i.4.2.4 Decision #4 – Select an interest rate type

i.4.2.4 Decision #4 – Select an interest rate type

The public agency must also choose an interest rate type. For municipal debt obligations there are two principal interest rate modes: fixed and variable. See Chapter 2 – Debt Structures – What Factors Drive Structuring Decisions? Most public debt is issued as fixed rate debt. Some public agencies, particularly those with large cash reserves, may benefit from issuing variable rate debt.

The interest payment on a fixed rate obligation is calculated using a single rate set at the time the debt is negotiated. The rate in a variable rate obligation is set based on market demand at the time the debt is repriced or rolled over.

Variable rate debt products tend to have lower initial interest rates than fixed rate debt products. The market expresses this relationship of costs over time through a “yield curve,” which is a representation of interest rates at different moments in time. Generally, the farther one goes out on the yield curve (i.e., the longer the maturity of the debt), the higher the interest rate. This reflects the exchange of risk between the issuer of debt and the investor: the longer the maturity, the more the public agency has transferred to the investor the risk that interest rates will increase and purchasing power will be eroded, and for tax exempt debt, the risk that tax laws will change. Figure i-2 offers an example of a yield curve.

The decision to use a fixed or variable-rate hinges on two basic questions:

  1. Do the potential interest rate savings of variable interest rate products outweigh the financial burden that substantially increased interest rates would impose on the public agency?

  2. Can the public agency bear the interest rate and market risk associated with variable rate debt?

Figure i-2

SAMPLE YIELD CURVE, AAA ISSUES
Figure

Variable rate options may provide advantages over current fixed rates, but they bear certain risks, namely, volatility risk. If interest rates increase substantially, then the overall interest cost on the debt product can become a significant burden to the public agency.