The following policies have been created by the Texas Bond Review Board to standardize and rationalize the use and
management of interest rate management agreements, primarily interest rate swaps by issuers of state securities.
As used herein, the term “swaps” includes swaps, caps, floors, collars, options and other derivative financial products
used in conjunction with the issuance and management of debt obligations.
These policies are meant to be guidelines for general use and allow flexibility for issuers to be able
to respond to changing market conditions. However, all issuers should develop and maintain their own swap policies based
on their unique goals and programs. Additionally, regular review and updates for an issuer’s swap policies can be an
important tool to help ensure that its policies remain consistent with those goals and programs.
The primary objective of these policies is to establish conditions for the use of swaps and to create
procedures and policies that encourage an optimum balance between risk and reward, provide credit protection and
maintain full and complete financial disclosure and reporting. Another objective of these swap policies is to stimulate
discussion and broaden appreciation of the issues involved in the use of swaps.
Policy 1: Legal Authority
State issuers should establish and state the basis of the legal authority that permits them to enter
into the use of swaps. In most cases, Chapter 1371 of the Texas Government Code provides a statutory framework for the
use of swaps. Prior to entering into any specific swap transaction, an issuer should secure an opinion from qualified
legal counsel that the transaction has proper legal authority. Similarly, the issuer should obtain an opinion from the
swap provider’s counsel that the swap provider’s obligations under the swap agreement are valid, binding and
Policy 2: Procedure
Prior to entering into a swap, issuers should define procedures for evaluating and approving swap use.
The procedures should include:
Policy 3: Risk Evaluation and Mitigation
a financial analysis of the swap transaction and the risks and rewards it presents, including sensitivity
analysis for how the swap and its associated structure might perform in stressful market environments;
a review of the swap’s potential impact on the issuer’s credit rating, credit costs and mix of fixed and
an estimate of any added administrative burden and,
an authorization of the officials who will have responsibility and authority for authorizing the size,
terms and pricing of the swap.
In preparation for entering into a swap, an issuer should evaluate and seek to mitigate all relevant
Policy 4: Documentation
Counterparty Risk: The risk of a failure of a counterparty to perform as required under its swap contract with
Termination Risk: The risk that a swap may be terminated prior to its scheduled maturity due to factors outside
the issuer’s control.
Collateral Posting Risk: The risk that an issuer will be required to post collateral in the event of a credit
downgrade or a market change.
Interest Rate Risk: The risk that the issuer’s costs associated with variable-rate exposure increase and
negatively affect budgets, coverage ratios and cash flow margins. Variable-rate exposure may be created by
a fixed-to-floating rate swap or a swap that otherwise creates some type of floating-rate liability such as
a basis swap. The interest rate risk presented by such a swap may increase as interest rates increase generally,
as intra-market relationships change or because of credit concerns relating to the issuer or a credit-enhancer.
Basis Risk: The risk in a synthetic fixed-rate structure that the floating-rate on the swap fails to offset the
floating-rate on the underlying liability. Because swaps are generally based on a floating-rate index, the
chosen index should correlate closely with the floating-rate on the underlying instrument but may not correlate
exactly. A common type of basis risk on swaps used in conjunction with synthetic fixed-rate structures is often
referred to as “tax risk”, or the risk of a mismatch between the floating-rate on the tax-exempt debt of the
issuer and a swap index such as one based on a taxable index like LIBOR. The correlation between the LIBOR-based
rate and the floating-rate on the debt may change based on changes in tax law or other market events. The degree
of risks should be evaluated in comparison with degree of benefit provided.
Amortization Risk: The risk presented by a mismatch between the term of the swap or the notional principal
amortization schedule of the swap and the term or principal amortization schedule of the underlying liability
of the issuer being hedged by the swap. This risk increases when the amortization schedule of the underlying
liability is uncertain as occurs with the debt of certain forms of issuers like housing agencies.
Bank Facility Rollover Risk: When a swap is used in conjunction with underlying puttable floating-rate debt,
bank facility rollover risk exists if the term of a needed liquidity or credit facility on the debt is shorter
than the term of the swap. In this case the issuer is at risk as to both the availability and the price of
successive bank facilities.
Pricing Risk: The risk that the swap may not be priced appropriately in comparison to the market for comparable
swap transactions. This risk is magnified in the swap market because of the complexity of the structures and the
lack of readily available comparable price information.
To insure standardization, better pricing and greater transparency, swaps should be documented using
the standard forms developed by the International Swap and Derivatives Association, Inc. (“ISDA”). Within that
framework, swap documentation should seek to provide:
Policy 5: Purposes
Credit protection with downgrade and collateralization provisions reflective of the relative credit strength of
the issuing entity in comparison with the swap provider. This comparison should give weight to the prevailing
greater credit strength of public sector entities as compared with private sector financial institutions.
Flexibility for the issuer to terminate a swap at “market” at any time over the term of the corresponding
agreement at its option without necessarily granting the swap provider a similar right.
As market developments evolve and are tested, the reasons for using swaps may change over time. As a
general matter, swaps should be used to achieve one or more of the following purposes:
Policy 6: Savings
Managing the issuer’s exposure to floating and fixed interest rates;
Hedging floating-rate risk with caps, collars, basis swaps and other instruments;
Locking-in fixed-rates in current markets for use at a later date through the use of forward swaps, swaptions,
rate locks, options and forward delivery products;
Reducing the cost of fixed or floating-rate debt through swaps and related products to create “synthetic” fixed
or floating-rate debt;
Accessing the capital markets more rapidly than may be possible with conventional debt instruments;
Managing exposure to the risk of changes in the legal and regulatory treatment of tax-exempt bonds including
changes in federal marginal tax rates and other changes in tax laws that may affect the value of tax-exempt
bonds relative to other investment alternatives;
Managing credit exposure to financial institutions and other entities through the use of offsetting swaps and
other credit management products; and,
Accessing other applications that enable the issuer to increase income, lower costs or strengthen its balance
When a swap is used rather than the issuance of conventional bonds to produce interest rate savings
such as in a forward or advanced refunding context, the level of savings should exceed the three percent (3%) refunding
savings target for a refunding using conventional fixed-rate bonds to compensate for the added risks of using a swap.
If the swap risks have been eliminated or significantly mitigated, the savings threshold could be the same as for
Policy 7: Non-Speculation
While swaps may be used to increase or decrease the amount and type of variable-rate exposure on an
issuer’s balance sheet, swaps should not be entered into for purely speculative purposes such as generating trading
Policy 8: Protection from Counterparty Credit Risk
Unlike conventional bonds, swaps can create a continuing exposure to the creditworthiness of financial
institutions that serve as counterparties. To protect the issuer’s interests in the event of a counterparty credit
problem, issuers should take certain precautions, including:
Policy 9: Competitive Procurement
Use highly-rated counterparties: Differing standards may be employed depending on the term, size and
interest-rate sensitivity of a transaction and types of counterparty used. As a general rule, transactions
should be entered into only with counterparties whose obligations are rated at least double-A by one nationally
recognized rating agency. In cases where the counterparty’s obligations are rated based on a guarantee or
specialized structure to achieve the required credit rating, the issuer should review the nature and legal
framework of the guarantee or structure in order to determine that it is satisfactory.
Collateralization on downgrade: If a counterparty’s credit rating weakens or swap exposure becomes large, the
swap documentation should provide added protection by requiring the posting of collateral. The standard document
to allow for collateral posting is a Credit Support Annex. The Credit Support Annex may allow either
counterparty to post collateral, as appropriate.
Termination provisions: If a counterparty’s credit weakens beyond an acceptable level, even with
collateralization, the swap documentation should provide the issuer with a right to terminate the transaction
prior to its scheduled termination date on preferential terms. The key preferential term is to allow the issuer
to trigger a termination on the side of the bid-offered spread which is most beneficial to the issuer. By using
the favorable side of the bid-offered spread for calculating the termination payment, the issuer may be able to
replace the downgraded swap provider with another suitable counterparty at little or no out-of-pocket cost. This
credit-based termination should be in addition to a normal optional termination that allows the issuer to
terminate a swap prior to its scheduled termination date on a discretionary basis (i.e., regardless of
counterparty credit rating) with the cost of such termination based on a standard market methodology.
Notice of downgrade: An issuer my require swap counterparties to provide notice in the event a credit agency
takes negative action with regard to the counterparty’s credit rating including both an actual downgrading of
the credit rating as well as the publication of a notice by a rating agency that the counterparty’s rating is
in jeopardy of a downgrading (i.e., being placed on Standard & Poor’s Credit Watch or being assigned a negative
outlook by Moody’s or other comparable action by another rating agency).
Diversification: In order to limit counterparty risk, issuers should avoid excessive concentration of exposure
to a single counterparty or guarantor by diversifying counterparty exposure over time. Exposure to any
counterparty should be measured based on the termination value of any swap contracts entered into with the
particular counterparty as well as such other measurements as “reasonable worst case” or “peak exposure”.
Issuers should track termination values at least semi-annually based on a mark-to-market calculation of the
cost of terminating each swap contract given the market conditions on the valuation date. Aggregate swap
termination value for each counterparty should take into account netting of offsetting transactions (i.e.,
fixed-to-floating vs. floating-to-fixed). As a matter of general principle, issuers may require counterparties
to regularly provide mark-to-market valuations of swaps they have entered into and may also seek independent
valuations from third party professionals.
Issuers may choose swap counterparties on either a negotiated or competitive basis. A competitive
selection process is merited if the product is relatively standard, if it can be broken down into standard components,
if two or more providers have proposed a similar product to the issuing entity or if competition will not create market
pricing effects that would be detrimental to the issuing entity’s interests. The award of a competitive bid should be
based on the lowest fixed interest rate to be paid, or the highest fixed interest rate to be received or other similar
objective standard as is appropriate to the transaction.
Policy 10: Negotiated Procurement
Negotiated procurement should be considered under the following circumstances:
Policy 11: Hybrid Procurement
if a swap provider has proposed original or proprietary products or original ideas for applying a specified swap
product to a particular issuer’s needs;
to avoid market pricing effects that would be detrimental to the issuing entity’s interests (for example, if the
size or complexity of the swap has the potential to move market pricing in a detrimental manner); or,
on a discretionary basis in conjunction with other business purposes. To provide safeguards on negotiated
transactions, the issuer should secure outside professional advice to assist in the process of structuring,
documenting and pricing the transaction as well as to provide a written certification that a fair, on-market
price was obtained.
Issuers may employ a hybrid structure to reward unique ideas or special effort by including with a
competitive process a provision reserving a specified percentage of the swap to a swap provider on the condition that
the firm match or improve upon the best bid.
Policy 12: Reporting and Financial Disclosure
The state is committed to full and complete financial disclosure and to cooperating fully with rating
agencies, institutional and individual investors, state departments and agencies, other levels of government and the
general public to share clear, comprehensible and accurate financial information. The state is also committed to
meeting secondary disclosure requirements on a timely and comprehensive basis.
Official statements accompanying debt issues, Comprehensive Annual Financial Reports and continuing
disclosure statements will strive to meet the minimum standards (to the extent applicable to each debt issue)
promulgated by regulatory bodies and professional organizations such as the Securities and Exchange Commission (SEC),
Municipal Securities Rulemaking Board (MSRB), the Governmental Accounting Standards Board (GASB) and follow Generally
Accepted Accounting Principles (GAAP).
Issuers that enter into a swap may also provide a regular report to their governing bodies and the
public on the financial implications of the swaps they have entered into. Such reports may include:
A summary of key terms of the swaps including notional amounts, interest rates, maturity and method of
procurement including any changes to swap agreements since the last reporting period;
The mark-to-market value (termination value) of the applicable swaps as measured by the economic cost or benefit
of terminating outstanding contracts at specified intervals;
The amount of exposure that the issuer has to each specific counterparty as measured by an aggregate
mark-to-market value netted for offsetting transactions;
The credit ratings of each counterparty (or guarantor, if applicable) and any changes in the credit rating since
the last reporting period;
Any collateral posting as a result of swap agreement requirements;
The actual debt-service requirements or the underlying liabilities versus the amount of debt-service that was
projected at the time each swap transaction was entered into; and for swaps used as part of a refunding, the
actual cumulative savings versus the projected savings at the time the swap was entered into;
An updated contingency plan to replace a terminated swap or fund a termination payment in the event that an
outstanding swap is terminated; and,
The status of any liquidity support used in connection with floating-rate bonds associated with a swap including
the remaining term and current fee.