As the Federal Reserve Board holds the line on higher interest rates, seasoned muni issuers and advisors are taking advantage while playing within the rules.
“Higher interest rates allow construction funds to be invested at rates that exceed bond yields,” said Barry Fick, executive director of the Minnesota Higher Education Facilities Authority. “This has resulted in the opportunity to earn a positive return. We are monitoring the spending of construction fund proceeds closely to make sure we don’t have to rebate any earnings to the federal government.”
Issuers exploring investing construction funds have to work around arbitrage rules that could funnel any proceeds back to the government in the form of what the Internal Revenue Service calls “rebates.” There are exceptions to the rebate rule that include funneling proceeds into reserve funds or using them for specific projects which triggers expectations and deadlines for spending the money.
Arbitrage proceeds are subject to yield restrictions which can sometimes be circumvented via tactical moves affecting the size of the issuance. “The decisions often revolve around whether it makes sense to divide the deal into two issues for the purpose of satisfying a rebate exception,” said Rich Moore, a tax partner at Orrick, Herrington & Sutcliffe.
Questions about yield restrictions also come into play as funds are now sitting in escrow accounts that in the past didn’t pay enough interest to worry about. “These questions generally relate to which amounts in the escrow are subject to yield restriction and which are not and, if so, whether they are restricted to the yield on the refunded bonds or the refunding bonds,” said Moore.
“The good news for issuers is that in refundings, the bulk of the amounts in escrow are sale proceeds of the refunding bonds and such amounts are not subject to yield restriction or rebate.”
Parking money in interest-bearing escrow accounts also opens up options for resizing the issuance. “A common situation is a short-term defeasance escrow of up to ninety days,” said Matthias Edrich, a partner at Kutak Rock. ”Investment rates have been such that investment above the bond yield has been feasible and earnings have been used towards the refunding, enabling issuers to size smaller bond deals to accomplish the same refunding purpose.”
Higher interest rates and the 2017 Tax Cuts and Jobs Act put the kibosh on any tax-exempt advance refunding options. Handling refundings currently is based on simpler arithmetic.
“Higher interest rates have not had a material effect on how we handle refunding options other than to continue to defer refunding until the date for a current refunding,” said Fick. “We monitor and update cost-benefit analysis on outstanding bond issues, but generally find that bonds issued in the last few years have significantly lower overall true interest costs than current rates, so we are waiting until the outstanding debt can be currently refunded.”
Using interest bearing escrow accounts and leveraging arbitrage options can help tag an issuer with auditing complications. In August the IRS found the Port of Port Arthur Navigation District of Jefferson County, Texas’ 2017 $55 million bond issuance to be taxable, issuing a notice of proposed adverse determination.
The Port used proceeds to finance a construction project which led to complications with the troublesome IRS Section 149 rule which governs an issuer’s expectations about how fast they will be spending money used on project financing. The Port is defending its position. Higher rates continue to offer a mixed bag of consequences to issuers.
“Higher interest rates make all facets of bond analysis more complex,” said Fick. “They add an additional dimension of planning for issue timing, repayment options, call features, covenants, and result in more ongoing analysis during the life of the bond issue.”
For some issuers, the current market conditions are presenting a steep learning curve. “I have found it very interesting to discuss the effects of higher interest rates with people who have not been in public finance for more than a few years,” said Fick. “They have never experienced a rising rate environment, much less an environment with sustained higher rates across the entire yield curve.”