Guidelines for effective uses of swaps in asset-liability management.

• Author: McManus, Katherine

Editor's note: This article is reprinted with the permission of Fitch Ratings. The views expressed herein are the authors' and do nat represent the official position of GEQA or its standing committees.

The ongoing decline of interest rates has presented credit-worthy borrowers with exceptional financing opportunities. In this low interest rate environment, many borrowers have reduced their debt service costs by refunding outstanding debt and have financed new projects at very low costs. Lower debt service costs have also provided some budget relief. Simultaneously, low interest rates have affected returns on investments. The impact on tax-exempt borrowers with sizeable funds restricted to short-term fixed-income investments has been especially severe, as they repeatedly reinvest maturing principal at ever-lower rates.

Responses to the mixed blessings of the low interest rate environment have varied among tax-exempt borrowers and have to some extent depended on their management structure. Those that manage investments and liabilities separately may adjust only their investment policy without changing their debt policy or vice versa. These borrowers may also adjust both their debt and their investment policies-but in isolation.

Alternatively, in recognition of the potentially offsetting impact of interest rate fluctuations on certain assets and liabilities, some tax-exempt borrowers are adopting comprehensive asset and liability management policies. Such policies, which are more prevalent in corporate finance, incorporate coordinated investment and debt structuring decisions. The goal of such coordination is to use each side of the balance sheet to mitigate, or hedge, cash flow risks posed by the other side of the balance sheet.

Either as part of or separate from asset and liability management strategies, increasing numbers of tax-exempt borrowers have used interest rate swaps to hedge their exposure to interest rate fluctuations. They have used swaps to increase exposure to variable-rate debt through fixed-to-floating interest rate swaps and have hedged their exposure to variable interest rates through floating-to-fixed rate swaps. Although the current trend of increased use of interest rate swaps has developed during a period of declining interest rates, the use of interest rate swaps and other interest rate hedging products, such as caps and collars, is expected to continue even if the interest rate environment changes, as these products provide tax-exempt borrowers with financial flexibility not offered by traditional financing methods.

Fitch Ratings recognizes that, when used in the context of comprehensive asset and liability management strategies, variable-rate debt and interest rate hedges can enhance the finances of some tax-exempt borrowers. However, when used without a coherent strategy or by borrowers with finances that are already vulnerable, such financial products can result in adverse credit consequences. Furthermore, because many municipal swap features are both unique and relatively new, borrowers should consider carefully all assumptions underlying risk calculations.

The guidelines in this report are intended to inform municipal market participants of the factors that Fitch considers when analyzing the impact of variable-rate debt and interest rate swaps on debt issuer credit. Fitch finds that, while a number of elements may influence the credit impact of variable-rate debt and interest rate hedging products, the overall management framework is the most relevant indicator of future credit impact. Therefore, Fitch considers borrowers' policies and procedures for managing the benefits and risks of selected debt structures, investments, and any related interest rate hedging products (asset and liability management policies). Fitch also considers the application of asset and liability management policies, including overall debt structure and asset profile, future capital needs, consideration of alternative structures, and reasoning in support of selections, as well as the likelihood of achieving the goals of the adopted policies.

When borrowers use interest rate swaps to create or mitigate exposure to variable interest rates, Fitch focuses on the following aspects of swap transactions: priority of swap payments; basis risk; termination...