That buzzing you hear in the municipal market is the swaps nest. In the early 2000s, many municipal issuers entered into interest rate swap agreements because interest rates had fallen to what at the time were very low levels. The idea was that funding costs would fall as interest rates rose because many municipal issuers were paying a fixed interest rate and receiving a floating interest rate. As a reminder, an IR Swaps agreement is between two private parties where one stream of future interest payments is exchanged for another. For instance, a municipal issuer would engage a bank and exchange a fixed payment for a floating payment linked to an index, like LIBOR. Well, interest rates did not rise but fell, and have been held at the zero bound for almost seven years. Mark-to-market pricing further excited the swaps nest because as interest rates fell the fixed-rate payer saw the value of the IR Swap decline. The result was a potentially large reduction in balance sheet strength and increased leverage ratios for many municipalities. Less balance sheet strength and more leverage is a credit negative. Furthermore, IR Swaps can have specific covenants such as maintaining a minimum credit quality. If the covenants are breached, the counterparty can trigger a termination clause and require that the mark-to-market present value of the IR Swap be delivered. These types of events can cause even more strain on liquidity ratios than the negative arbitrages of unbalanced payment streams and, ultimately, a spiral into a default. The City of Chicago’s recent turmoil is partially due to rating downgrades and subsequent IR Swap terminations. Chicago’s termination event couldn’t have come at a worse time because as the U.S. economy continues to improve the likelihood of the Federal Reserve removing easy monetary policies grows. Many market pundits would argue that rising interest rates are bad for bond investors, as well as for issuers that need to roll debt or borrow more because the costs of doing so rise. But in the case of municipal issuers with outstanding IR Swap exposure, rising interest rates can be a credit positive and help calm the swaps nest.
Source: Bloomberg; SNWAM Research