Refunding Opportunities and Strategies
Sean E. Ekiert, CFA
Mid- Atlantic Public Finance
804-225-1197
[email protected]
December 2014
WHAT IS A REFUNDING?
• A refunding occurs when the proceeds of a new debt issue are used to
retired previously issued debt
• The prior debt is considered “defeased”, and is no longer an obligation on the
books of the issuer
• Purposes of Refundings may include:
– Savings through lower interest rates
–
“Net Present Value Savings” available only on callable bonds
– Restructure payments to provide budgetary relief
– Change the mode or structure of a bond
–
–
Convert from floating rate to fixed rate
Extend the maturity
– Change bond covenants or other contractual terms:
–
–
Rate covenant and additional bonds test
Required reserve funds
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TYPES OF REFUNDINGS
Advance Refunding
Current Refunding
•
•
•
New debt is issued on the date
that the old debt will be
redeemed, or not more than 90
days prior to the redemption of
the old debt.
A refunding escrow may be
necessary for a short period
(<90 days) or may not be
needed at all.
Tax regulations do not restrict
the number of times a taxexempt bond issue may be
currently refunded.
•
New debt is issued more than
90 days prior to the redemption
date of the old debt.
•
A refunding escrow is required
and may be in place for an
extended period (years).
•
Generally, tax-exempt bonds
issued for government
purposes may be advance
refunded with new tax-exempt
bonds only once.
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TYPES OF REFUNDINGS
Current Refunding
2005
2015
•
•
New debt issued with 10-year
optional redemption provision
Current Refunding Bonds
Issued
2015 Refunding Bonds are eligible
for Advance Refunding In the Future
Advance Refunding
2005
•
New debt issued with 10-year
optional redemption provision
2012
•
Advance refunding bonds
issued with 10-year optional
redemption. Escrow
established to redeem
original bonds
2015
•
Escrow retires old bonds
2022
•
2012 Refunding Bonds Eligible
for Current Refunding
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WHY REFUNDINGS OCCUR
MOVING DOWN THE YIELD CURVE
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WHY REFUNDINGS OCCUR
CHANGES IN MARKET CONDITIONS
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WHY REFUNDINGS OCCUR
CURRENT MARKET = NEAR RECORD LOW INTEREST RATES
Current
Average
High
Low
2.15%
3.64%
6.10%
1.47%
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WHEN TO ISSUE REFUNDING BONDS
SAVINGS CRITERIA
• Minimum Savings Target - net present value (“NPV”) savings as a percentage
of refunded bonds (common target of 3% to 5%), or absolute dollar amount:
– Present Value Savings = $1 Million
– Par Amount Refunded = $20 Million
– Present Value Savings Percentage = 5.0%
• Sliding Minimum Savings Target - higher savings target for longer maturities
• Opportunity Cost Test - evaluation of potential additional savings from
improvement of market conditions
• Savings Efficiency - evaluates impact of negative arbitrage
• Theoretical Option Valuation - evaluates savings against theoretical value of
call option
• Budgetary Needs
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NEGATIVE ARBITRAGE
In an Advance Refunding, the refunding escrow is invested in U.S. Treasuries until the
redemption date of the old bonds. Yields currently available on escrow securities are
below the yield permitted by tax rules, preventing issuers from achieving greater savings
on advance refundings.
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STRATEGIES TO ADDRESS NEGATIVE ARBITRAGE
• Open Market Escrow Securities - Purchasing a portfolio of Treasuries or similar securities through a
competitive bidding process may improve the yield on the escrow slightly.
• Wait until closer to the call date to issue the refunding bonds.
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WHY REFUNDINGS OCCUR
CURRENT MARKET = NEAR RECORD LOW INTEREST RATES
Current
Average
High
Low
2.15%
3.64%
6.10%
1.47%
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REALIZING REFUNDING SAVINGS
Level Savings
• Annual debt service is
reduced by an equal amount
in each year remaining until
final maturity
Upfront Savings Savings
• Savings realized in earliest
year(s) with debt service in
remaining years unchanged
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REALIZING REFUNDING SAVINGS
Targeted Savings
• Savings realized in specific
year(s) to address specific
circumstances
Deferred Savings
• Annual Debt service payments
remain unchanged, but final
maturity is shortened
• Common for refunding of 40year USDA Rural
Development Loans
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TYPICAL METHODS OF SALE
• Public Bond Sale
–
–
–
Requires credit rating (s), preparation of Official Statement
Typically produces lowest cost of funds/greatest savings for highly rated (“Aaa/Aa”)
bonds, longer maturities, and larger ($20 million+) issues
Negotiated sale generally offers greatest flexibility/customization
• Virginia Resources Authority , Virginia Public School Authority or other
Pooled Financing Program
–
–
–
No local issuer credit rating or Official Statement required
Cost of funds based on program ratings (VRA = “Aaa/Aa2”; VPSA = “Aa1”) plus
administrative fees
Timing of sale determined by program issuance schedule
• Bank Placement
–
–
–
–
a.k.a. “Private Placement” or “Direct Purchase”
No credit rating or Official Statement required, although banks will review credit
quality/financial condition
Final maturity often limited to 15 (maybe 20) years
“Bank Qualified” issues less than $10 million may receive pricing advantage
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METHODS OF SALE – OTHER VARIATIONS
• Taxable Refunding Bonds
–
–
Bonds that cannot be refunded with tax-exempt bonds because they are not
currently callable and have been advance refunded previously (or are private
activity bonds not eligible for advance refunding at all) may be refunded with
TAXABLE bonds.
Although Build America Bonds and similar ARRA programs have generally ended,
investor demand for taxable municipal bonds created by these programs remains.
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TAXABLE MUNICIPAL BONDS
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BUILD AMERICA BONDS
• Build America Bonds (“BABs”), including Recovery Zone Economic Development
Bonds (“RZEDBs”), were issued by many state and local governments in 2009
and 2010 pursuant to the American Recovery and Reinvestment Act of 2009.
• Interest on BABs is taxable for investors, and a portion of the interest paid by the
issuer is eligible for a subsidy from the U.S. Treasury.
• The original subsidy levels of 35% for BABs and 45% for RZEDBs have been
reduced since March 1, 2013 due to “sequestration”, and subsidies are likely to
remain below original levels and subject to further adjustment for several more
years under current federal law.
Build America Bond Illustration
Maturity
Taxable Coupon
Original Subsidy (35% of Coupon)
Original Net Interest Rate
Current Subsidy Reduction (7.3% of Subsidy)
Current Net Interest Rate
7/1/2040
6.28%
-2.20%
4.08%
0.16%
4.24%
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REFUNDING OF BUILD AMERICA BONDS
• Most BABs contained “Extraordinary Optional Redemption Provisions” allowing
issuers to redeem the bonds if the Federal Government eliminated or reduced
the subsidy payments.
• Most bonds contain a “make whole” clause in favor of investors that results in a
redemption price that is well above par if the Extraordinary Redemption Provision
is used in the current market, eliminating any economic advantage of current
refunding of BABs.
• Advance refunding of most BABs is not economical in the current market
due to the relatively low net interest rates on the BABs despite the impact of
Sequestration, the length of time remaining until the first optional par call date (if
any) on the bonds, and the potential loss of the entire interest rate subsidy during
the period that debt service is paid from a refunding escrow.
• Redemption provisions and other terms and conditions vary, so each bond
issue should be reviewed individually and bond counsel should be
consulted regarding any potential refunding.
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CASE STUDY – GREATER RICHMOND CONVENTION CENTER
SERIES 2015 REFUNDING BONDS
Series 2015 Refunding
$111,245,000
Par Amount
Forward Delivery
Current Refunding
Structure
October 22,2014
Sale Date
March 19, 2015
Closing Date
Net P.V. Savings $13,704,211
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CASE STUDY – VIRGINIA RESOURCES AUTHORITY
FALL POOL 2014 SELECTED PARTICIPANTS
Net Present
Value
Savings ($)
Net Present Value
Savings
(% of Refunded
Par)
Obligation
Refunded
Refunded
Par Amount ($)
Fluvanna County
Bank Loans
3,532,000
335,534
9.50%
Middle River Reg Jail Authority
Public Bonds
30,420,000
4,103,900
13.49%
Powhatan County
VRA Debt
5,395,000
375,921
6.97%
Powhatan County
Clean Water Loan
950,352
50,596
5.32%
Strasburg, Town of
VRA Debt
845,000
37,504
4.44%
Borrower
Tazewell County
VML/VACo Loan
6,685,000
844,668
12.64%
Tazewell County
Public Bonds
7,805,000
687,952
8.81%
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FINAL OBSERVATIONS
• At today’s low interest rate environment, even some subsidized debt
can now be refunded for savings using unsubsidized financings:
– Literary Fund Loans
– Clean Water State Revolving Fund Loans
– USDA Rural Development Loans
• Many bank loans and other obligations are callable at any time and
therefore are candidates for current refunding without any adverse
impact on savings from negative arbitrage in the refunding escrow.
• If economists continue to predict rising interest rates, chances are
they will eventually be correct. In the meantime, borrowers have a
great opportunity to lower the cost of debt obligations and finance new
projects at low interest rates.
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DISCLAIMER
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