Fixed Income: Interest Rate Swaps
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  • Thank you Dow Overview of Debt’s Financials Start 1 or 2 general slides Dig deeper into group performance for the qtr Conclude or end with general slides – again point out our collective success over the years The results are great, it is a very lucky time for me . . . if ever the numbers aren’t so good, we’ll ask Demo or some other member of the management team to explain

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  • 1. Third Annual Investment Management Conference, with Consultiva Internacional, Inc. November 15, 2002 Presentation to the Active Debt Management – Managing Interest Rate Risk with Swaps
  • 2. Active Debt Management – Managing Interest Rate Risk with Swaps Presentation to Third Annual Investment Management Conference, with Consultiva Internacional, Inc.
    • Asset and Liability Management 1
    • Uses of Interest Rate Swaps in Debt Management 13
    • Current Market 23
    Table of Contents Merrill Lynch prohibits (a) employees from, directly or indirectly, offering a favorable research rating or specific price target, or offering to change such rating or price target, as consideration or inducement for the receipt of business for compensation, and (b) Research Analysts from being compensated for involvement in investment banking transactions except to the extent that such participation is intended to benefit investor clients.
  • 3. Asset and Liability Management
  • 4. Asset and Liability Management Surplus Return Adopt a risk-based approach to raising and investing capital to maximize surplus returns. Actively manage entire balance sheet Minimize Risk Management Surplus Return Investing Capital Maximize Raising Capital
  • 5. Asset and Liability Management Summary Optimizing liabilities is part of a comprehensive balance sheet management process. RESULT Moderate-to-Aggressive risk tolerance. RESULT Adopt a target for variable rate exposure (e.g. 50%). RESULT Balanced portfolio with assets allocated in 4 categories. Gather Information & Establish Goals Risk Appraisal Investment Optimization Liability Optimization Monitoring & Surveillance Asset/Liability Management Liquidity Assessment & Capital Segmentation 1 6 5 4 3 2
  • 6. Asset and Liability Management Liability Optimization Three inter-related decisions lead to an optimal liability structure. Pay Fixed or Variable? Committed or Temporary? Accept or Eliminate? Risk v. Reward: Greater Uncertainty = Lower Expected Cost 1. Interest Rate Exposure 2. Liquidity Considerations 3. Tax Law Risks
  • 7. Asset and Liability Management Portfolio Approach: Getting Appropriate Fixed/Variable Balance A mix of both fixed rate and variable rate debt reduces risk while minimizing expected debt cost. Variable Rate Debt 100% Fixed Rate Debt 100% Low Low High High Expected Cost Risk Fixed Rate Debt Variable Rate Debt
  • 8. Why Variable Rate Debt and How
  • 9. Why Variable Rate Debt and How Fixed Rate Debt Versus Variable Rate Debt Fixed Rate Debt Variable Rate Debt Historically, variable rate cost of funds has been less than fixed rate cost of funds. BMA Index Revenue Bond Index
  • 10. Why Variable Rate Debt and How Fixed Rate Debt Versus Variable Rate Debt Recently the spread between fixed rate and variable rate has been unusually large. BMA Index Revenue Bond Index Fixed Rate Debt Variable Rate Debt Large Spread= Savings with Variable
  • 11. Why Variable Rate Debt and How Market Volume The use of interest rate swaps by government and non-profit organizations has steadily increased. It now exceeds the issuance of direct tax-exempt variable rate bonds by four to five times. Bond statistics from Securities Data Corp. Swap statistics estimated as independent data are not available. Billions
  • 12. Why Variable Rate Debt and How Importance of Variable Rate Debt and Swaps
    • Savings
      • Historically, variable rate debt is less expensive than fixed rate debt
      • Variable rate debt saves money in low interest rate environments
    • Risk management
      • Variable rate debt can reduce risk when interest rates are low
    • Swap Programs
      • Cost effective way of obtaining variable rate debt or more fixed rate debt
      • Hedge against rising interest rates
      • Simple to execute compared to bond issuance
    • Ongoing Liability Management
      • Debt programs should be actively managed, just as assets should be managed
      • Identify market opportunities to manage debt
  • 13. Why Variable Rate Debt and How Benefits Issuers should determine and then achieve an optimal level of variable rate exposure. Adjustable Risk Profile Flexibility: Easy to Adjust/Restructure Asset-Liability Balance Reduced Interest Cost Benefits of Variable Rate Exposure
  • 14. Why Variable Rate Debt and How Variable Rate Products Understanding the risks and mechanics of variable rate products is essential for effective liability optimization. Direct Variable Rate Puttable and non-puttable products. Synthetic Variable Rate Fixed rate debt converted to variable with interest rate swaps. Variable Rate Hedging Increased cash flow and protection against rising interest rates.
  • 15. Why Variable Rate Debt and How Differences between Traditional and Synthetic Fixed Rate Debt
    • Issued for a term, but remarketed periodically
    • Letter of credit needed for liquidity or bond insurance
    • Principal exchanged
    • Simple accounting treatment
    • Put risk for some forms of variable rate debt
    • Transaction need only be completed once
    • Credit terms negotiated between two parties before execution; no third party required
    • No principal exchanged
    • Accounting treatment for swaps depends on structure
    Traditional Variable Rate Debt (Bonds) Synthetic Variable Debt (Swaps)
  • 16. Why Variable Rate Debt and How Risk Components Both direct and synthetic variable rate exposure introduce multiple risk elements. Interest Rate Tax Industry/ Regional Institution-Specific Liquidity Counterparty Changes in interest rates will affect cost of funds. Lower marginal tax rates may increase cost of funds. Lower demand for bonds of comparable organizations may increase cost of funds relative to other borrowers. Any credit deterioration may increase cost of funds. Higher cost or unavailable bank liquidity facilities. Swap counterparty unable to make periodic or reversal payments.
  • 17. Uses of Interest Rate Swaps in Debt Management
  • 18. Fixed-to-Floating Swaps
  • 19. Fixed-to-Floating Swaps Fixed Receiver Swaps Convert to Variable Rate
    • Fixed receiver swap: Issuer receives a fixed rate and pays a variable rate, typically the BMA Index (e.g. 3.35% for 10 years).
    • Notional amount: The size of the interest rate swap and the dollar amount used to calculate interest payments. There is no obligation to pay principal.
    • Term: The length of time payments are exchanged.
    (1) 10-Year BMA swap rate. (2) Approximate BMA Index. (3) Typical fixed rate paid to bondholders. Merrill Lynch Issuer 3.35% (1) BMA Index = 1.50% (2) Bondholders 5.00% (3) Interest Rate Tax Industry/ Regional Institution-Specific Liquidity Counterparty An interest rate swap is a contract between the issuer and counterparty to exchange payments--one fixed and one variable--for a period of time. Risk Analysis
  • 20. Fixed-to-Floating Swaps Cash Flow and Mark-to-Market Sensitivity Mark to Market on a $100 million notional amount (2) The mark-to-market will go up or down depending on interest rate movement and the passage of time. (1) Approximate average of BMA Index since 1992. (2) Assumes rate movement occurs immediately after execution of 10-year swap. Cash Flows Interest rate savings are affected by the BMA Index, term and notional amount.
  • 21. Floating-to-Fixed Swaps
  • 22. Floating-to-Fixed Swaps Fixed Payer Swaps Convert to Fixed Rate
      • Fixed payer swap: Issuer pays a fixed rate and receives a variable rate, typically the BMA Index (e.g. 3.55% for 10 years).
      • Notional amount: The size of the interest rate swap and the dollar amount used to calculate interest payments. There is no obligation to pay principal.
      • Term: The length of time payments are exchanged.
    (1) 10-Year BMA swap rate. (2) Expected BMA Index. (3) Typical rate paid to bondholders BMA +0.40% including remarketing and liquidity fees. Merrill Lynch Issuer 3.55% (1) BMA Index = 1.50% (2) Bondholders BMA Index + 0.40% (3) Interest Rate Tax Industry/ Regional Institution-Specific Basis Counterparty An interest rate swap is a contract between the issuer and counterparty to exchange payments--one fixed and one variable--for a period of time. Risk Analysis
  • 23. Floating-to-Fixed Swaps Cash Flow and Mark-to-Market Sensitivity The mark-to-market will go up or down depending on interest rate movement and the passage of time. (1) Approximate average since 1992. (2) Assumes rate movement occurs immediately after execution of 10-year swap. Cash Flows Interest rate savings are affected by the BMA Index, term and notional amount. Mark to Market (2)
  • 24. Basis Swaps
  • 25. Basis Swaps
    • Issuer receives a fixed percentage of 1-month LIBOR (i.e., 81.00% for 20 years).
    • Issuer pays the BMA Index, which is typically 64.50% of 1-month LIBOR.
    (1) In the form “x% of 1-month LIBOR = y%,” x% is the ratio between a 20-year BMA swap and a 20-year LIBOR swap. 1-month LIBOR assumes a BMA Index/1-month LIBOR ratio of 64.50%, and is adjusted to an Act/Act day count. (2) Approximate BMA Index. Merrill Lynch Issuer 81.00% of 1-Month LIBOR = 1.91% (1) BMA Index = 1.50% (2) Interest Rate Tax Industry/ Regional Institution-Specific Liquidity Counterparty A BMA/LIBOR basis swap is the exchange of payments based on two variable interest rates: Risk Analysis Gross Merrill Lynch Issuer Net 0.41% On a $100 million notional amount, 0.41% equals $410,000 of annual cash flow. At the 1992-date average BMA Index of 3.18%, annual cash flow would be $861,000.
  • 26. Basis Swaps Hedging Effect/Combined with Receiver Swaps (1) Current approximate BMA Index. (2) Approximate average since 1992. Basis swap cash flows partially hedge the interest rate risk of variable rate debt. Cash flows also increase when BMA Index/1-month LIBOR ratios are low. Ratios are primarily and inversely affected by marginal tax rates.
  • 27. Basis Swaps Market Value (1) Assumes rate movement occurs immediately after execution of 20-year swap. The mark-to-market will decrease to zero as the swap nears maturity. Projected Value Based on $100 Million Notional Amount in ($000s) (1)
  • 28. Basis Swaps Basis Swap Ratio History -1 stdev +1 stdev 20-Year Basis Swap Ratio Basis swap ratios are currently high due to the exceptionally high municipal supply.
  • 29. Swap Reversals
  • 30. Swap Reversals Rates 10-Year Average vs. Current BMA Swap Rates The current yield curve is steeper than average. Short swaps offer the greatest incremental benefit. Current and Historical Yield Curves
  • 31. Swap Reversals Lockouts Timeline (2-Year “Lockout”) (1) 5-year swap rate. (2) Approximate BMA Index. Cash Flows On a $100 million notional amount, execute a 5-year BMA receiver swap today at 2.59% lockout the first year at 1.58%. Receive an upfront cash benefit of $1 million for this 1-year “lockout.” Swap cash flows are temporarily suspended. In return, the issuer receives an upfront cash benefit equal to the anticipated savings during the lockout period. Merrill Lynch Issuer 2.59% (1) BMA Index = 1.50% (2) Swap matures Execute transaction 2002 2007 2003 Cash flow begins No variable rate exposure during the lockout period When interest rates rise in the future, the issuer can extend the swap at a higher rate. Upfront Cash Benefit: $1,010,000 (1-Year “Lockout”) $1,467,000 (2-Year “Lockout”)
  • 32. Current Market
  • 33. Current Market Factors Dictating Swap Opportunities BMA Index — Historic Lows 10-Year Payer Swap Rates — Historic Lows 20-Year Basis Swap Ratios — High Option Volatility — High
  • 34. Current Market Capitalizing on Recent Market Conditions
    • Fixed Receiver Swaps
    • Execute short swaps (5 years or less) to take advantage of low variable rates for the next few years.
    • Extend to longer maturities when rates increase.
    • Fixed Payer Swaps
    • Issue variable and swap to fixed.
    • Resulting cost of “synthetic” fixed rate debt is less than that of AAA GO bonds.
    • Basis Swaps
    • Current BMA/LIBOR ratios at record highs due to excess municipal supply and lowest Fed funds in 40 years.
    • Consider delaying start for one year to avoid current negative cash flows.
    • Options
    • Consider selling swap options to counterparty while volatility is high and options are historically expensive.
  • 35. Current Market Case Study: Swap Program Management Fixed-to-Floating Swap Program Fixed Receiver Overview $90 Million Basis Swap Program Basis Swap Overview Reversal of 1996 Swap Execution of 4 New Swaps Swaps Reversal Total Profit & Upfront Payments: $7,260,000 Swap #1 Swap #2 Swap #3 Total Profit & Accrued Interest to Date: $731,000
    • “ BBB” hospital wanted to obtain variable exposure and used fixed receiver swaps to do so.
    • Swaps “tranched” to minimize market timing risk.
    • When interest rates declined, and mark-to-market values of the swaps were favorable, hospital “reversed” swaps, generating up-front cash payments of $7.2 million.
    • Basis swaps also “tranched.”
    • Basis swaps further reduced cost of funds and hedged receiver swaps against rise in interest rates.
    • Even after fixed receiver swaps reversed, the basis swaps were maintained because they have generated $730,000 for the hospital to date and they are expected to continue to do so.
  • 36. This information is for your private information and is for discussion purposes only. We are acting solely in the capacity of an arm’s length counterparty and not in the capacity of your financial adviser or fiduciary. We or our affiliates may buy or sell instruments identical or economically related to any instruments mentioned here. We or our affiliates may have an investment banking or other commercial relationship with the issuer of any security or financial instrument mentioned here or related thereto. Generally, all over-the-counter (“OTC”) derivative transactions involve the risk of adverse or unanticipated market developments, risk of illiquidity and other risks. Unless specifically stated otherwise, any transaction terms are indicative only and are subject to change and any prices mentioned here are not bids or offers by Merrill Lynch to purchase or sell any securities or financial instruments. All trades are subject to credit approval. Prior to undertaking any trade, you should discuss with your professional tax or other adviser how such particular trade(s) affect you. This brief statement does not disclose all of the risks and other significant aspects of entering into any particular transaction. Options are not suitable for all investors. Option buyers may lose their entire investment. Option sellers may have an unlimited loss.