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CDFA Spotlight:
Basis Risk With Interest Rate Swaps

By Stan Provus

Preview

This article explains “basis risk” in the context of interest rate swaps. Basis risk is one of several risks are issuer must consider when entering into interest rate swap agreements.

Body

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel.

Basis Risk

Basis risk on a floating-to-fixed rate swap is the potential exposure of the issuer to the difference between the floating rate on the variable rate demand obligation bonds and the floating rate received from the swap counterparty. This occurs, for example, when the floating rate on the bonds such as the Bond Market Association (BMA) index is different than the index used by the counterparty such as 60-70% of LIBOR.

The BMA Municipal Swap Index (“BMA Index”, formerly PSA) is a market basket index of over 200 active high-grade, governmental, tax-exempt, variable rate demand obligation bonds with weekly interest resets. The BMA index is the market benchmark for short-term, tax-exempt rates. See www.bondmarkets.com and select “swap Index” for a description, including a 10-year history of rates.

LIBOR is the London Interbank Offering Rate. This is the rate at which financial institutions will lend Eurodollars to each other. See www.bba.org.uk/public/LIBOR
for a description.

In recent years, a number of issuers have used “% of LIBOR” swaps while issuing tax-exempt bonds, such as State Housing Finance Agencies. This results in such issuers taking on basis risk (and tax risk) as the bonds of these issuers may trade at a level above the index that the swap is based on. In other words, there is a shortfall in the variable rate payment received from the counterparty and the variable rate due on the bonds, which the issuer must cover in addition to its fixed rate payment. BMA historically trades at about 65% of LIBOR, swaps priced at 60-70% of LIBOR are common. However, in recent months the spread between LIBOR and BMA has narrowed considerably—with BMA at times trading very close to LIBOR, such as 85-95% of LIBOR. When the spread between LIBOR and the BMA index narrows to a point that is below the swap index rate (60-70% of LIBOR) and the bonds and swap use these different indexes, the issuer must take on a portion of the variable rate payment on the bonds in addition to its fixed rate counterparty payment.

For example, assume the BMA index (rate governing variable rate demand obligation bonds) for any given month was 1.5% and the swap counterparty payment was based on 65% of LIBOR at a time when LIBOR was 1.4%. In this example, the counterparty payment would be .91% (.0065 X 1.4—nine tenths of 1%). Therefore, the issuer in this example would have to pay an additional .59% (fifty-nine basis points or over one-half of 1%) of the notional principal amount for the month in this example in addition to its fixed rate counterparty payment.

Historical BMA and LIBOR Rates
Period BMA Index 1 Month LIBOR Index
1990 to date 3.08% 4.54%
Last 10 Years 2.80% 4.25%
Last 5 Years 2.06% 2.94%
Last Year 1.26% 1.55%

While BMA index swaps in contrast to LIBOR would reduce basis risk, since the variable-rate paid on the bonds would be the same index paid by the counterparty in a floating –to-fixed rate swap, the fixed rate paid by the issuer would also be higher than a LIBOR based swap. In addition, there will still be some basis risk because most variable rate demand obligation bonds (weekly low-floaters) are priced weekly based on a rate determined by the remarketing agent that would enable the bonds to trade a par—they are not priced based on the BMA index. In other words, there can be a spread between the rate on the bonds and the BMA index.

It is very important for an issuer to understand any potential basis risk exposure as a party to a swap agreement and to access the cash flow implications over the term of the swap. In floating-to-fixed rate swaps where the counterparty is paying the variable interest rate based on a different index than that used on the bonds, the issuer should get from its counterparty a graph showing how the two interest rates, such as LIBOR and BMA, track each other historically.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.

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