the reset dates are also reflected on the income statement
-Swaps unrealized gains or losses for a given period must be reflected in the municipal entity’s earnings for that periods
Basis Swap (aka floating to floating rate swap)
*A swap contract under which the counterparties swap payments based on different interest rate indexes
-Potential use
-Is to hedge against the risk of an adverse change in marginal income tax rate
Interest Rate Cap
*Issuer of a variable rate debt can buy an interest rate cap
-To hedge against rising short term int rates
-In exchange for paying a premium the issuer will receive a payment form the cap sell (provider) when the int rate on the caps underlying rate index exceeds a specified strike rate (the cap rate)
Forward Interest Rate Swaps (Forward Swaps)
*Are interest rate swaps that are structured such that the accrual and exchange of cash flows begin at a specified date in the future rather than the current date
*Issuers that have existing fixed rate debt but want to swap fixed rates for floating rates in the future or vise versa can do so with future swaps
*Important
*Is that while future rates may be locked in today these rates are derived from the forward rate curve which is not the same as the rate from the current yield curve
Interest Rate Collar
*Agencies with variable rate debt sell interest rate floors while simultaneously buying interest rate caps in order to establish a position called interest rate collar
*Collar is often constructed such that the cap premium is initially equal to the premium of the floor resulting in a zero cost collar
- Interest Rate Swap Option (Swaption)
*Is similar to a forward interest rate swap because it specifies the terms of an interest rate swap that will become effective at a future date
*With a Swaption however
-The owner (usually a swap provider) has the right instead of the obligation to enter into a swap agreement with the municipal issuer on a specific date or over a specified period of time in the future
-In exchange for this right the owner of the swaption (provider) must pay a premium to the swaption seller (the municipal issuers)
*Swaption Contract specifies the
-Tenor
-Fixed rate
-Floating rate formula for the underlying swap contract
-The future date or time period when the swaption may be exercised
Interest Rate Risk
- Is a risk that an investments value will change as a result of a change in int rates
- Interest rates rise bond prices fall, when interest rates fall bond prices rise
- Longer the maturity of a bond the greater the interest rate and price risk
- Long term low coupon bonds including zeros are the most volatile as interest rates change
Interest Rate Floor
*Holder of an interst rate floor is protected against losses resulting from falling interest rates
-Agency that sells an interest rate floor receives a premium in exchange for payments to the floor buyer if an underlying index (LIBOR) falls below the strike rate (floor)
4.9 INVESTMENT RISK
Financial/Credit Risk
- Stems from the possibility that a bond issuer will default on a payment or that its credit rating will be downgraded leading to loss of principal or missed int payments
- Rating services such as S&P and moody rate bonds to inform investors which bond are investment grade with lower chance of default and corresponding lower yield
- And which are non-investment grade with a higher chance of default and a higher yield
- Gov bonds especially those issued by the by the US federal gov have the lowest default risk and lowest returns while corporate bonds have the greater credit risk but pay more interest
Call Risk
*Call provision included with some municipal and agency bonds entitles issuers to redeem them at a specified price on a date prior to maturity
*Risk to investors is that declining int rates may lead to a bond being called
*Investors will be forced to reinvest the principal at the lower rates
*If the bond is called at or close to par value, the investors that paid a premium for their bond also risk loss of principal
*Callable bonds are riskier than non-callable bonds they offer a higher yield
*Call risks lead to reinvestment rate risk
*Which is the risk that no available investment can provide a similar return to a bond that has been called
*Investors prefer a longer call date (20 rather than 10 years) to better protect themselves from call and reinvestment rate risk
Inflationary Risk
*Purchasing power
*Risk impacts the amount of goods or services that money can buy
*Todays dollar is worth less in the future, while today dollar is worth more in the past
*Most detrimental to fixed income investments as the coupon will purchase fewer goods over time
*AAA have a relatively low yield
-Purchasing power can go be decreased if inflation increases
*Common benchmark is the Consumer Price Index (CPI)
*Estimates the average price of consumer goods and service purchased by households
Liquidity Risk
- Assets that cannot be converted to cash in the open market
- May take time to get cash
- Risk that a security cannot be resold in the open market
Political Risk
*Can be generally defined as the uncertainty of investment returns due to the possibility of changes or instability within a political structure
*Ex of political risk that can impact the performances of municipal securities
*Important elections that may change the political outlook
* new candidates or parties prioritizing changes in economic reforms and gov policies
*Proposals for change to tax laws or investment regulations that are part of a political reform
*Best method for mitigating political risk is diversification
Market Access Risk
*Is the uncertainty that fair and open markets will be readily available to all market participants
*Success of investment performance is highly dependent on accessible markets that offers investors liquidity and transparency
Risks Associated with Derivative Investments - Derivative strategies are used to hedge against market risk and increase income to municipal portfolios
-Counterparty Risk
-Basis Risk
-Termination Risk
Counterparty Risk
*Is the risk that the counterparty to a swap will not fulfill its obligation as specified under the contract for the life of the agreement
-Can be addressed by establishing guidelines for exposure levels rating thresholds and establishing collateralization requirements
*Municipal issuers may attempt to mitigate risk by swapping only with AA rated counterparties or better
Basis Risk
*Is the risk that the floating rate debt payments that a municipal issuer is obligated to make will exceed the floating rate payments it will receive when it hedges variable rate debt with a fixed to floating interest rate swap
-If mismatch occurs agency must pay the fixed rate on the swap plus the spread between the variable rate payments
Termination Risk
*Is the risk that a swap contract may terminate or be terminated prior to its planned expiration as a result of certain termination events
-Events include
*Cross defaults
*Mergers
*Changes in legal or regulatory status
*Changes in financial situation
*Credit rating changes
*If a swap is terminated earlier than expected one of the swaps counterparties will owe the other a termination payment equal to the swap value on the termination date
Collateral Risk
Associated with a swap agreement that requires a counterparty that is out of the money above a specified limit to post collateral
5.1 BOND PRICES AND INTEREST RATES
*When new bonds come to market they are issued with a face value or par value
-Represents the amount that will be returned to an investor at the end of a bonds term (maturity)
*At maturity of a municipal bond, a bondholder is repaid the principal amount (par value) along with the final interest payments
-The market value of the bond is received only when its sold in the secondary market
*Bonds also come to market with a coupon rate of interest
-This is the rate of interest that will be paid on the bonds face value for the time that the bond is outstanding
-Also called the Nominal Yield
Premiums and Discounts
*After a newly issued bond is sold, it can be sold to another investor in the secondary market at the current market price
*Price of bonds in the secondary market fluctuate based on current market conditions
*Bond prices and interest rate move in opposite directions
*Int rates fall bond prices rise
-Current int rates decrease to 3%, the 4% bond now is more attractive
*The investor would now pay a premium for the bond with a coupon rate of 4% on the secondary market
*Int rates rise bond prices fall
-Current int rates rise to 6%, the value of the bond will decrease because an investor would not pay $1000 for a bond will a coupon rate of 4% when a new issue is paying 6%
*In order to remain competitive with new issue the bond will sell at a discount to its face value on the secondary market
*Price will have the fall to the point that its reduced sales price and the interest it pay provide a buyer with 6% total return equal to the new issue
*Bond trades at a premium when its coupon rate is higher than prevailing interest rates
*Bond trades at a discount when its coupon rate is lower than prevailing interest rates
*The coupon rate of a bond does not necessarily determine its rate of return
*Only bonds purchased exactly at par will pay the exact coupon rate
*If bond is bought in the secondary market the actual rate of return is determined by the combination of the price paid for the bonds as well as the coupon rate
Accrued Interest
*One of the advantages of owning a municipal bond is the right to receive interest from the issuer on a regular basis
*If the bond is sold in between interest payment dates part of the interest belongs to the seller of the bonds and part of the interest belongs to the buyer of the bond
*Calculation of accrued interest determines the amount of interest that both parties get
*To calculate the amount of accrued interest several rules must be followed
-The issuer can choose to use actual day months for the calculation
*For municipal bonds a year is assumed to be 360 days with 30 days in each month
-The number of days of accrued interest is calculated beginning on the last coupon date up to but not including the settlement date
-For new bonds that have no prior interest payment date, the calculation starts with the dated date
*First payment may be for an irregular time period it may be longer or short than the normal 6 month period
-Bonds that are currently in default are issued as zero coupon securities trade flat
*Is not accrued int payment for bonds that trade flat
Dirty Price
*The full price or price plus accrued (dirty price) of a bond includes the present (discounted) value of all future cash flows plus the interest that has accrued since the last coupon date
*Europe its customary for bonds to be quoted at the dirty price
Clean Price
*The flat price (clean price) of a bond is the present value of all future cash flows that bondholders will receive from the settlement date until the bond matures
*Does not reflect accrued interest
*US its customary for bonds to be quoted at the clean (quoted) price
Dirty Price = Clean Price + Accrued Interest
5.2 PRESENT VALUE AND BOND VALUATION
*A dollar today is worth more than a dollar tomorrow because todays dollar can be reinvested and generate additional returns for an investor
-The Present Value of a cash flow is almost always less than its future value because of its interest earning potential
Price to Yield Conversion
*Relies heavily on the concept of present value
*Process of computing the present value is called discounting
*Process of discounting cash flows is a key component of security valuation
Yield to Maturity
*Is the single discount rate that makes the present value of a bonds cash flow equal to its price
*Is the appropriate discount rate if a bond is expected to be held until maturity
*Is the single rate used to discount all of a bonds cash flows that are received over the life of the bond
-It is implied when computing bond prices using the yield to maturity that each of the bonds periodic cash flows can always be reinvested at its yield to maturity
*The calculation of yield to maturity assumes that all cash flows throughout the life of the bond can be reinvested at the same constant yield
-Therefore spot rates which assume that the investment rate changes over the life of the bond is not relevant
Yield to Call
*For callable bonds the yield to call is the discount rate that makes the PV of a bonds cash flows equal to its price
-Assuming the bond will be called on its next call date
*When pricing callable bonds the cash flows include the periodic coupon payments and the call price
Yield to Put
Is the discount rate that makes the present value of a puttable bonds cash flows equal to its price assuming that the bond is until the bonds put date versus maturity and is put (sold) to the issuer at a specific prince (put price)
Yield to Worst
*Is the lowest yield obtained when every possible call, put date, and price are considered
*Is a conservative yield measurement that represents the worst possible return an investor will realize
Cash Flow Yield
*Is used when evaluating a bond or bond portfolio that has uneven coupon payments
*Similar to yield to maturity, yield to call, and yield to put
-It is the discount rate that equates the present value of the cash flow form the portfolio to the market value of the bond portfolio
*Often used when evaluating mortgage backed securities, variable rate notes, serial bonds, and other instruments that do not provide a level stream of coupon payments
Spot Rates Derived from Optionless Yield Curve
oAn optionless yield curve is a graph that plots the relationship between interest rates and the time to maturity for option free coupon bonds
oIt is not realistic to assume that a bonds periodic cash flows can always be reinvested at the same rate
-Instead a more precise calculation is to discount each of the bons cash flows at a rate that is appropriate for the time at which the cash flow is to be received
-These individual rates are called spot rates sometimes referred to as zero rates
Valuation of Call Options
*Call features must be considered when determining the value of a bond
*As long as there is risk that the issuer will redeem the debt prior to maturity the price of the callable bond will be less than that of a noncallable (straight) bond
*Investors are not willing to pay full price since the embedded call option creates uncertainty over whether they will receive all future interest payments
*Value of the call option could be stated as
-Call Value = Price (straight) - Price (callable)
Duration
*Bond Durations is calculated to measure the sensitivity of a bond’s price to interest rate movements
*Duration is the approximate % by which the value of the bond will for a 1% increase in interest rates
-Example - A bond with a duration of 7 would fall approximately 7% in value if interest rates increased by 1%
*Bonds with a higher or longer duration = more risk and have greater price volatility
*Bonds with a lower or shorter duration - less risk and have smaller price volatility
*A long term bond will have a higher duration that a short term bond
*A low coupon or zero coupon bond will have a higher duration than a high coupon bond
Interest rate risk for non-callable bonds is found using modified duration
*Which measures the change in the price of a bond is response to small parallel shifts in the yield curve
*Modified duration is not appropriate for measuring the interest rate risk of callable bonds because it assumes that expected cash flows will remain constant
-Does not consider the change in cash flows that may accompany an interest rate shift
*For callable bonds effective duration should be used
-Effective duration is computed for bonds with embedded options by measuring the change in a bond’s price in response to small changes in interest rates
*For callable bonds effective duration should be used
-Effective duration is computed for bonds with embedded options by measuring the change in a bond’s price in response to small changes in interest rates
Convexity
*Is a further measure or second derivative measurement of how the price of bond varies with interest rates
-Calculates how the duration of a bond changes as the interest rates change
Dollar Value of a Basis Point
*Is the dollar change in the value of a bond or bond portfolio that results from a one basis point change in yield
-A basis point is equal to 0.001%
-Price value of a basis point (DV01) is a measure of interest rate risk
5.3 INTEREST RATE DERIVATIVES VALUATION FUNDAMENTALS
Vanilla Interest Rate Swap Valuation
*When a vanilla (fixed to floating or floating to fixed) interest rate swap is structured, the floating rate payments are normally computed using the forward rates for the underlying floating rate index (LIBOR)
*A fixed rate is then derived such that the present value of the fixed rate payments equal the present value of the expected floating rate payments
-So when initiated the two rates will offset one another and the value of the swap at the initiation date will be worth 0 to both parties
*In order to value the swaps initial cash flow payments one would complete the following steps
*Step 1 - determine the forward rates that will be used for the floating rate index (LIBOR) to compute swap cash flows
*Step 2 - Calculate the cash flows from the swap assuming the LIBOR equals the forward rates
*Step 3 - Discount the swap cash flows using the risk free rate
-Process requires the estimates of both the future rates for each floating rate payment and the risk free interest rate that will be used to discount the cash flows to todays present value
-As interest rates in the market change the value of the swap may become positive or negative based on the actual direction the underlying variable rate takes
-Example -
*As int rates increase the counterparty making fixed payments will see higher returns
*As int rates decrease the floating rate counterparty will see the value of its position go up
Valuation of an Interest Rate Cap
*Issuers of a variable rate bond can use interest rate caps to hedge against rising interest rates
*Rates rise above a specific level the cap seller will make a payment to the issuer which will offset the costs of the higher interest payments
*In an interest rate cap the seller of the option agrees to compensate the buyer for the amount by which an underlying short term rate exceeds a specified rate on a series of dates during the life of the contract
*At each interest payment date
*The holder decides whether to exercise the particular option or let is expire
*Interest rates caps are often used by borrowers in order to hedge against floating rate risk
*Int rate cap protects against rates on a variable rate note risking above a specific level
*A Cap is essentially a portfolio of interest rate call options (caplets) with a common exercise price (cap rate) and an underlying interest rate index (the underlying)
*Ideally each caplet will expire on the date that the floating loan rate will be reset
*Each caplet generates a payment for the buyer whenever the underlying rate is greater than the cap rate otherwise it is allowed to expire
*Cap Payments
*A cap payment is equal to the principal times the spread between the underlying rate and the cap rate or zero whichever is greater
*If the cap rate is above the exercise rate then the buyer will allow the option to expire worthless
-Cap will pay nothing
Valuation of Interest Rate Floors
*Interest rate floors can be viewed as portfolio of interest rate put options (floorlets) on a specified underlying rate
*In exchange for a premium the floor seller agrees to compensate the buyer if the underlying rate falls below the floor rate
*Similar to cap, the interest rate floor will pay the greater of the principal amount time the spread between the floor rate and the underlying rate or zero
*Underlying rate is above the floor rate
-Buyer will allow the option to expire
Caps and Floors Valuation
*Value of a cap or floor is equal to the total value of the individual call options (caplets) or put options (floorlets)
*Value of a cap or floor equals the present value of the expected cash floors from each of its caplets or floorlets, discounted at an appropriate rate
Caps and Floors Valuation
5.4 FEDERAL RESERVE
The Federal Reserve fulfills three critical functions in our economy
*Establishment an implementation of monetary policy
*Regulation and supervision of banks
*Operation of the nation’s payment system
*The Federal Reserve Board also enforces MSRB rules applicable to the systems member banks that are municipal securities dealers
Fluctuating exchange rates can have a huge impact on both business profits and securities prices
Gross Domestic Product (GDP)
*defined as the total market value of goods and service produced within the borders of a county regardless of the nationality of those who produce them
*Primary tool for measuring the US economic growth and analyzing economic performance
*Growth of the US economy is determined by the year over year change In GDP
-When the rate is adjusted for inflation or deflation the measurement is known as real economic growth
Gross National Product (GNP)
*Is the total market value of goods and services produced by the residents of a county even if they are living abroad
-Example -
*If a US resident earns money from an overseas investment the value would be included in the GNP but not the GDP
*Goods produced by a foreign owned business within the US are included in GDP but not GNP
Exchange Rate
*Specifies how much one currency is worth in terms of another currency
-If the Canadian dollar is quoted at 1.07, it takes 1.07 Canadian dollars to purchase one US dollar
Consumer Spending
- If consumer have a negative attitude about the economy = not tryna spend money
- Confidence in the economy is high = consumers spending and investing a lot more
*When US dollar strengthens against another currency
-The dollar buys more of that currency
-US imports increase as its cheaper to purchase foreign goods
-US Exports decrease as the US goods are too expensive for other countries
*When US dollar weakens against other currency
-Imports into the US decline as they will be more expensive to US businesses and consumers
-Export from the US will Increase as they will be cheaper for other foreign countries
Inflation
Is a rise in the general level of prices of goods and services in an economy over time
-Price level rises = currency buys less goods
-Price levels drops = currency buys more goods
Consumer Price Index (CPI) is used to measure inflation at the retail level while the Produce Price Index (PPI) measures wholesale inflation
Negative effects of inflation
-Decrease in the value of money
-Uncertainty of future inflation may discourage investment and saving and high inflation may lead to a shortage of goods if consumers begin hoarding out of concern for future price increases
*Unemployment
*Measured by the unemployment rate
-Defined as the percentage of those in the labor force who are without work
-Causes of unemployment
-Theoretically it arises from insufficient demand for goods and services
-Structural problems and inefficacies in the labor market
-High unemployment is considered a negative economic factor
*Balance of Trade
*Is the difference between a country’s exports and imports
-Debit items which can lead to a deficit include
*Imports
*Foreign aid
*Domestic spending abroad
*Domestic investments abroad
-Credit items which can lead to a surplus include or reduce a deficit include
*Exports
*Foreign spending in the domestic economy
*Foreign investment in the domestic economy
Country has a trade deficit if it has a large debit balance with more imports than exports and a trade surplus or higher credit balance if it exports more than it imports
*A deficit balance of trade is not always a bad thing
-In a recessions countries try to increase exports with the aim of creating new jobs and increasing demand
*In strong Expansion countries prefer to increase imports, providing price competition
-Helps limit inflation and without increasing prices provides goods that the economy is otherwise unable to supply
Objectives of Federal Reserve Monetary Policy
*Goals of monetary policy are identified In the federal reserve act of 1913
-Seek to promote effectively the goals of maximum employment, stable prices and moderate long term interest rates
*Pricing Stability
*Long Term Economic Growth
*Sustainability of Foreign Exchange Markets
Pricing Stability
- Stable prices create a foundation for max sustainable output, growth, and employment, and moderate long term interest rates
- If prices are stable and believed to stay so, the prices of goods, services, materials and labor are not impacted by inflation
Long Term Economic Growth
*Counteract financial disruptions and prevent their spread outside the financial sectors
*If something bad develops the FED can
-Cushion the impact on financial markets and the economy by providing liquidity through open market operations or discount window lending
*Changes in long term interest rates affect stock prices
*Lower consumer loan rates create increased demand for consumer goods
*Lower mortgage rates make housing more affordable and lend to more home purchases
-Encourage mortgage refinancing , reducing housing costs and resulting in extra money for households
Sustainability of Foreign Exchange Markets
*Economic development in the US have a major influence on economic stability, productions, employment, and prices beyond our borders
*Developments abroad also effect our economy significantly
* because of this the FED participates in international economic affairs
*During downward pressure on the dollar the Federal reserve
-Has purchased dollars (sold foreign currency) to support the price
*The Federal Reserve may sell Dollars (purchase foreign currency) to counter upward pressure
Interest Rate Summary
- US Int Rates increase = increase in the price of US goods
- US int rate decrease = decrease in the price of US goods
Operating Tools of the Federal Reserve
-Open Market Operations
-Discount Rate
-Reserve Requirements
-Margin Requirements
Open Market Operations
*Primary tool of monetary policy
*Federal Open Market Committee
-Controls the quality of money in circulation through the buying and selling of treasury securities with primary deals
*Such as JP Morgan Securities or Citigroup Global Markets
*When Fed sells securities, primary dealers are forced to purchase these securities, and cash is drained from the banking system
-Less available cash cause interest rates to rise
*Tightening the money supply
*To curb inflation or prevent the economy from overheating
*When Fed purchases securities from primary dealers, the money supply increases and
-Int rates fall
*Easing the money supply
*Increase lending, spur economic growth, and bring the economy out of a recessions
*Banks also lend funds to each other on an overnight basis
-Int rate charges between banks is known as
*Federal funds rate
*Changes in this rate are heavily influenced by open market operations of the fed reserve board
*Federal funds is generally considered the most volatile US investment rate
Discount Rate
*Fed Reserve board lend funds to depository institutions at the discount window
*Discount Rate
-Applies to interest rate on credit available from the Federal Reserve’s discount window
*The discount rate is typically higher than the federal funds rate
Reserve Requirements
*Portions of deposits that banks are not permitted to lend and must keep on hand or on deposit at a federal reserve bank
-10% of transaction deposits
*Higher reserve requirements result in reduced money creation and in turn reduced economic activity
-Increase in the reserve requirements tightens the money supply
-Reductions in the reserve requirements is an expansionary strategy
Margin Requirements
*An initial margin requirement is
-The amount of funds required to satisfy a purchase or short sale of a security in a margin account
*Also known as the Reg T Requirement
*Currently 50% of the purchase price for most stocks
*Municipal bonds are exempt from the Reg T and typically have a margin requirement of at least 7% of the securities market value
*Raising margin requirements could reduce risk in the financial system by limiting the potential leverage and total buying power of investors
*Lower margin requirements could increase systemic risk by expanding the buying power and leverage available to investors
5.5 US TREASURY DEBT MANAGEMENT PRACTICES
Operations of the Federal Reserve
*Controls the three tools of monetary policy
*Open market operations
*Discount rate
*Reserve requirement
Open Market Trading Desk
*Is located at the federal reserve bank of New York
*Desk deals directly with a group of financial institutions called primary dealers
-Primary dealer is a securities dealer that has an agreement with the Fed
-Requires them to trade with the SOMA
-Systems open market account
*When the Fed wants to loosen monetary policy and lower the federal funds rate
-Trades at the desk inject cash into the financial system
-Do this by purchasing treasury securities from primary dealers in a repurchase agreement
-Puts extra cash in the hands of the primary dealers
*When the fed wants to extract money form the system
-Sells treasury securities to primary dealers in a reverse repo
-Takes cash out of the hands of the primary dealers which prevents them from putting it into the financial system
US Treasury
*Operates the following critical financial systems
-The production of coin and currency
-Disbursement of payments to the public
-Borrowing of funds necessary to run the federal government
-The office of debt management within the Us treasury is responsible for the treasury’s debt management policy
-Issuance of treasury securities
-Financial markets
-The office produces the treasury’s official yield curve, sets and certifies interest rates for federal borrowing and lending programs and advises on the regulation of the government securities market
-Treasury department issues enough bills, notes and bonds to pay ongoing budget expenses that exceed incoming tax revenue
-Treasury department primary goal in debt management is to finance the government borrowing needs at the lowest cost over time
-To finance debt the treasury sells bills, notes, bonds, floating rate notes and treasury inflation protected securities
*Federal Budgetary Practices and Impacts
-Established by the president and the US congress
-Cyclical deficit
-Is the portion of the budget that is caused by fluctuation in the economic cycle
-Structural Deficit
-Is the amount of budget deficit that would exit based on full employment of the labor force
