Roberts Risk

Add a new category of risk to the checklist municipal issuers need to assess before entering into interest-rate swaps:  Roberts Risk.

For the next year, swap counterparties on both sides of municipal transactions will have to try and read the Supreme Court tea leaves to figure out whether the nearly-universal system of state income tax exemptions will be thrown out. [free article]  The issue is most acute in high-tax, wealthy states like California and New York, where the state tax exemption has a material impact on a bond's taxable-equivalent yield, and thus allows those states' bonds to trade at a premium.  In The Bond Buyer today, Municipal Market Data pegs the market yield for one-year paper in California at 3.58%.  The next-lowest yield in the region is 3.65%. [subscription article]

Roberts Risk is a form of tax risk, which, in turn, is a particular species of basis risk -- the chance that an issuers' receipts from its swap counterparty won't match the amounts it owes to investors in the underlying bonds.  In its simplest implication, if that premium goes away, issuers who created "synthetic fixed-rate" bonds by selling variable-rate debt and then entering into a floating-to-fixed interest-rate swap could find themselves having to contribute additional cash to the deals almost immediately, because the amount they'd collect from their counterparty for the floating leg of the swap -- whether tied to the LIBOR or TBMA indicies -- would not change, even as the market re-valued the underlying bonds and demanded additional yield.

The changes are unlikely to be disastrous for most issuers, but the additional cost would pinch -- and the market should brace itself for a flurry of bad press as local elected officials wring their hands over the hits to their budgets.  At some level, this is unavoidable -- swaps involve risks, and issuers were willing to assume them because the long-term rates they offered were far more competitive than alternative cash-market financing vehicles.  But it's fair to say that very few issuers considered this particular risk when entering into a synthetic fixed-rate transaction, and that's a worry.  

"Tax risk" is most-often defined in terms of its most catastrophic instance:  Namely, the chance that Congress would repeal municipal bonds' tax-exemption, or replace the income tax with an alternative funding mechanism that would eliminate munis' favored treatment.  Issuers were willing to take that risk because they thought it to be extremely unlikely, in part because of their ability to lobby members of Congress to avoid that outcome. 

But while the public sector is no doubt already preparing its friend-of-the-court briefs, the Supreme Court can have a mind of its own.  So far, the market seems to have accepted legal observers' opinion that the court is likely to uphold the exemptions, and no real changes in trading value have been seen.  But if oral arguments go badly, that could change -- issuers involved in swaps would be among the first to feel the impact.