Using Variable Rate Debt Instruments

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Type: 
Advisory
Advisory: 

GFOA Advisories identify specific policies and procedures necessary to minimize a government’s exposure to potential loss in connection with its financial management activities. It is not to be interpreted as GFOA sanctioning the underlying activity that gives rise to the exposure.

Background: 

Issuing variable rate debt is a sophisticated strategy. Variable rate debt primarily1 consists of debt securities with nominal long-term maturities in which the interest rate is reset by a remarketing agent on a periodic basis (e.g., daily, weekly, monthly, annually or commercial paper periods up to 270 days).  In optimal conditions, a government might experience lower borrowing costs or reduce the impact of volatile investment earnings by issuing variable rate securities; however, their use exposes governments to many additional forms of risk. Issuers of variable rate debt need to be informed about these risks and their implications and possess or retain substantial expertise to mitigate them. 

Short-term interest rates are usually lower than long-term interest rates. Governments with debt that resets to prevailing interest rates can save money in their long-term financing if rates stay constant or fall over the life of the debt. Generally, if  interest rates rise, governments are better off issuing fixed-rate debt from the beginning in order to lock in an interest rate today and avoid paying higher interest costs in the future. This interest rate risk is only one form of risk associated with variable rate debt. Additional risk is introduced by liquidity and remarketing provisions. Variable rate debt programs typically involve regular re-marketing or rollover events, and these provisions determine what happens when there are problems in that process. Those problems can impose sudden principal repayments or large increases in interest rates unless the variable rate instrument is carefully designed to reduce this concern.

In addition to these forms of risk, variable rate debt requires continuous active monitoring which in turn leads to additional demands on government resources. Governments without the resource capacity or level of expertise to manage such a program should consider issuing fixed rate debt.

Variable rate debt can be used as a tool for interim financing or to provide asset/liability balance to an enterprise’s operations. Since the expectations of variable-rate investors are, by their nature, short-term, variable rate debt can often be redeemed on short notice without premium or any penalty to the issuer. This feature makes variable rate debt a preferred tool for financing projects for which a prepayment or restructuring is a high probability. Certain variable rate instruments, most notably commercial paper, can be issued incrementally as funds are needed to finance current construction needs and reduce the long-term cost of construction financing.   Such issuances are then refunded with a long-term financing when the project is completed. Although variable rate debt is a valuable instrument, issuers should consult with their independent municipal  advisors and review applicable rating agency criteria to determine the appropriate level of variable rate exposure for their individual circumstances.

Recommendation: 

GFOA advises governments who plan to issue variable rate debt to exercise caution and carefully evaluate their objectives. Governments should consider how this debt, and the various risks associated with it, will be managed over the long term. Issuance of variable rate debt should be guided by the government’s overall financial and debt management objectives and its financial condition. In particular, an issuer should:

  1. Review statutes or ordinances governing the issuance of debt, both at the local and state levels, to ensure that the issuance of variable rate debt (including particular instruments) is permitted and to understand any conditions connected therewith, such as periods between rollovers, interest rate ceilings, or requirements governing debt-related funds.
  2. Ensure that the government’s debt policy specifically addresses the use of variable rate debt, including (a) the goals to be achieved, (b) the permitted instruments, (c) the maximum amounts that may be issued, (d) the steps required to minimize risk, and (e) the monitoring requirements.
  3. Be aware of a dynamic market and political environment that can create basis risk, regulatory risk and operational challenges that may impact the cost and/or benefit of existing or future use of variable rate debt.
  4. Prepare senstivity analyses to evaluate the impact on debt service requirements assuming different interest rate scenarios and develop appropriate contingency plans for a rising interest rate environment. This may include setting aside reserves consistent with applicable arbitrage regulations or purchasing hedging instruments. An issuer should also consider the impact of changing interest rates on rate covenants and its financial position. Governments issuing variable rate debt should have adequate financial capacity to accommodate rapid and potential large changes in borrowing costs.
  5. Evaluate the total cost of issuing variable rate debt, including fees to tender agents, remarketing agents, and liquidity providers under expected and adverse scenarios (e.g., if tendered bonds cannot be immediately remarketed). If the issuer is considering purchasing an interest rate cap, the cost of purchasing the instrument should also be assessed in relation to interest rate risk exposure. The issuer should include the cost of municipal advisors and/or the cost of additional professionals that may be needed to monitor the variable rate instrument.
  6. Evaluate the need for an external liquidity facility such as a highly-rated financial instituion. If an external liquidity facility is required, an issuer should  (a) evaluate such potential providers, including a review of their credit ratings, (b) understand the consequences of a change in the rating, and the need to post collateral, and (c) understand the impact of the maximum interest rate on the  bonds if they  are tendered, and (d) understand the timing of renewal provisions. 
  7. Ensure the diversification of remarketing agents, liquidity facility providers and counterparties in their selection. This would assist the issuer in diversifying its exposure in market uncertainties and creating competition among such entities. 
  8. Develop a full understanding of the unique risks that arise when variable rate payments are realized through an interest rate swap, including counterparty risk, basis risk, rollover risk, and termination risk.

To evaluate the appropriate amount of variable rate debt to be issued for risk mitigation purposes, the following criteria should be evaluated:

  1. Balance sheet risk mitigation. The following factors should be analyzed on the basis of the fund that will be repaying the debt:
    1. The historic average of cash balances over the course of several prior fiscal years;
    2. Projected cash balances based on known demands on a given fund and on the issuer’s fund balance policies; and
    3. Any basis risk, such as the difference in the performance or duration of the issuer’s investment vehicle compared to the variable rate debt instrument to be used by the government.
  2. Interest Rate Risk. In determining the amount of interest rate risk, the issuer should consider the specific fund exposed to the risk and the budgetary flexibility that fund has in accommodating rapid increases in interest rates.
  3. Remarketing Risk. Issuers should have specific backup contingencies in the event that they cannot remarket their bonds. These should include sources of funds to cover redemptions and provisions for substitution remarketing.
  4. Acceleration Risk: Issuers should determine how to mitigate any risk that the immediate collection of payment and termination of contract as a result of any number of reportable events take place (including downgrade of debt). If an acceleration clasue is used, triggers should be set for reportable events. Issuers should be particularly aware of the “most favored nations” clause among lenders. 
  5. Liquidity/Renewal Risk. Issuers should have a plan that specifies their actions and backup provisions should one or more guarantors to the transaction fail to perform. This also applies to a government’s ability to renew its liquidity agreements during a difficult market.
  6. Rollover Risk. There are at least two instances in which issuers may want to refinance their variable rate debt.  First, in the case of variable rate instruments secured by a letter of credit, if the letter of credit is drawn upon to pay for tendered bonds that cannot be remarketed, the letter of credit agreement may require the issuer to pay the draw back within a relatively short period of time (e.g., 5 years).  This is referred to as a “term-out.”  If the issuer cannot secure take-out financing, the term-out may prove onerous.  Second, issuers may decide that long-term fixed rates are likely to rise in the future, so that a refinancing to lock in current fixed rates is desirable.  
  7. Reissuance Risk. Issuers should take care in structuring their variable rate instruments so that an option to convert to a long-term fixed rate is included and that tax counsel advise that exercise of that conversion option will not trigger a “reissuance” for tax purposes.  If a reissuance were to occur, the reissued bonds would be subject to the tax law in effect at the time of reissuance.  A reissuance could, therefore, affect the tax-exempt status of the issuer’s bonds.  
  8. Tax Compliance Risk. Issuers who issue tax exempt variable rate debt should be aware and prepared to comply with all covenants for post issuance to avoid the bonds becoming taxable which could result in an increase in interest rates or mandatory redemption of the bonds.
Committee: 
Governmental Debt Management
Notes: 

1 Issuers should be aware that variable rate can take the form not only of variable rate demand bonds but also floating rate notes, either as private placements to commercial banks who otherwise might provide liquidity on variable rate demand bonds, or through a competitive process.  Floating rate notes have their own set of risks and benefits.

References: 
Approved by GFOA's Executive Board: 
March 2018