| HOME | CONTACT | PERSONNEL | COMPANY | LINKS | NEWS |
 Forward Starting Swaps and Swaptions Forward Starting Swap A synthetic advance refunding, combines an interest rate swap (the swap actually begins on the date the old bonds are called) which is executed today, at today’s prevailing interest rates, with the issuance of variable rate refunding bonds, which occurs at the call date of the old bonds. For example, the Issuer executes a forward interest rate swap contract today. The Issuer agrees to pay a fixed rate of interest on the current call date and will be entitles to receipt of a floating rate of interest on the current call date. Note that the payment of fixed rate amounts will commence on the current call date, the date on which the old Bonds will have been refunded. Under this scenario, the Issuer can structure the swap contract so that it can take payments (at a variable) prior to the call date on the outstanding Bonds. The Issuer would then use this cashflow to offset a portion of the existing outstanding Bonds debt service requirement. As a result, according to the Issuer’s preferences, it could realize none, some, or all of the economic benefits of the transaction between the present time and current call date depending on the structure of the payment arrangements in the swap. At the current call date the Issuer (1) issues its variable rate refunding bonds (at then prevailing rates); (2) call the outstanding bonds; and (3) begins making a fixed rate payment to its swap counterparty. The combined transactions create a “synthetic” fixed rate debt through the mechanism of the swap contract. There are several consideration to take into account in such an arrangement. First, the counterparty to the swap must be of particularly strong credit quality. Next, the Issuer must determine the basis on which it will take variable rate swap payments and on which it will pay its own variable rate debt after the call date. For example, it is common for municipal issuers to use indices like PSA or a percentage of LIBOR in the calculation of interest on their debt. Another consideration is basis risk, which is the possible non-convergent numerical relationship between the two indices. Terms and structure of this type of transaction are easy to “customize” to individual situations. The swap market is both active and relatively efficient. The documentation is straightforward, as far as these transactions go. Swaption A swaption is variant of the synthetic advance refunding. A swaption involves a payment by the counterparty to the Issuer of a sum, determined today, for the right to compel the Issuer to enter into a synthetic advance refunding as discussed above during an option “window” period. All the risks and benefits as discussed above exist in this form of transaction as well. Moreover, should the counterparty not exercise its rights to compel the Issuer to enter into the swap during the window period, then the Issuer would be able to refund its bonds on a current basis with no obligation to remit the upfront payment received for selling the swaption. Swaps can also be cash settled in which the Issuer would pay the counterparty the mark to market termination value for the swap and issue fixed rate debt to refund the bonds. The Issuer would bond additionally for this payment. But regardless of the settlement terms, and relative market interest rates the Issuer’s borrowing costs are locked in today since any settlement payment would be offset by the lower fixed rate at the time of issuance. |
