Variable Rate Debt

Variable Rate Debt Variable rate debt is a useful tool for the State Bond Commission to utilize to diversify its debt portfolio, reduce interest costs, provide interim financing for capital projects and improve the match of assets to liabilities. The State Bond Commission will use the guidelines set forth below to evaluate potential uses of variable rate debt and/or derivatives in managing the State’s overall interest rate risk profile. Each transaction will be evaluated and analyzed for the long-term implications of such agreements for the State’s finances and will be structured to complement the overall asset/liability position of the State. When recommending the use of variable rate debt and/or derivatives, the State Bond Commission will examine, among other things, the cost of borrowing, historical interest rate trends, risk- reward trade-offs, variable rate debt capacity, and opportunities to refund associated debt obligations. The Commission must approve all state supported debt and derivative transactions. A. Variable Rate Debt Guidelines Permitted Instruments – The State may use at its discretion variable rate instruments and interest rate swaps or similar agreements which result in the State effectively paying interest at a rate or rates which vary from time to time. Decisions about which mode of variable rate debt to incur at any point in time will be based on the relative costs, benefits and risks to the State. Factors to consider will include: 1. Cost and availability of liquidity facilities and/or letters of credit/bond insurance; 2. Cost to implement and manage the program on an ongoing basis; 3. Ability to convert to a different interest rate mode or redemption flexibility; 4. Trading performance of underlying variable rate securities; Page 6 of 38 5. Demand in the market. B. Budgeting for Variable Rate Debt The State Treasury Bond Director and the Deputy Treasurer will use conservative budgeting practices in association with its variable rate debt so that a cushion, which may change from year to year depending upon budget conditions as well as other factors enumerated in this policy, is built into the budget to guard against an unexpected increase in the variable interest rates. C. Evaluation and Management of Risks for Variable Rate Debt The State recognizes that variable rate exposure carries inherent risks not present in traditional fixed rate transactions. The following areas of potential risk shall be included in the evaluation of the proposed transaction and monitored on an ongoing basis after issuance to determine if the variable rate debt is still achieving its objectives: 1. Interest Rate Risk – the risk that the State will be exposed to rising interest rates. This risk can be mitigated through conservative budgeting practices, matching variable rate liabilities with offsetting investment assets that will produce higher income in rising interest rate environments or by utilizing derivatives; 2. Liquidity Risk – arises when a variable rate borrowing has a demand feature that allows bondholders to tender their bonds or notes back to the issuer at their option, or upon occurrence of certain designated events. If the State has secured liquidity through a bank agreement, then the terms of the bank agreement could require the State to repay the bank in a relatively short period (the “term-out”). If the State has provided self liquidity, then the risk would be the possibility of drawing against current funds; 3. Rollover/Renewal Risk – arises when the variable rate borrowing has a demand feature and the liquidity support does not extend for the life of the bonds. In this situation, the State may lose access to the liquidity facility and face the need to either identify an alternative provider, at a potentially higher costs, or convert bonds to a payment mode that does not have a demand feature, potentially on relatively short notice and at a potentially higher rate of interest; 4. Remarketing/Auction Failure Risk – arises when a failure occurs in the ongoing remarketing or the periodic auctions. In case of Variable Rate Demand Bonds (VRDBs) this may result in replacing a remarketing agent or a put on the bonds to the liquidity provider, and ultimately, to the State. In the case of Auction Rate Notes (ARNs), this may result in paying the maximum rate or replacing the auction Page 7 of 38 agent/broker-dealer; and 5. Tax Risk – the risk of potential changes to the Federal and/or State income tax laws, regulation, etc. affecting interest payments on variable rate debt obligations. This risk in inherent in any issuance of VRDBs or ARNs since the interest rates are reset periodically at market levels and are not fixed at the time of issuance.