This issue snapshot addresses the rules applicable to terminations and deemed terminations of qualified hedges.
IRC Section and Treas. Regulation
Resources (Court Cases, Chief Counsel Advice, Revenue Rulings, Internal Resources)
Hedge. In the context of tax-advantaged bonds, a hedge is a contract entered into primarily to modify the issuer’s risk of interest rate changes with respect to a bond. For example, the contract may be an interest rate swap, an interest rate cap, a futures contract, a forward contract, or an option.
Qualified Hedge. If a hedge is identified as a qualified hedge, payments made or received by the issuer under the hedge relating to bonds of an issue are taken into account when determining the yield on that issue. See Treasury Regulations Section 1.148-4(h)(2) for the requirements for a hedge to be considered a qualified hedge. See also TEB Phase II – Lesson 2 – Advanced Topics in Arbitrage, for a detailed discussion of qualified hedges.
Termination. A termination of a qualified hedge means either an actual termination or a deemed termination of a qualified hedge.
An actual termination of a qualified hedge occurs to the extent the issuer sells, disposes of or otherwise actually terminates all or a portion of the hedge.
A deemed termination of a qualified hedge occurs if:
The hedge ceases to meet the requirements for a qualified hedge,
The issuer makes a modification of the hedge that is material either in kind or in extent resulting in a deemed exchange of the hedge and a realization event under Section 1001, or
The issuer redeems all or a portion of the hedged bonds.
A modification of a qualified hedge that otherwise would result in a deemed termination does not result in a deemed termination if the modified hedge is re-tested for qualification as a qualified hedge as of the date of the modification, the modified hedge meets the requirements for a qualified hedge as of such date, and the modified hedge is treated as a qualified hedge prospectively in determining the yield on the hedged bonds.
Continuation of Certain Qualified Hedges in Refundings. If hedged bonds are redeemed using proceeds of a refunding issue, the qualified hedge for the refunded bonds is not actually terminated, and the hedge meets the requirements for a qualified hedge for the refunding bonds as of the issue date of the refunding bonds, then no termination of the hedge occurs and the hedge instead is treated as a qualified hedge for the refunding bonds. For these purposes, the fact that the hedge is off-market with respect to the refunding bonds as of the issue date of the refunding bonds is disregarded. See Treasury Regulations Section 1.148-4(h)(3)(iv)(D).
Termination Payments. Termination payments are payments made in conjunction with the termination of a hedge or a payment deemed made or received for a deemed termination. The amount of a termination payment is generally based on the fair market value of the hedge on the date of termination, and represents the amount by which an outstanding swap is “off market”.
Assuming no transaction costs, the termination payment would allow the non-terminating party to replace the swap with an identical contract and thus sustain no economic disadvantage from the termination.
Valuation of a Hedge. The value of a hedge depends on a variety of factors, including the market for similar contracts at the time the hedge is valued.
For example, if a floating-to-fixed interest rate swap with a fixed payer rate of 6 percent and a variable payer rate of SIFMA is being valued for a termination at a time when the market for swaps with similar terms indicates a fixed payer rate of 5 percent, the fixed payer would owe the variable payer a termination payment and the amount of the termination payment would be based on the lower fixed rate in the prevailing market.
Under standard ISDA documentation, there are multiple methods to calculate the amount of a termination payment (e.g., Market Quotation, Loss) and the different methods do not always produce identical results. Actual termination payment amounts (or the methodology for calculating) may be negotiated between the issuer and the hedge provider.
Allocation of Termination Payments. A payment made or received by an issuer to terminate a qualified hedge, or a payment deemed made or received for a deemed termination, is treated as a payment made or received on the hedged bonds.
Upon an actual termination or a deemed termination of a qualified hedge, the amount that an issuer may treat as a termination payment is the fair market value of the qualified hedge on its termination date, based on all of the facts and circumstances.
Since no payment is made or received in the case of a deemed termination, issuers must determine the fair market value of the hedge at the time of the deemed termination, and use that as a basis for computing the amount to be treated as paid or received.
Bonds Not Redeemed. If the hedged bonds are not redeemed, a termination payment is reasonably allocated to the remaining periods originally covered by the terminated hedge in a manner that reflects the economic substance of the hedge.
For an issue that is a variable yield issue after termination, an amount must be allocated to each date on which the hedge provider’s payment would have been made had the hedge not been terminated. The amounts allocated to each date must bear the same ratio to the notional principal amount that would have been used to compute the hedge provider’s payment on that date, and the sum of the present values of those amounts must equal the present value of the termination payment. Present value is computed as of the termination date, using the yield on the hedged bonds without regard to the termination payment. For an issue that is a fixed yield issue after termination, the termination payment is taken into account as a single payment on the date it is paid. See Treasury Regulations Section 1.148-4(h)(3)(iv)(H).
Bonds are Redeemed. If the hedged bonds are redeemed, the fair market value of the hedge on the redemption date is treated as a termination payment (made or received). Any actual or deemed termination payment received by the issuer reduces, but not below zero, the interest payments made by the issuer on the hedged bonds in the computation period ending on the termination date. The remainder of the payment, if any, is reasonably allocated over the bond years in the immediately preceding computation period or periods to the extent necessary to eliminate the excess. See Treasury Regulations Section 1.148-4(h)(3)(iv)(F).
Termination of a Superintegrated Qualified Hedge. If a qualified hedge that is superintegrated is terminated, special rules apply that may result in:
Treatment of the termination payment differently than a treatment of a termination payment for a qualified hedge that is not superintegrated, or
The inapplicability of fixed yield treatment (superintegration) for purposes of arbitrage rebate (but not yield restriction) rules if the hedge is terminated within 5 years after the issue date of the issue of which the hedged bonds are a part (i.e., the hedged bonds are treated as variable yield bonds from the issue date).
However, the special rules for terminations of superintegrated qualified hedges do not apply to a termination if, based on the facts and circumstances (taking into account both the termination and any qualified hedge that immediately replaces the terminated hedge) there is no change in yield on the hedged bonds. See Treasury Regulations Section 1.148-4(h)(4)(iii)(C).
When a superintegrated hedge is modified the foregoing rule takes precedence, even in circumstances when a qualified hedge otherwise meets the requirements for certain modifications when the hedge remains qualified under Treasury Regulations Section 1.148-4(h)(3)(iv)(C).
Example: A termination would be disregarded if an issuer terminated a swap with a provider and replaced it with a substantially identical swap with a different provider. This might occur if the original swap provider’s credit was impaired.
An anticipatory hedge is a hedge entered into prior to the issue date of the hedged bonds. This includes forward starting swaps, with mandatory or optional redemption features.
To be considered a qualified hedge, an anticipatory hedge must satisfy one of 2 sets of requirements. The applicable set of requirements depends on the issuer’s reasonable expectations on the date the anticipatory hedge is entered into with regard to whether the contract will be:
Closed (terminated) substantially contemporaneously with the issue date of the hedged bond, or
Not closed substantially contemporaneously with the issue date of the hedged bond.
See Treasury Regulations Sections 1.148-4(h)(5)(i)-(iii).
Hedges Expected to Close on Issue Date. If the issuer reasonably expects to terminate the contract substantially contemporaneously with the issue date of the hedged bonds, the amount paid or received by the issuer to terminate the contract is treated as an adjustment to the issue price of the hedged bonds. It is also treated as an adjustment to the sale proceeds of the hedged bonds for purposes of Section 148.
The amounts paid or received, or deemed paid or received, before the issue date are treated as paid or received on the issue date. Such amounts are equal to the future value of the payment or receipt on that date. Future value is calculated using the yield on the hedged bonds, without taking into account amounts paid or received on the contract. See Treasury Regulations Section 1.148-4(h)(5)(ii).
Hedges Not Expected to Close on Issue Date. If the issuer does not reasonably expect to terminate the contract substantially contemporaneously with the issue date of the hedged bonds, no payments made by the issuer before the issue date are taken into account.
However, if the contract is terminated in connection with the issuance of the hedged bonds, the amount paid or received, or deemed to be paid or received, is treated as an adjustment to the issue price of the hedged bonds. It is also treated as an adjustment to the sale proceeds of the hedged bonds for purposes of Section 148. See Treasury Regulations Section 1.148-4(h)(5)(iii).
Identification of Anticipatory Hedge. In addition to information otherwise required for a qualified hedge, the identification required for an anticipatory hedge generally must specify the following with respect to the hedged bonds:
- Reasonably expected governmental purpose,
- Issue price,
- Issue date,
- The manner in which interest is reasonably expected to be computed, and
- Whether the issuer reasonably expects to close the hedge substantially contemporaneously with the issue date of the hedged bonds.
See Treasury Regulations Section 1.148-4(h)(5)(iv).
Issue Indicators or Audit Tips
Following are sample IDR requests which may be used in conjunction with an examination of bonds with a qualified hedge:
A. Documents Requested
- Arbitrage/Tax Certificate
- Form 8038/8038-G
- ISDA Master Agreement
- ISDA Swap Confirmation
- Bond Yield Calculation(s)
- All documents pertaining to the hedge identified on Form 8038 / 8038-G filed for bonds issued on xx/xx/20xx and any other hedges entered into related to the bonds (the “Hedge”), including the hedge provider’s certification per Treasury Regulation Section 1.148-4(h)(2)(viii)(B).
- Rebate Report for the computation date related to the first rebate installment payment made (or required to be made). In most instances, this will be the calculation at approximately the 5th anniversary date of the bonds.
- Records showing all amounts taken into account in computing the bond yield in the above referenced Rebate Report (principal, interest, qualified guarantee, hedge payments/receipts).
- Records showing any payments related to the Hedge that were not included in item 6 above. If there were no other payments (i.e., that all payments and/or receipts related to the Hedge were taken into account in computing the yield on the bonds), please include a statement as such.
- If you used Bloomberg to price the Swap and the information is still available, please provide copies of the Bloomberg screen that will show the data used to price the swap.
- In connection with the Hedge, were all amounts that were included in the computation of the yield on the bonds:
- reasonably allocable to the modification of risk of interest rate changes,
- reasonably allocable to the Hedge provider’s overhead, or
- for the actual or deemed termination of the hedge?
- A hedge is treated as terminated if:
- the hedge was modified.
- certain assignments or modifications of the hedge occur, or
- the hedge ceases to be a qualified hedge,
- the hedged bonds are redeemed,
- the issuer acquires an offsetting hedge,
- the hedge is sold or otherwise disposed of,
- certain assignments or modifications of the hedge occur, or
- the hedge was modified
Did any of these events take place? If so, please describe and include all documents and records relating to the termination. If a termination payment was made or received, please describe in detail how the amount of the payment was computed.