Beware Blaming Bad Bond Bets!

The debate about speculation vs. investment has gone on at least since the Sumerians traded wine forwards five or six millennia ago. More recently − five or six decades ago −  one of our most famous value investors put it this way:

ben graham


“The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices.”

– Benjamin Graham
The Intelligent Investor

Graham’s words of wisdom come to mind after reading this piece from CNBC.com. It keys off a “study” by the Services Employees International Union about derivatives usage by municipalities.

The central premise: if a municipality (and by extension, a corporation, asset manager, pension fund, sovereign or other entity) decided to lock in rates a few years ago with an interest rate swap, it made a “bad bond bet.” That’s because rates stayed low, meaning there was no need to hedge and so the premiums spent on the hedge could have been spent elsewhere.

The logic (?) of this position is: it’s better to stay exposed to market fluctuations than to manage the risk of those fluctuations.

But isn’t that betting (or speculating)?

Well, yes, actually, it is.

But wait…what about the fact that terminating that hedge can mean big payments from a hedger to its counterparty? Isn’t that another sign that it’s just a bad bet?

Well, no, actually, it is not. Here’s why:

Assume a hedger issues floating rate debt and then does a swap to lock in a fixed rate (by paying fixed and receiving floating).

Rates then go lower, which means the cost of the floating rate debt declines. The hedger pays less in interest income on the debt.

At the same time, the hedger continues to make the same fixed rate payments on the swap (and continues to receive floating rate payments from its counterparty). The market value of the swap has changed, because the hedger’s fixed rate payments are more valuable now that rates have gone down.

So if the hedger wants to terminate the swap, its counterparty wants a larger termination payment to compensate for the loss of those fixed rate payments.

Keep in mind that the hedger is under no obligation to terminate the swap. Its decision to do so is voluntary.

So why would a hedger voluntarily pay a large termination fee to exit a swap?

The most likely reason: It has determined that it could save money by issuing new debt — and by calling in its existing debt and terminating its existing swaps.

So, to summarize: a hedge enables a hedger to optimize its financings while protecting against changes in rates. The effectiveness of the hedge is a function not just of its cost but also of the cost of the hedger’s debt. Termination payments reflect changes in value of the swap hedge and are made voluntarily when the hedger has determined that there’s financial value in calling old debt, terminating swaps related to that debt and issuing new bonds.

Any Given Sunday….

Another Sunday, another New York Times column on “you guessed it – derivatives.” This one purports to show how derivatives are costing mass transit riders higher fares and lower services. The story goes like this:

“Bankers have embedded interest-rate swaps in many long-term municipal bonds. Back when, they persuaded states and others to issue bonds and simultaneously enter into swaps. In these arrangements, the banks agreed to make variable-rate payments to the issuers – and the issuers, in turn, agreed to make fixed-rate payments to bond holders.”

At which point we need to stop to point out that the example is actually wrong.  We think what the column meant to say was that “the issuers, in turn, agreed to make fixed-rate payments to the bank.” This would be a classic example of an issuer doing a floating rate bond issuance and then swapping into a fixed rate to lock in its exposure. But we digress:

“These swaps were supposed to save the public some money. And, for a while, they did.”

Oh, maybe this won’t turn out so badly?  But then:

“Then the financial crisis hit – and rates went south and stayed there. Now issuers are paying bond holders above-market rates as high as 6 percent. In return, they are collecting a pittance from banks – typically 0.5 percent to 1 percent.”

To recap: the swaps saved issuers money. They effectively lowered the issuers’ interest payments. This remains true today. But now apparently those savings are not enough. Given the level of interest rates today, the column posits that muni issuers could be saving even more.

Well, if that’s the case, why don’t the states and municipalities refinance their debt and issue new bonds with lower interest rates? The problem, according to the column, is that:

“Well, if you think it’s costly to refinance a home mortgage, try refinancing a derivatives-laced muni.  The price, in the form of a termination fee, can be enormous.”

Banks do charge fees for terminating swaps, based on the market value (or replacement cost) of those transactions. Lower rates could and probably did increase the value of those contracts.

But how is this different from what issuers would face if they had just issued fixed-rate debt in the first place (with no swap)? They would have garnered none of the interest expense savings. And they would have to compensate bondholders in the form of a premium if they now wished to refinance higher–rate debt with lower-rate debt. (That’s why there’s generally a premium paid by issuers who issue callable debt.)

The article then goes on to say:

“Corporations rarely do deals like these, because they generally avoid making long-term bets on interest rates. But bankers sold the idea to public borrowers.”

It’s not clear what exactly is meant by “deals like these,” but here are a few facts. All of the top companies – and thousands of large, mid-sized and smaller firms – in the US and around the world use interest rate swaps. This suggests that corporations frequently seek to lock in their financing costs.

So now we get to the crux of the column:

 “…the banks are taking advantage of our generosity by gouging us on these toxic deals.”

What, exactly, is toxic about helping municipalities manage their interest rate risk and save money?