Swaps
When a municipal entity issues debt, it is not necessarily locked into the payment structure described in the bond indenture. The marketplace offers opportunities to modify its financial obligations through different financial products. Swaps are one of the most common ways of changing the costs of existing debt without changing the structure or size of the debt. Swaps can also provide potentially better terms for an issuer because they can offer payment structures that better meet the financial goals of a municipality. For instance, swaps can help a firm to:
- • Lower financing costs
- • Manage the mismatches between cash flows due to differences in assets and liabilities
- • Manage interest rate risk
To municipal issuers, the most important type of swap is the interest rate swap. At its most basic level, an interest rate swap is an agreement or contract between two parties to exchange regular interest payments for a specified period of time. When one payment is fixed and the other is variable, it is called a plain vanilla interest rate swap. The value of a swap is derived from a change in the value of an interest rate.
Often, a municipal entity wants to make fixed payments on the bonds it issues, but it can get a lower rate if it issues variable-rate bonds. A swap agreement allows a municipality to issue variable-rate bonds, yet still make the fixed-rate payments it desires by creating synthetic fixed-rate debt. To do this, the municipal entity will contact a financial institution that deals in swaps. The swap dealer will give the municipality a quote for a fixed-rate swap. The municipality will make fixed payments at the quoted rate to the swap dealer in exchange for receiving variable payments from the swap dealer. This is called a fixed-rate swap because the municipality is paying a fixed rate in exchange for variable payments. It is sometimes referred to as a floating-to-fixed rate swap because the municipali