Risks
Interest rate swaps carry a variety of risks.
Counterparty risk. This is the risk that the counterparty in a swap agreement will default on its payments. This is also the risk that the counterparty’s credit quality will decline so much that the market will fear that it will default on its payments. When a municipality enters into a swap agreement, it is exposing bondholders to counterparty risk that didn’t exist before the agreement was signed.
Basis risk. Basis risk is the risk that the variable rate paid by the issuer to its bondholders will differ from the the rate it receives on the swap. This can happen when the floating rate of the bond is based on a different index than the floating rate of the swap. For example, suppose one is SOFR-based and the other is SIFMA-based. If the municipality is paying SIFMA + 2% to its bondholders and receiving SOFR + 1% from a swap agreement, basis risk is the risk that the SIFMA rate will rise relative to the SOFR rate. In this case the municipality wou