Interest Rate Hedging Overview January 29, 2009 Hans Hurdle Domenic D’Ginto Managing Director, Senior Vice President Managing Director, Vice President PNC Capital Markets PNC Capital Markets
Background of Speakers Hans Hurdle � Education: Swarthmore College � � Certifications: Certified Public Accountant (CPA) � � Over 15 years of commercial/investment banking experience � Structured over $2.5 billion in interest rate hedges over the past 10 years � Underwrote/placed and remarketed over $2.0 billion of taxable and tax-exempt bonds � Provided financial advisory services on numerous project financings � Credit underwrote over $1 billion of municipal credit with a focus on municipal revenue authorities and special purpose entities Dom D’Ginto � Education: Villanova, B.S. Finance � Villanova, MBA � � Certifications: Chartered Financial Analyst (CFA) � � Joined PNC Bank in 1987 as a Corporate Banking Relationship Manager in the Philadelphia Region � Originated the marketing effort for PNC’s Derivatives Trading Group in Eastern Pennsylvania, New Jersey and Delaware � Executed a variety of interest rate and equity hedges for corporate and high net worth PNC clients � President of the CFA Society of Philadelphia 1 1
Table of Contents Sections I Current and Historical Interest Rate Environment II Taxable and Tax-Exempt Interest Rate Swaps, Caps and Collars III Risks Associated with Interest Rate Hedging IV Hedging Documentation V Case Study One: Manufacturing IRB VI Case Study Two: Advanced Refunding of a Fixed Rate Bond VII Case Study Three: Conduit or Permanent Taxable Financings VIII Contact Information 2
Current and Historical Interest Rate Environment 3
Flat vs. Steep Yield Curve LIBOR Swap Curve 2/22/07 LIBOR Swap Curve 8/1/08 Today’s LIBOR Swap Curve 4
Credit Spreads: BBB vs. AAA General Obligation Curves 1/28/2007 Yield Curve BBB GO Spread = 32 Bps AAA GO 1/28/2009 Yield Curve BBB Spread = 357 Bps GO AAA AAA GO GO 5
Which Instruments Trade at the Short End of the Yield Curve? Variable Rate Demand Bonds (VRDBs) � Long dated credit enhanced municipal securities which trade on a short term basis. � VRDBs generally trade in a weekly mode: they can be put with 7 days notice. Weekly bonds trade off of the BMA and LIBOR indices. There is also an active daily market. � Sold to third party investors which include money market funds, corporations and high net worth individuals. � The Borrower’s effective interest rate equals the BMA or LIBOR derived coupon plus the credit enhancement fee plus other expenses. Note BMA and LIBOR are floating indices. For tax-exempt VRDBs, the floating rate has historically been the Securities Industry and Financial Markets Association (SIFMA) index plus/minus zero to ten basis points depending on whether the bonds are subject to AMT or not and also depending on the relative strength of the credit enhancement provider. During the recent financial crisis, most municipal credit enhancement providers and some bank LOCs weren’t marketable or required a large risk premium for investors. 6
Why is the SIFMA Index generally lower than LIBOR? � Investors are not taxed on the interest income they receive from tax-exempt bonds. � If the marginal tax rate is 33% then an investor will be willing to accept: (taxable rate) X (1 – tax rate) = 67% of the taxable rate. 7
LIBOR, SIFMA, and 67% of LIBOR (15-Year History) Rate (%) 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 12/21/1994 06/21/1995 12/21/1995 06/21/1996 12/21/1996 06/21/1997 12/21/1997 06/21/1998 12/21/1998 LIBOR vs. SIFMA since 12/21/1994 06/21/1999 12/21/1999 06/21/2000 12/21/2000 8 06/21/2001 12/21/2001 06/21/2002 12/21/2002 06/21/2003 12/21/2003 06/21/2004 67% of LIBOR 1M LIBOR SIFMA 12/21/2004 06/21/2005 12/21/2005 06/21/2006 12/21/2006 06/21/2007 12/21/2007 06/21/2008 12/21/2008
LIBOR, SIFMA, and 67% of LIBOR (Since June 2008) 9.00 LIBOR 8.00 SIFMA 7.00 67% of LIBOR 6.00 5.00 Rate (%) 4.00 3.00 2.00 1.00 0.00 06/06/2008 06/20/2008 07/04/2008 07/18/2008 08/01/2008 08/15/2008 08/29/2008 09/12/2008 09/26/2008 10/10/2008 10/24/2008 11/07/2008 11/21/2008 12/05/2008 12/19/2008 01/02/2009 01/16/2009 9
U.S. Treasury vs. LIBOR Yield Curve LIBOR Swap - 9/26/08 Treasury - 9/26/08 LIBOR Swap – 1/29/09 291 bps on 9/26/08 Treasury – 1/29/09 ������������������ �������� 99 bps on 1/29/09 ��������������������� ������������� 10
Historical Environment – 5 Year Swap Rates 15 Year History 2.35% (5 year Swap Rate as of 1/28/2009) History Since 11/30/07 11
Historical Rate Environment – 10 Year Treasuries � 10 Year Treasuries have historically been the permanent taxable financing benchmark 10-Year History 2.68% (10 year Treasury as of 1/28/2009) History Since 11/30/2007 12
Historical Environment – 10 Year Swap Rates 15 Year History 2.90% (10 year Swap Rate as of 1/28/2009) History Since 11/30/2007 13
Historical Spread Analysis (10-Yr Treasury vs. 10-Yr Swap) Spread (Bps) 100 120 140 160 20 40 60 80 0 02/01/1999 05/01/1999 08/01/1999 11/01/1999 02/01/2000 05/01/2000 08/01/2000 11/01/2000 02/01/2001 05/01/2001 08/01/2001 11/01/2001 02/01/2002 05/01/2002 ������������������������������� ������������������������������ ������������������������������ 08/01/2002 11/01/2002 02/01/2003 05/01/2003 14 08/01/2003 11/01/2003 02/01/2004 05/01/2004 08/01/2004 11/01/2004 02/01/2005 05/01/2005 08/01/2005 11/01/2005 02/01/2006 05/01/2006 08/01/2006 11/01/2006 02/01/2007 05/01/2007 08/01/2007 11/01/2007 02/01/2008 05/01/2008 08/01/2008 11/01/2008
Historical Environment – 15 Year Swap Rates 15 Year History 3.21% (15 year Swap Rate as of 1/28/2009) History Since 11/30/2007 15
Municipal Interest Rate Indices � SIFMA Index (Weekly Variable Interest Rates) vs. Bond Buyer 25 Index (Fixed Interest Rates) � The BB25 is an estimation of the yield that would be offered on 30-year revenue bonds. The 25 issuers used for this index cover a broad range of types of issues (transportation, housing, hospital, water and sewer, pollution control, etc.) and vary in ratings from Moody’s“Baal” to “Aaa” and Standard and Poor’s “A” to “AAA,” for a composite rating of Moody’s “A1” or Standard and Poor’s “A+.” SIFMA vs. Bond Buyer 25 9.00 Average Spread: 265 bps BB25 8.00 Max Spread: 554 bps Min Spread: 23 bps 7.00 Current Spread: 531 bps 6.00 5.00 4.00 SIFMA 3.00 2.00 1.00 0.00 02/11/1994 08/11/1994 02/11/1995 08/11/1995 02/11/1996 08/11/1996 02/11/1997 08/11/1997 02/11/1998 08/11/1998 02/11/1999 08/11/1999 02/11/2000 08/11/2000 02/11/2001 08/11/2001 02/11/2002 08/11/2002 02/11/2003 08/11/2003 02/11/2004 08/11/2004 02/11/2005 08/11/2005 02/11/2006 08/11/2006 02/11/2007 08/11/2007 02/11/2008 08/11/2008 16
2-Year History of the Bond Buyer 25 Index (Since 1/5/2007) Rate (%) 4.00 4.50 5.00 5.50 6.00 6.50 7.00 01/05/2007 02/05/2007 03/05/2007 04/05/2007 05/05/2007 06/05/2007 07/05/2007 08/05/2007 09/05/2007 Bond Buyer 25 Since 1/5/2007 10/05/2007 11/05/2007 17 12/05/2007 01/05/2008 02/05/2008 03/05/2008 04/05/2008 05/05/2008 2.10% ������� 06/05/2008 07/05/2008 08/05/2008 09/05/2008 10/05/2008 11/05/2008 12/05/2008 01/05/2009
Taxable and Tax Exempt Interest Rate Swaps, Caps and Collars 18
What Is Interest Rate Hedging? The use of interest rate swaps and other tools to manage cash flow volatility (risk) tied to changes in interest rates. 19
The Benefits of Hedging � Hedging allows you to decide when you want to fix rates. � Hedging allows you to decide the term (up to 40 years) of the fixed rate. � Hedging allows you to decide how much of the debt has fixed rates. � Hedging allows you to lock in rates in advance. 20
Key Facts � Swaps are commitments to pay or receive future cash flows. � Swaps have a value. � The value can be positive or negative. � The value at maturity is zero. � Traditional fixed rate loans or bonds can have only a negative value. � Values are derived from hypothetical cash flows based on a notional amounts. � They can be valued like any other series of cash flows. Hedges are also called derivatives because their value is derived from Hedges are also called derivatives because their value is derived from another "underlying" financial security. another "underlying" financial security. 21
Basic Floating-to-Fixed Swap �� ������� Counterparty Borrower ������������� ���������������� A Swap is a separate transaction ������ The bond/loan is unaffected by hedging Bondholder / Lender 22
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