Bond Market Association (BMA) Swap

What Is a Bond Market Association (BMA) Swap?

A Bond Market Association (BMA) swap is a type of swap arrangement in which two parties agree to exchange interest rates on debt obligations, where the floating rate is based on the U.S. SIFMA Municipal Swap Index. One of the parties involved will swap a fixed interest rate for a floating rate, while the other party will swap a floating rate for a fixed rate. The BMA Swap is also referred to as the municipal interest rate swap.

Understanding the Bond Market Association (BMA) Swap

The Bond Market Association (BMA) is a defunct trade association that consisted of brokers, dealers, underwriters, and banks that dealt with debt securities. In 2006, the BMA merged with the Securities Industry Association to form the Securities Industry and Financial Markets Association (SIFMA).

BMA vs. SIFMA

SIFMA is a securities trading group in the U.S. that represents the shared interests of securities firms, banks, and asset management companies. The association created The Securities Industry and Financial Markets Association Municipal Swap Index (formerly called The Bond Market Association/PSA Municipal Swap Index), which is a high-grade market index comprised of hundreds of tax-exempt variable-rate demand obligations (VRDOs).

VRDOs are municipal bonds with floating interest rates. The index is calculated on a weekly basis as the non-weighted average of the weekly rates of various VRDO issues included in the index. The U.S. SIFMA Municipal Swap Index serves as a benchmark floating rate in municipal swap transactions.

When an interest rate swap is entered into by an issuer and a counterparty, such as a dealer, bank, insurance company, or other financial institution, both parties agree to exchange payment streams according to a notional principal amount which is never exchanged but only used to calculate the cash flow payments. In an interest rate swap, two counterparties “swap” fixed interest rate payments for floating-rate payments.

A Bond Market Association (BMA) swap is a municipal interest rate swap that has its floating rate payments based on the SIFMA Index. Because the interest received from VRDOs qualifies for certain exemptions from income tax, the SIFMA rate tends to trend toward a rate that makes the after-tax position of a VRDO holder roughly equivalent to the after-tax position of a holder of non-tax-exempt obligations.

Special Considerations

Just as the London InterBank Offered Rate (LIBOR) is the most common measure of short-term taxable rates, SIFMA is the most common measure of short-term tax-exempt rates. The SIFMA rate generally trades as a fraction of LIBOR, reflecting the income tax benefits associated with municipal bonds.

The SIFMA Index is usually 64%-70% of its taxable equivalent three-month LIBOR. For example, assume the three-month LIBOR is 2.29%, and the SIFMA rate is approximately 67.5% of the three-month LIBOR, the SIFMA rate can be calculated to be 0.675 * 2.29% = 1.55%.

The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing one-week and two-month USD LIBOR after Dec. 31, 2021. All other LIBOR will be discontinued after June 30, 2023.

Example of a BMA Swap

In a municipal interest rate swap, the issuer enters into a swap agreement to convert existing fixed-rate debt synthetically into floating-rate debt, or vice versa. An issuer that has fixed-rate debt but expects prevailing interest rates in the market to decrease and does not want to refinance or refund its existing debt issue, may choose to add variable exposure by entering into a BMA swap.

In this case, the issuer will pay the counterparty the current SIFMA rate, and the counterparty pays the issuer an agreed-upon fixed interest rate. However, the issuer will continue paying its bondholders the regular fixed interest associated with the existing bond issue.

If the floating rate is less than the fixed-rate, then the issuer receives a surplus from the counterparty which can be used to make its interest payments. In effect, the variable rate exposure which the issuer now has reduces its overall interest costs or debt service payments.

The benefits of two parties entering into an interest rate swap arrangement can be significant. Often, each of the two firms involved has a comparative advantage in its fixed or variable interest rate obligation. Consequently, for budgeting or forecasting reasons, a company may wish to enter into a loan with a fixed or variable interest rate in which it does not have a comparative advantage.

The BMA swap can be used to either bet on the direction of interest rates in the municipal market or hedge exposure to U.S. state and local government debt.