---
title: "Issuers BEWARE: Tax risk is NOT in LIBOR Swaps! | Intuitive Analytics"
description: Tax risk is a concept that is commonly misunderstood. This article makes it clear that tax risk resides in VRDBs, not in LIBOR swaps.
image: https://www.intuitive-analytics.com/hs-fs/file-15745526-png/images/no_confusion_graphic_small.png
---

# Issuers BEWARE: Tax risk is NOT in LIBOR Swaps!

 Posted by Peter Orr on Oct 13, 2010

The other day I was perusing the swap notes in the financial statements of a big city I won’t name. In it I found a statement in the section on swaps:

“(6) *Tax Risk*. The swap exposes the City to tax risk or a permanent mismatch (shortfall) between the floating rate received on the swap and the variable rate paid on the underlying variable-rate bonds due to tax law changes such that the federal or state tax exemption of municipal debt is eliminated or its value reduced.” 

I couldn’t disagree more and I’m not just being disagreeable – this is flat out wrong and it’s screwing up the issuer’s financials and potentially exposing them to legal liability. The City’s LIBOR swaps absolutely do NOT expose the City to *any* new tax risk. The tax risk sits in the VRDBs irrespective of whether the interest rate risk is hedged with a LIBOR swap or not. Here’s an easy example that proves it…

Say there’s a tax-exempt variable rate demand bond (VRDB)![No confusion](https://www.intuitive-analytics.com/hs-fs/file-15745526-png/images/no_confusion_graphic_small.png)  
 trading at 3% with zero support costs. Let’s further assume LIBOR is at 5% which means this VRDB is trading at 60% of LIBOR. If we look at an environment where the US moves to a value added tax and the preference for tax-exempt income goes to zero, ceteris paribus (my Latin teacher would be so proud), those VRDBs will start trading at 100% of LIBOR or 5%. This is a **2% increase in cost**. 

Now, let’s say these same VRDBs had a 60% LIBOR swap in place with the issuer paying 4% fixed. Before the value added tax change, the issuer was paying a net 4% (3% VRDB rate minus 3% floating leg of swap plus 4% fixed rate). After the event, the issuer pays 6% (5% VRDB rate minus 3% floating leg of swap plus 4% fixed rate), a **2% increase in cost**.

Notice that each situation both with *and* without the swap show a **2% increase in cost**! So can someone please explain how the “swap exposes the City” to something called “tax risk”? Of course it doesn’t. The VRDBs have the risk; the swap is *utterly irrelevant*.  ****

If there’s going to be a note on tax risk, the revised and corrected version should be:

“(6) *Tax Risk*. The interest paid on variable-rate bonds issued by the City is impacted, in part, by investor preference for income that is exempt from federal or state tax. Therefore a change in tax law that eliminates or reduces the value of this exemption may increase the interest expense paid by the City on these bonds.” 

 Frankly what these *financials* succeed in accomplishing is exposing the City to legal liability due to poor and inadequate disclosure. As we can see, the reality is that *all* VRDBs contain “tax risk.” So the fact that this disclosure is limited to only swapped VRDBs is flat out wrong and actually understates the possible impact of a tax law change because it ignores the City’s other bonds.  With the [SEC making noise about municipal disclosure](http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aX4ake_Tn6OY) quality, auditors better start understanding what they’re doing and issuer’s must beware of this type of inaccuracy. 

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