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Parameters for Bond Refinancing Beyond the 3% Rule

Parameters for Bond Refinancing Beyond the 3% Rule. Excel PV Function =PV (rate, nperiod,PMT, FV) 30 Year Bonds @ 6.0% $1.0 million Annual Debt Service =PV (.03, 60, $500,000,0) $13,837,781. 1. 2. 3. 4. 5. n. i. PV. PMT. FV. 60. 3.0. ?. $1 million. $0.

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Parameters for Bond Refinancing Beyond the 3% Rule

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  1. Parameters for Bond RefinancingBeyond the 3% Rule

  2. Excel PV Function =PV (rate, nperiod,PMT, FV) 30 Year Bonds @ 6.0% $1.0 million Annual Debt Service =PV (.03, 60, $500,000,0) $13,837,781 1 2 3 4 5 n i PV PMT FV 60 3.0 ? $1 million $0 Basic Bond Formulas: PV • HP 12-C PV Function • How much debt can I afford? • TermsSemi-Annual • N = 60 periods • Rate = 3.0 • PV = ? • PMT = $1.0 million • FV = $0

  3. Measuring Savings

  4. Optional Redemption • Most municipal bonds have an optional call feature which allows issuers to repurchase bonds at a specified price on certain dates in the future • Call date usually 8-10 years • Notification: typically 30 to 60 days prior to call December 1, 2010 through June 1, 2010 102% December 1, 2011 to June 1, 2011 101% December 1, 2011 and Thereafter 100%

  5. Bonds that have matured Current Refunding • Refinancing in which bonds are redeemed within 90 days of call date • No limit on # of current refundings (2-3 times over life of bonds)

  6. Advance Refunding • Bonds are redeemed more than 90 days from the call date • IRS allows only1 advance refunding

  7. Structuring an Escrow & Basic Sizing

  8. Defeasance • Legal Defeasance • Escrow securities backed by full faith & credit of U.S. government (e.g., U.S.Treasuries / SLGS) • Requires bond counsel opinion • Debt removed from books • Economic Defeasance • Escrow securities not backed by full faith & credit of U.S. government (e.g., Corporates & Agencies) • Higher yield / Greater savings • Debt remains on the books

  9. Defeasance Escrow • Refunding (Defeasance) Escrow • A portfolio of “eligible securities”, as defined in the Indenture (U.S. Treasuries / SLGS) • Cash flows sufficient to pay: • Principal • Interest • Call Premium to the call date, without reinvestment

  10. Escrow Requirements

  11. Escrow Structuring • Escrow cash flow requirement = $8,769,525 • Escrow funding costs = $7,631,692 • Escrow can yield the same rate as the arbitrage yield on the refunding bonds (e.g., 3.64%) • Perfect escrow would cost = $7,493,310

  12. Perfect Escrow $7,493,310 Escrow Cash Flow Requirements to Call Date $8,769,525 Arb. Yield = 3.64% Perfect Escrow $7,493,310 Escrow Cash Flow Requirements to Call Date $8,769,525 Escrow Yield = 3.01% Negative Carry Negative Carry • Proceeds invested @ the bond rate pays for itself > “carry” • Investment yield (3.01%) lower than bond yield (3.64%) • Inefficient Escrow: increase par value of refunding bonds by 2.1% • $138,382 in Negative Carry (“negative arbitrage”)

  13. Bonds Outstanding $6.15 Million + Bond Sizing Requirements Additional Costs 3.0% to 6.0% • Cost of Issuance: .50% to 1.0% • Underwriter’s Discount: .50% to 1.0% • Redemption Premium: 2.0% to 3.0% • Bond Insurance: (~2x principal) .50% to 1.0% Current Refunding Bonds: $6,580,000

  14. Advance Refunding

  15. Additional Costs 3.0% to 10.0% + Bond Sizing Requirements Bonds Outstanding $6.15 Million Principal & Interest $1.6 Million • Cost of Issuance: .50% to 1.0% • Underwriter’s Discount: .50% to 1.0% • Redemption Premium: 2.0% to 3.0% • Bond Insurance: (~2x principal) .50% to 1.0% • Negative Carry *: 1.0% to 3.0% * Advance Refunding Advance Refunding Bonds: $8,000,000

  16. How to Evaluate a Refunding

  17. Issuer Objectives • Debt Service Savings • Cash Flow Structuring • Consolidation of Debt • Remove Restrictive Covenants • Combination (of above)

  18. Rolling Down the Yield Curve

  19. Measuring Savings • $30,000 Avg. Annual Cash Flow Savings • $440,293 NPV Savings • 6.9% of Refunded Bonds • 6.7% of Refunding Bonds

  20. The Impact of Investments

  21. Gross vs. Net Refunding Must take into account impact of investments • Gross-to-Gross Refunding • Comparison solely of gross debt service • Does not take into account reinvestment of bond proceeds • Net-to-Net Refunding • Compares Net Debt Services • Takes into account reinvestment of bond proceeds

  22. Net-to-Net Refunding • Net-to-Net Refunding reflects true savings • May reduce savings level (e.g. 7.1% vs. 4.8%)

  23. Beyond the 3% Rule

  24. Key Factors in Evaluating a Refunding • Current vs. Historical Interest Rate Levels • Maturity-by-Maturity (shape of yield curve) • Term to maturity (years remaining) • Absolute level of savings: minimum $ threshold (e.g. $1 million) Evaluating an advance refunding generally more important than current refunding.

  25. Savings Formula Rule of Thumb Call Premium + Issuance Cost Coupon Spread X # of Years > Savings

  26. Current vs. Historical Interest Rates Refunding should be driven by the potential value captured • Refunding undertaken near historical low interest levels, may capture most potential savings

  27. Maturity-by-Maturity Analysis • Although overall level of savings attractive • Issuers should begin to evaluate refunding on a maturity-by-maturity basis. • Review shape of Yield curve

  28. Shape of the Yield Curve Shape of the Yield Curve + Time to Final Maturity • 3.0% to 10.0% in par value required to issue refunding bonds • % spread of 100 bps more significant later years: • 3 year = 300 bps / 9 years = 900 bps

  29. Adjusted Maturity-by-Maturity • Adjusted Par Value – 7% for each Maturity • Level debt service solution, places more principal in shorter maturities – distorts savings in back end.

  30. Value of Call Option • Measures Efficiency of a Refunding • Requires complex multi-variable model • Simple approximation: benchmark savings to historical low interest rates • Rates as of June 12, 2003 • Efficiency of Refunding - % of potential savings

  31. Coupon Spread

  32. Capture Potential Economic Value • Benchmark to historical low interest rate level – provides simple gauge of efficiency of refunding

  33. Absolute Value & Other Considerations • “Suit Rule” – A refunding should generate more savings to the issuer than the suits (i.e., bond counsel, FA, underwriter, etc.) get paid. • Minimum $X million NPV savings, regardless of % of par value • Current Refundings • Short term to maturity • Restrictive Covenants • Debt Service Coverage • Developer payments

  34. Use of Swaps & Derivatives • Issuers may realize greater savings by using swap & derivative instruments • However, must consider that: • % of LIBOR swaps assume tax risk • Swaps are effectively non-callable • must measure the option value of the call

  35. Questions and Discussion

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