Interest Rate Swap Summary
Like other large issuers in the municipal market, the Commonwealth has periodically entered into hedge agreements – commonly referred to as interest rate swap agreements – to effectively manage and mitigate interest rate risk on its outstanding variable rate bonds. As part of these hedge agreements, the Commonwealth will receive a variable or floating payment from a swap counterparty that is used to offset variable rate payments made to bondholders of a specific series of outstanding variable rate bonds. In return, the Commonwealth will make a fixed payment to the same swap counterparty. This exchange of payments as part of the hedge agreement fixes the Commonwealth’s cost of capital over the life of the bonds at a rate that is lower than what the Commonwealth would have paid had it issued fixed rate bonds. The hedge also reduces or eliminates the Commonwealth’s interest rate risk, which provides much-needed cash flow and budgetary certainty over the life of the outstanding variable rate bonds.
When used effectively, interest rate swaps can be important risk management tools that have tremendous application for large issuers of municipal debt. The potential benefits to public sector issuers include:
- lowering borrowing costs,
- hedging interest rate risk,
- matching assets and liabilities in terms of interest rate risk,
- increased flexibility in financings, especially refundings, and
- reducing reliance on bank liquidity agreements (for variable rate demand bonds).
These potential benefits must be weighed against certain risks that are inherent in swap agreements, including:
- counterparty risk,
- termination risk,
- interest rate risk,
- basis risk, and
- roll-over risk.
The Commonwealth manages these risks by limiting its overall use of interest rate swaps, structuring important provisions in the agreements that are beneficial to the Commonwealth, diversifying its counterparties, and closely monitoring the swap portfolio.