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Interest Rate Cap Case Study - Mercer University
In 2003, Mercer University issued $30 million of revenue bonds to finance
a variety of projects including the construction of a University Center (an
intramural athletic facility with food service, meeting rooms and offices)
and renovations to the Campus Bookstore, Student Center Cafeteria, and
various other buildings on the University's campus. Seeking to take
advantage of the lower interest rates typically found on the shorter
end of the yield curve, the University decided to issue the bonds in a
variable rate mode with a 'Aa3' letter of credit provided by Branch
Banking & Trust Company.
The bonds represented the first variable rate transaction for the
University. George K. Baum & Company worked with the University in
selecting the most appropriate derivative product to hedge the interest
rate risk associated with a variable rate financing. Mercer came to the
conclusion that purchasing an interest rate cap would be the best solution
as it would allow the University to benefit from the low interest rate
market prevalent at the time while setting a defined limit to their
exposure to any increases in variable rates.
To minimize the University's exposure to counterparty risk, George K.
Baum & Company, acting as the bidding agent, solicited bids from a range of
interest rate cap providers with minimum credit ratings of 'Aa3/AA-' (with
some providers in the 'AAA' category). After a highly competitive bid
process, the University purchased a 3 year 6% BMA based interest rate cap
from an 'Aa3' rated institution at a one time cost of $81,900.
Purchasing an interest rate cap proved to be the correct decision for
the University. One alternative the University considered was to enter
into an interest rate swap which would "fix" the interest on the bonds for
a 3 year period. At the time, entering into a 3 year BMA based interest
rate swap would have "fixed" the rate on the bonds at 2.30%. To date, the
average interest rate on the University's variable rate bonds has been
1.78%, an average difference of 50 basis points. The savings of 50 basis
points on $30 million for three years amounts to approximately $450,000
in interest cost savings.
The interest rate cap on the bonds expired in early 2006. The University
has since requested that George K. Baum & Company assist them in bidding
another interest rate cap which will cover not only the Series 2003 bonds,
but a new issuance of bonds set to close in the summer of 2006 as well.
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