STUDY NOTES FOR DEBT MANAGEMENT
GFOA EXAMINATION
MAY 21, 1999
NASHVILLE, TN
I. SOURCE: DEBT ISSUANCE & MANAGEMENT - A GUIDE FOR SMALLER
GOVERNMENTS
Chapter 1: Developing an Effective CIP
CIP administrative process produces:
 capital improvement plan – multi year plan
 capital improvement budget – spending plan for the current fiscal year
7 Steps for Effective CIP:
 establish CIP policies
 perform capital inventory
 adopt standards to rank projects
 identify projects
 assess funding sources – pay as you go/borrowing
 develop CIP
 approve CIP and budget
Govt should incorporate formal debt policies in CIP – serve as framework w/in w/c the
govt can evaluate each potential issuance.
Benefits of a CIP:
 management tool – determine amount of infrastructure/equipment spending required
to accommodate growth; forecasting future capital demands; provide adequate time
for advance planning to effectively implement CIP
 long-term policy development – assist in long term policies
 creditworthiness – well prepared CIP viewed positively by rating agencies and credit
markets
Chapter 2: When Is Borrowing the Right Choice?
Major alternative sources of capital funding:
 grants – does not have to be paid back but getting more difficult to obtain
 capital contributions from external sources – e.g., developers
 low or no interest loan – state bond banks w/c consolidate borrowing of a number of
governments in single issue w/c result in administrative savings – state’s “moral
obligation” – pledge w/c takes form of a promise to seek appropriation of state funds
whenever necessary to replenish bond bank’s reserve fund
 joint ventures/privatization – w/ other agencies or w/ private sectors
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pay as you go – s/b part of every CIP – requires annual target or set aside of surplus
borrowing – appropriate for CIP w/ long useful life – ensures intergenerational
equity
Debt Issuance Checklist (10 considerations for issuing tax exempt bonds)
 Is the type of debt considered most appropriate form for type of facility?
 Does maturity structure match anticipated flow of revenues available for debt
service?
 What is most appropriate method of sale?
 For competitive, do terms and conditions allow potential bidders sufficient flexibility
to structure most aggressive bid possible?
 For negotiated, does RFP for underwriter request sufficient info to enable issuer to
select most qualified at best price?
 Do disclosure documents meet or exceed standards?
 Is distribution of materials and notice of sale broad enough to ensure response from
all interested or qualified bidders?
 Have all advertising requirements been satisfied?
 Is proposed issue unusually large or complex, have investor information meetings
been held at appropriate location?
 Have rating agencies/bond insurance companies been given all info to make informed
judgements concerning credit quality of issuer?
Chapter 3: An Overview of the Municipal Market
Key participants: issuers; financial advisors; bond counsel; underwriters; rating
agencies; credit enhancement providers; trustees or paying agents/resgistrars; printers;
verification agents, etc.
GO bonds – backed by full faith and credit; revenue bonds backed by specific revenue
streams.
Most of 1992 and 1993 markets were for refunding activities b/c of lower interest rates.
Tax exempt borrowings account for most of the municipal marketplace – tax exemption
applies to interest earnings – federal and state/local (within state of issuer) taxation –
known as “principle of reciprocal immunity” under w/c states and federal agreed not to
impose taxes on each other’s securities. Got changed by recent Supreme Court decision
in that interest on muni bonds not immune from a non-discriminatory federal tax code.
To be tax exempt must meet certain criteria tests or fall within volume limitations:
 limit volume of small issue IDB and other private activity bonds
 restrict purpose of tax exempt
 set strict guidelines on investment of tax exempt bond proceeds
 restrict refundings
 require tax exempt obligation w/ maturity greater than one year issued in registered
form
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Note: interest income received on securities that qualify as governmental purpose bonds
remains exempt from federal income tax – met if:
 available for general public use rather than to benefit an individual or corporation
 if payment of debt is not obtained from private firm that will benefit from the project
taxable equivalent yield = tax free yield
100% - tax bracket (%) e.g.,
taxable equivalent yield for investor at 28%; invest @ 7% is 9.72%
7%
100% – 28%
=
9.72%
Interest and principal are treated differently when it comes to taxation – interest may be
exempt but the price paid for a security may cause an income taxation depending on the
price a security is purchased (and its maturity) at the secondary market.
The emergence of mutual funds dealing with muni bonds in 1970-80’s – primarily
responsible for the growing importance of individual investors. Many muni market
participants consider mutual funds as an institutional inv. rather than an individual inv.
The decline of banks as major participants in the muni market caused by TRA of 1986 as
they were previously allowed 80% of the “cost to carry” such loans to be interest
expense…some relief on bonds categorized as governmental or section 501© (3) or an
issue not more than $10M.
Chapter 4: Common Methods of Financing Capital Improvements
Most common financing techniques:
 general obligation bonds
 special assessments
 lease purchase
Most bonds issued in multiples of $5,000 – limitation on the size of a single bond is the
number of $5,000 increments in each maturity – e.g., if issue $1 million w/ 10 year
maturity and w/ $100,000 maturing each year, the most investor could purchase in the
form of a single bond is $100K.
Muni notes tend to be an institutional investment – typically marketed in $100K or
multiples thereof but maybe offered as small as $25K – fall into 2 categories:
 those issued in anticipation of receipt of a specified revenue – for cash management
purposes – e.g., TANs – to cover mismatch in tax receipts and expenditures
 those in anticipation of permanent financing – for capital project financing
RANs – issued in anticipation of revenues, generally other than tax revenues for
operating purposes
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TRANs – issuer pledges tax receipts and other sources of revenue to note redemption
BANs – obtain interim financing for a cap. proj. for construction until a permanent
financing can be arranged. – normally can’t be sold before the authority to issue the
bonds is in place
GANs – anticipation of a grant from state of fed – may be for either operating or capital
GO Bonds – most secure – generally authorized by voters in a referendum – carry levy to
tax, typically property tax for local govt, w/o limit as to rate and amount to pay principal
and interest on bonds – for State, use sales tax or income taxes – b/c backed by taxes and
issuer’s pledge to make payments from all available source, debt service reserve is not
required – issuer not constrained by limited flow of available revenues so structure is
very flexible – many jurisdictions require GO bonds be sold through competitive method
Because many states require notice of sale between 10 and 14 days prior to the bid
opening, competitive sale method may put the issuer at the mercy of the market on the
date of sale if interest rates are volatile and unfavorable – otherwise, issuer may have to
accept the rate offered or cancel the sale and begin process again. Many states impose
constitutional or statutory limits on GO bonds – so some may be issued as limited-tax GO
bonds.
Revenue bonds are limited liability obligations – pledge of specific revenue stream –
sold for system w/ identifiable users, e.g, water – considered very equitable means of
financing system improvements – most cases not backed by the general credit of issuing
govt – in cases where they’re backed, they’re called “double-barreled” bonds – most can
be sold w/o voter approval – debt service reserve usually required, often funded by
proceeds of bond issue equal to 10% of the annual debt service.
Alternative sources of funding for debt service reserve:
 bond proceeds
 cash on hand
 system revenues – build up usually less than 5 years
 purchase or credit facility
Special assessment bonds – issued to finance cip that benefits the taxpayers in a
particular, carefully defined area of the community – its similarity to GO bonds is that it
carries a lien against the property that is second only to the govt’s property tax.
However, unlike GO bonds, does not always carry a pledge of govt’s full faith and credit.
Riskiest when assessments are made on unimproved or against a small number of
property owners.
Capital leases – simple agreements between the govt and the vendor to provide
equipment and facilities – if vendor does not provide, leasing company will act as
intermediary.
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COPs – similar to muni bonds backed by a proportionate share in the lease payments
made by the govt – a form of lease obligations in w/c govt enters into an agreement to
pay fixed amount annually to a third party, the lessor in exchange for occupancy or use of
facility of equipment.
Lease purchase carry higher interest rates than GO bonds – secured by govt’s general
resources w/o authority to raise taxes. In most lease purchase structures govt’s obligation
back by annual appropriation of lease payments – this sets it apart from muni obligation
b/c the issuer’s obligation is technically limited to a single fiscal year, so issue is not
considered a debt under definition of most states. Use lease purchase only when there is
a long term nature of the commitment – mostly sold thru negotiations.
If lessee fails to make payments:
 lessor assumes ownership of equipment or facility
 potential change in tax treatment of obligation – new owner may not qualify for tax
exemption – that’s why investors in this type of obligation emphasize the essentiality
of the equipment or facility.
Lease purchase can still obtain favorable rates if:
 equip or facility essential to govt operations
 size of obligation is small relative to govt’s resources
 issuer has strong track record
 there is perception that financing is strongly supported by govt and electorate
Chapter 5: Assembling the Financing Team
Financing team facilitate debt offering by providing: experience w/ type of obligation
being considered; knowledge how issuer has managed previous financings;
understanding of legal ramification of various types of obligations and structures and
innovative approaches to obtain savings and other efficiencies; ability to schedule all
required events; familiarity w/ issuance costs and capacity to relieve issuer of
administrative burden.
As much as possible, use competitive process in selecting team – base choice on merit as
well as price.
Financial advisor (FA) – first to be retained – must have issuer’s full confidence – may
be best if independent from underwriter, trader or seller – on the other hand, if associated
w/ either commercial or investment banks, may have advantage in marketing of
securities. (See list of functions on the attachment.) – s/b chosen on a competitive
process – emphasize selection on the qualifications of the individual(s) as well as the
qualifications of the resources of the firm – should have no financial stake in size of
issuer’s offering therefore compensation should not be contingent upon issuance of debt.
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Compensation for FA may be flat dollar amount per bond issued although per bond
approach may be flawed as it does not necessarily compensate FA based on amount of
work and also puts FA in position of benefiting from a larger issue – preferred method to
pay on hourly basis (w/ not to exceed amount) or fixed fee.
RFP to contain:
 identification of individual serving as principal advisor
 experience of this individual
 discussion of firm’s understanding of issuer’s financing plans and innovative
approaches to the proposed financing
 commitment on the availability of the primary and back-up advisors
 references from at least three other clients
Bond Counsel’s role – certify that issuer has the legal authority to issue obligation and
provide legal opinion that the securities being offered are tax exempt – issuers may prefer
bond counsel within the issuer’s state – paid either hourly (by category of employee) or
flat (more often used)
Underwriter (or team) – firm, group of firms selected to purchase securities from issuer
and re-market them to the investment community – usually an investment banking firm, a
commercial bank or the securities subsidiary of a commercial bank.
In a competitive sale – U/W involvement w/ issuer limited – until bids are opened and the
award is made, identity is not known – selected on the basis of bid. In negotiated sale,
U/W is selected fairly early and plays central role in structuring and marketing efforts.
U/W should have: experienced bankers, strong underwriting desk and a distribution
(sales network) system.
Compensation of U/W – competitive, built into its bid; in negotiated, issuer must
examine both the U/W’s compensation and its interest rate proposal; U/W is paid a
spread.
4 components of U/W spread:
 take-down – amount paid to the firm’s sales force to place issue w/ investors
 management fee – paid to the firm’s investment banks to structure and market issue –
should reflect amount of input and involvement
 expenses – travel, lodging, etc.
 underwriting fee – “risk” paid to put its capital risk – issuer has considerable
flexibility since argument could be made that firm’s capital is not at risk since it does
not sign the U/W agreement until it negotiates an acceptable price w/ the issuer
Of these 4, management fee and UW fee vary the most from issue to issue
The Red Book – a directory of municipal market participants listed on The Bond Buyer’s
Municipal Marketplace.
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Paying Agent/Registrar – a financial inst. that serves as paying agent w/c receives funds
from the issuer prior to each debt service payment then distributes to bondholders; as
registrar, it establishes and maintains records of bond ownership. In some cases, issuers
assume responsibility as paying agent/registrar.
Prior to 7/1/83, muni issuers sold bonds in bearer form (whoever had physical custody
was considered owner) – was changed later by Tax Equity & Fiscal Responsibility Act of
1982 w/c required issues w/ maturity greater than one year to be in registered form
Securities Depository – alternative to paying agent/registrar – two form: certificates can
be printed and qualified for immobilization w/c limits physical circulation of the bond
certificates and gives investor option of taking possession or use securities depository;
second form issue bonds in book entry only form.
Bond Printer – issuer will need to retain if physical certificates needed.
POS – preliminary official statement w/c is a disclosure doc. prior to sale
OS – official statement w/c is the revised doc. w/c reflects sale results and any material
changes subsequent to circulation of the original doc. In comparing POS/OS printer bids,
issuer should evaluate fee to be charged for each correction or change.
Trustee – a financial inst. who serves as custodian of funds for benefit of bondholders
Note: see attachment regarding guidelines for a successful RFP in assembling financing
team.
Chapter 6: Selecting the Method of Sale
Most common methods: (decision influenced by legal, policy and market considerations)
 competitive – most common method for GO bonds – issuer selects date and time
when it accepts bids
 negotiated – typically used for revenue backed financing esp. those w/ complex
security agreements – in some cases can offer the best results for GO bonds - issuer
selects the underwriter (or underwriter syndicate) in advance of the planned sale date
– enables issuers to reschedule sale if market conditions become unsettled or other
unfavorable developments occur
 private placement – a variation of negotiated sale – issuer able to market securities
directly to investors – investors often require higher interest rates on issues marketed
under this method
Issuers should evaluate market condition, credit quality, complexity of issue, investor
preferences, before selecting the method of sale.
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In a competitive bid process, the underwriter must make a judgment concerning the tone
of the market – e.g., if interest rates appear firm and there is good buying interest,
aggressive posture may be appropriate; if there is concern where interest rates may go
and buyers are being cautious in their commitments, a conservative approach s preferred
– for these reasons, a competitive sales process may not necessarily result in the most
favorable rates for the issuer in every case.
One of the most common concerns about negotiated sale is that underwriters may be
chosen for reasons other than their ability to effectively market the bonds, including
friendships w/ the issuer’s staff to political favoritism – as a result, the MSRB adopted a
rule that would prohibit a municipal securities dealer from engaging in a negotiated
transaction w/ an issuer within a two year period after any contribution was made to an
issuer official.
Market factors w/c affect success of bond offering:
 market’s perception of issuer’s credit quality
 interest rate volatility
 size of proposed issue
 complexity of proposed issue
 competition w/ other issuers for investor interest
Composition of underwriting firms (impt foundation for deciding merits of competitive or
negotiated sale) – interests of these individuals not always compatible
 underwriters – responsible for determining the market rate on the securities being
offered based on feedback from sales force – determine an interest level w/c the firm
is willing to commit to purchase the issue
 investment bankers – deal directly w/ prospective issuers, assist w/ structure for
negotiated underwriting – does not usually play an active role in competitive sale
 sales force
Documents necessary for a competitive sale
1. Notice of Sale – formal announcement to the muni market of issuer’s intent to sell
bonds usually published in The Bond Buyer – summarizes legal treatment of securities includes:
 name of issuer
 type of bond being offered
 size of offering
 date and time of bid opening
 general description of security behind the bonds
 maturity schedule
 description of call provisions (if any)
 identity of paying agent/registrar and bond counsel
2. Bid form – document upon w/c bidders submit their offers to purchase the securities;
contents may vary accdg. to local requirements and custom
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3. Preliminary Official Statement (POS) – the primary disclosure document w/c
describe the issue’s structure, security, call provisions, etc. – widely distributed to the
investment community at least one week prior to the bid opening – if a rating or credit
enhancement is to be requested, the POS s/b provided to the appropriate analyst at
least two weeks prior to the sale date
Underwriter’s spread - compensation in a negotiated transaction – a discount from the
purchase price usually expressed as either a percent of as a dollar amount per thousand
dollars of the par value of the issue – consists of:
 takedown – compensates the sales force for each $1,000 par value sold in that
maturity (sale commission) – usually lower in the early maturities and higher in later
years – usually the largest component of the U/W spread
 management fee – paid to investment bankers for assisting in structuring and
marketing of proposed issue – varies depending on role of investment banker from
issue to issue
 underwriting fee or risk – compensates U/W for its commitment to purchase issue
before firm orders have been received from investors – many argue this s/b
eliminated since U/W rarely commit to a purchase until they are certain the securities
can be sold – usually the smallest component of the spread
 expenses – reimbursements for actual – issuer should ask that these be documented
Chapter 7: Structuring the Issue
The longer term of a bond issue affords the issuer considerable flexibility in structuring
the obligation – structure selected s/b consistent w/ issuer’s financing objectives and
match receipts that have been pledged to debt redemption. Structuring options are:
1. Fixed rate bonds – most common form of debt for smaller govt – issues on w/c the
interest rate paid is set at the time of original marketing and is not subject to revision
prior to maturity – most common structures are serial or term bonds
serial bond – a portion of the issue’s par value is paid off or redeemed each year – the
serial maturity structure takes advantage of the fact that in the muni market, longer
maturities bear higher rates of interest
term bond – when a number of serial maturities are combined into a single maturity w/c
makes the offering more attractive to institutional investors – term bonds are normally
created in the latter years of an issue w/c mitigate any negative impact resulting from the
spread between serial interest rates – in nearly every instance where term bonds are
utilized, a sinking fund is created to provide for bond redemption
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2. Variable rate bonds – more common among larger issuers and state govt – on
predetermined dates, the interest rate on the bonds is adjusted and the bonds are
remarketed for another period – most common maturities are 7 and 30 days – on each
interest adj. period, holder may extend investment or present bond for payment – not
effective option for issues under $20 million - 2 elements of risk in variable rate
bonds: interest rate risk and no market for the issue.
3. Capital Appreciation Bonds (CABs) and Zero Coupon Bonds – permit deferral of
principal and interest – sold at deep discounts from their par value and do not pay current
interest to investors – the effective yield to the investor is the difference bet the purchase
price and the maturity value – have been created as derivatives of conventional securities
and are used primarily by larger and more sophisticated issuers.
Debt Service Structures
1. level principal – equal amounts of the par value of an issue mature each year – may
be preferred by a more regular issuer
2. level debt service – amount of annual principal maturities is set so that the total
annual debt service requirements including principal and interest are approximately
equal each year – may be preferred by a small, infrequent issuer
3. graduated principal redemption – provide very low principal redemption in the early
years and larger amounts in the later years – often done when the facility being
financed is expected to generate revenue for the repayment of the debt
4. deferred principal – usually used to limit debt service during construction – most
common to capitalize interest into the issue
First two are the basic structures for most of the issues in the tax exempt market.
Many issuers are required to sell their bonds at par so U/W are unable to take their
compensation in the form of a discount bid – as a result, UW usually bid higher coupon
interest rates in the early years and reoffer those securities at a premium – this par bid
requirement makes it more difficult for the issuer to structure an offering that results in
level debt service payment.
To summarize, the 3 essential considerations in structuring the bond issue are:
 match the structure to the life of the project
 closely coordinate the pledged revenue w/ debt service requirement
 ensure compliance w/ debt management objectives
Chapter 8: The Notice of Sale
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Components of the Notice of Sale
 date, time and place of sale – Tuesdays to Thursdays preferred days – issuers should
also avoid sale during weeks w/ national or religious holidays, other large offerings,
when US Treas. is doing large financings or when economic indicators are released
 description of the bonds – dated date is when securities begin to accrue interest w/c
must be on or before the bond delivery date; maturity date is when the issuer must
provide for payment each year of all or portion of the securities per schedule
 form and payment of the bonds – if maturity exceeds one year, federal law requires
bonds in registered form – describe if book entry w/o physical custody – interest on
fixed rate bonds usually paid semiannually; for notes maturing in one year, paid at
maturity
 redemption provisions – optional or mandatory – in exchange for option or call
provisions, issuer pays premium – optional potentially valuable to achieve interest
rate savings in bond refundings as more efficient to refund bonds that have call
provisions than to create an escrow that will pay debt service on the prior issue until
final maturity - - - mandatory include: extraordinary call provision (e.g., original
proceeds not expended) or catastrophic call provisions (e.g., natural disasters)
 good faith deposit – usually 1 to 2 % of par value by certified or cashier’s check –
does not earn interest between sale date and closing – alternatives are surety policy
(insurer guarantees delivery of the good faith funds w/in 24 hours of the award) and
bank as conduit of funds w/c provides a single good faith check for all registered
bidders
 basis of award – preferred method to determine best bid on interest cost is TIC (used
to be NIC) since TIC considers time value of money
 CUSIP (Committee on Uniform Securities Identification Procedures) numbers – both
on physical bonds or book entry only obligations
 approving opinion – legal firm
 official statement – provides detailed disclosures re issuer’s credit quality
 delivery of the bonds – date and location
 credit enhancements – if issue is supported by insurance or other mechanisms to
increase creditworthiness – impt if bidders have option of bidding w/ or w/o use of
bond insurance
 bond counsel and financial advisor
Chapter 9: Disclosure and the Official Statement
2 developments w/c shook investor confidence w/c prompted the establishment of MSRB
 1975 New York City was unable to make debt service payments – State of NY
declared moratorium on the payment of the City’s $4 billion of short term debt
 1983 Washington Public Power Supply System (WPPSS) defaulted on $2.25 billion
of long term bonds – unlike NY w/c just had a temporary moratorium – the largest
default in history of the tax exempt bond market
MSRB – Municipal Securities Rulemaking Board – a self regulatory body comprising of
commercial banks, brokers/dealers and the public; limited to 15 individuals one of whom
must be an issuer of municipal securities.
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Following the report on the WPPSS default, SEC promulgated Rule 15c2-12 – places
significant disclosure requirements on brokers and dealers of municipal securities (SEC
has no direct authority to regulate municipal issuers except for antifraud violations).
Rule 15c2-12 – effective 1/1/90 – principal regulatory control over disclosure practices in
the muni market – four specific requirements broker/dealer must comply with this rule:
 due diligence review of OS – some info may not be known until date of sale; e.g.,
interest rate, principal amount, maturities, delivery date, ratings, offering price and
selling compensation distribution of OS – except in competitive bids, to be provided
w/in one day of a request
 timely receipt of final OS – for all sales, w/in seven business days of the sale in
negotiated sales, the U/W or syndicate assumes primary responsibility while issuer
assumes responsibility for delivery of all required disclosure items to the rating
agencies/and or credit enhancement firms
 distribution of final OS – upon request w/c begins upon receipt of the final OS and
continues for 90 days unless U/W has filed the final OS w/ a nationally recognized
repository (Municipal Securities Information Library or MSIL; Bloomberg Financial
Markets in Princeton, NJ; Kenny S&P Information Services in NYC; and The Bond
Buyer MuniStatements in NYC)
Exemptions to Rule 15c2-12
 issuances of less than $1 million
 special exemptions from SEC w/c are consistent w/ the public interest and protection
of the investor
 qualified private placements or commercial paper program
Disclosure – is the preparation and circulation of information an investor may need to
make an informed investment decision.
Continuing disclosure – effort to provide timely information on the current
creditworthiness of an issuer for the entire period that a bond obligation is outstanding.
POS – the primary disclosure document – used by U/W to market issues to prospective
investors.
In negotiated sales, the U/W often will retain the services of its counsel who will take the
lead in the preparing the POS.
Information concerning the security of the issue or the credit quality of the issuer does
not usually change between the printing of the POS and the preparation of the OS.
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Chapter 10: Securing Credit Ratings
3 principal rating agencies: Fitch; Moody’s; and S&P
ratings based on: assessment of an issuer’s financial, administrative, economic, and
demographic characteristics – reflect the analysts’ opinion about the likelihood that the
issuer will pay the principal and interest on the obligation in a timely manner – valuable
to investors who are willing to accept lower yields in exchange for greater security –
viewed as tangible evidence of the credit quality behind a security in the secondary
market where disclosure materials may be unavailable or dated
3 strategies to secure ratings:
 letter or telephone request
 meeting at rating agency
 agency site visit with issuer
To successfully appeal a rating, issuer must demonstrate that some material info has been
overlooked or must provide new info that has become valuable following the initial
submission.
The GO bond can be one of the most difficult obligations to evaluate accurately –
analysis to focus on: financial operations, economic performance; debt levels and
structure; and quality of administration.
In some cases, revenue bonds may be easier to determine than GO bonds since most
frequently issued by systems that are self supporting w/c have distinct sources of fund.
Analysis different from GO bonds - can be quantified by factors such as growth in user
base; stability of revenue flow; debt service coverage by net revenues.
From a credit perspective, there are two broad categories of short term debt:
cash flow borrowings – e.g., TANs, RANs, and TRANs – mismatch between receipts and
expenditures during fiscal year, that’s why maturity is usually one year or less
anticipation notes – (BAN) provide interim financing for a capital project
The assessment of cash flow borrowings requires a consideration of the likelihood that
the anticipated taxes and revenues will be collected in a timely manner. The review of
BAN credit quality is somewhat different b/c it must address the ability of the issuer to
market a long term obligation. successfully at some point in the future.
Chapter 11: Credit Enhancements
A. Bond insurance – most common form of credit enhancement for long term fixed rate
obligations – fee or premium usually based on the total debt service of the obligation
typically about 75 basis points – if less credit worthy, maybe 100 basis points – obtained
much the same way as bond rating
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Cost effectiveness of bond insurance calculation:
 calc debt service schedule for the issue based on the interest rate that issuer would
receive w/o bond insurance – then calc w/ bond insurance
 subtract the insured debt service from the uninsured for each maturity
 calc present value difference bet. the insured and the uninsured debt service
 if present value of the savings is greater than the insurance premium, then use bond
insurance
Issuer can relieve itself from above analysis by qualifying the issue for bond insurance in
advance of the sale then leave ultimate decision to U/W – issuer must do ff. things for a
competitive sale:
 disclose issue has been qualified for insurance and identify insurer
 indicate amount of premium
 specify that U/W must pay cost of bond insurance if used
 ask for bids either with or w/o bond insurance
B. Letters of Credit - frequently used for large transactions to enhance credit quality or
provide liquidity for securities that offer investors the option of putting the bonds
back to the issuer on preset dates – mostly structured as a contract between a
commercial bank and the bond trustee – nearly essential in variable rate transactions –
typically written for 10 year terms
C. Surety Policies – take the place of cash-funded debt service reserves - mean creating
debt service reserve (DSR) – usually funded at either average annual debt service,
maximum annual debt service or 10% of the par value of the issue
Chapter 12: Analysis of Refunding & Restructuring Opportunities
3 major reasons for refinancing/restructuring o/s obligations:
 achieve debt service savings (lower interest rates)
 remove or revise restricted bond covenants
 restructure to reduce existing debt service burden in certain years – may raise
questions among analysts and investors as a sign of credit weakness
Current and advance refundings may be undertaken for the same reasons but there are
legal and structural differences:
 current refunding – occur w/in 90 days of the first date upon w/c the bonds being
refunded may be called for redemption – normally will be exempt from arbitrage
yield restrictions and rebate requirements under section 103 of IRS code
 advance refunding – proceeds of the refunding are invested in an escrow account held
by a trustee until the old bonds can be redeemed – IRS code restricts the yield on the
escrow to essentially the yield on the refunding bonds; in a savings refunding, the
interest rate on the refunding issue is lower than the interest rate on the prior issue
 limit the number of advance refunding
 prohibit advance refunding on IDBs, MRBs and student loan bonds
 restrict advance refundings on governmental bonds or section 501©(3) bonds
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3 most common types of refundings
 refundings to realize savings – typically spread on interest rate reaches 200-250 basis
points
 refunding to change covenants – to permit greater flexibility in one of 3 areas: debt
service coverage; additional bond tests; or reserve requirements – part reason maybe
to permit use of surety policy, LOC or other third party guarantees instead of debt
service reserve
 restructuring refundings – usually involve reduction or deferral of debt service during
period when revenues initially expected to be available to cover debt service are
below project levels
When restructuring, must consider that the weaker credit may increase the govt’s
borrowing costs. It’s impt. to proceed with caution b/c federal law limits the number of
advance refundings.
Chapter 13: After the Sale
Participants interested in post sale management: investors, rating agencies, credit
enhancement providers and federal regulators.
Issuer’s first post sale responsibility: investment of bond proceeds – s/b planned before
delivery of proceeds – more restrictive investments to protect investors’ interest than
govt’s own operating fund investments.
Arbitrage reg. generally require the investment of bond proceeds to the yield on the
borrowing itself. As general policy, govt must use competitive bid w/ quotes at least
from three firms.
Exceptions to arbitrage earnings:
 gross proceeds expended w/in six months from issuance (amount expended may not
be the lesser of $100k or 5% of proceeds from certain bonds)
 no more than $5 million in any year – applies not to single issue but to all obligations
issued by govt during the year, including subordinate units
 if earnings of bona fide debt service fund not exceed $100k per year
 additional exceptions: meet one of two spend-downs tests
Secondary market disclosure – issuer’s effort to provide ongoing financial info for the
term of a borrowing – SEC requires issuers to develop a routine of ongoing disclosure
Continuing disclosure to: rating agencies, bond holders and muni securities info
repositories.
Most impt. reason for refunding is debt service savings thru lower interest rates – issuer
s/b aware of dates on w/c o/s debt become eligible for current refunding and the dates on
w/c there are reductions in the amount of call premium as these can affect viability of
refunding.
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An effective borrowing program consists of:
 capital planning
 debt issuance
 debt management
Post sale responsibilities
 develop schedule for investment of bond proceeds
 program to fully comply w/ arbitrage provisions
 continuing disclosure
 internal procedures for regular review of debt portfolio to examine refunding
opportunities
NOTE: SEE ATTACHMENTS REGARDING CHRONOLOGY OF TAX EXEMPT
FINANCING LAWS; GLOSSARY.
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II. SOURCE: LOCAL GOVERNMENT – CONCEPTS & PRACTICES
Chapter 14 – Debt Policies & Procedures:
Consideration in designing and marketing a particular issue:
 Differences among borrowers
 Uses of proceeds
 Technical attributes of each type of debt instrument
Debt – usually sold for the traditional purpose of capital financing.
State and local gov’t capital spending financed by:
 current revenues – problem in relying on current revenue is the relatively meager
amount available; postpones the receipt of benefits desired as gov’t accumulates
funds; requires political discipline that can seldom be sustained
 federal aid – greatest importance for highways, sewers and transit; continue to
decline
 borrowing in the credit market
Impact fees – user charge; establish nexus for the imposition of fees
Sale of tax-exempt bonds – for private developers – security to be provided by the credit
of the developer – payments from sales price or rental receipts
Lease-purchase financing – finance purchase of capital goods over time thru periodic
installments
Debt Financing:
Financing capital facilities – the most important purpose of borrowing
Not all debt nominally issued by state and local govt s/b viewed in the same light b/c of
the diff purpose for w/c it is undertaken and the diff sources of its repayments.
The principal factor in both the explosion in borrowing and its subsequent decline was
the loosening and then tightening of the allowable uses of the tax-exempt security –
passage of 1986 Tax Reform Act.
Municipal analysts rely on the ff. to come up with a denominator in calculating debt
burdens:
 broad measurers of economic activity or resources, e.g., gross nat’l product (nat’l
level)
 personal income or gross state product (state level)
 full market value of taxable property (local level)
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Debt declined bet 1970-1980 b/c of shift from tax-supported securities to limited
obligation debt.
Capital Financing: Examining the Alternatives:
Sources of funds:
 current revenues
 accumulated reserves
 grants
 contributions from private parties
 funds from prior bond issues
 receipts of new borrowings
Most gov’t can boil the options down to a few alternatives once the nature and scale of
the proj and the govt’s current fiscal circumstances, legal powers and the conditions of
the markets are considered.
Guiding Principles in Choosing the Financing Alternative:
 equity – those that benefit the improvement should pay for it; in contrast, user’s
ability to pay s/b considered – that income and wealth are themselves measures of
benefit or that certain goods and services are a right of citizenship and should not be
allocated accdg to the means to pay for them
 effectiveness – provides sufficient sum of money when it’s needed – maybe less
dependable or productive
 efficiency – relative costs of obtaining funds; allocating limited resources
Pay as you go versus borrowing:
Advantages:
 interest savings from not going into debt – used to expand prog or reduce tax rate
 conserve debt capacity – achieve more favorable credit rating – less interest expense
when borrowing is necessary
 leave legacy of paid-for infrastructure to the next generation of users
Disadvantages:
 impossible to raise money up front
 financing proj over useful life is equitable and efficient b/c who will benefit should
contribute
Debt Policies:
Debt policy – part of an overall capital financing policy that provides evidence of
commitment to meet infrastructures needs thru planned prog of future financing
 should be developed w/in context of existing law and present and prospective
financial position of local govt
 should embody planned behavior that reflects both cap needs and parameters
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
key factors – acceptable levels of indebtedness; priorities among types of proj
planned; policies re use of tax-supported versus self-supporting debt; mix bet use of
current revenues and borrowing; appropriateness and acceptable levels of short-term
indebtedness
Reasons for debt policies:
 establish criteria for issuance of debt obligations
 transmit message to investors and rating agencies of community’s commitment to
financial management
 provide consistency and continuity to public policy development
Borrowing must conform with state and local laws – requires that there must be a
relationship bet the improvement being financed and the public’s benefit.
Major limitations affecting indebtedness: (usually related to some percentage of a
municipality’s real property levels)
 debt limitations
 referundum requirements – voter approval
 various tax and expenditure limitations
Methods of issuing debt w/o voter approval:
 issuing gen obligation debt in amounts or maturities below the statutory amount that
would require a referundom
 issuing less regulated securities. e.g., revenue bonds
 shifting cost of cap construction forward to developers by rebating the cost thru tax
incentives or abatements
Maturity structure:
par value – face value
sold at discount – all or part of the interest is accumulated until the bond is repaid at par
at the final maturity date
2 basic approaches to designing maturity structure:
 serial bond issue – range of individual maturities
 term bond issue – single final maturity
Structure of debt service
 level debt service pattern – annual sum of interest and principal repayments is
constant
 level principal pattern – rapid retirement of outstanding bonds – repay equal
installment of outstanding principal
 declining
 ascending – grows over time
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Trust Indenture for Revenue Bonds
Trust indenture – contract between the borrower and the investor – required of revenue
bonds – sets forth in detail the pledge of revenues; how obtained/disbursed; various other
covenants that control the construction and operation of the facility; and the handling of
funds.
Flow of funds – application of revenues - sequence of deposits – how facility’s revenues
are applied to the cost of operation and maintenance, debt service, reserve maintenance
and contingencies.
Order of distribution for revenue bond funds:
 operation and maintenance
 debt service fund
 reserve fund
 contingencies fund
Margin of safety – debt service coverage – expressed as ratio of net revenues to annual
debt service
Trustee – typically appointed to oversee the enforcement of trust indenture
Sizing the Issue
Considerations
 Restrictions by U.S. Treasury on the investment of bond proceeds must be considered
in sizing the issue.
 To size issue accurately, issuer must first consider estimated project cost.
 Interest earnings on invested funds held in the construction acct can be used to reduce
the initial size of the bond issue.
 Size also affected by the extent to w/c other funds are available to pay for
improvements.
 Size also determined whether issuer chooses to capitalize issuance costs.
 Soft costs (e.g., costs of bond insurance, engineering, legal, advisory) are candidates
for capitalization but are limited in case of certain private activity bonds to 2% or
less of the total amount borrowed.
 Nature of security
 Size of the reserve fund is restricted by US Treas regulation – generally, can’t exceed
the lesser of max annual debt service, 10% of the par amount or 125% of average
annual debt service.
 Reserve funds will increase the size of the bond issue if funded from bond proceeds.
 Capitalized interest – common component of the limited obligation bond – if funded
from bond proceeds, the amount of the issue will be increased. Inclusion provides the
investor with addt’l security but also results in larger bond issue and heavier debt
burden.
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Call Provisions
Call – optional redemption
Callable bond – grants the issuer the privilege of paying the obligation prior to the stated
maturity date.
Ability to accelerate the redemption – very important to the issuer in case interest rates
decline.
Additional advantages of optional redemption feature:
 issuer can alter the maturity schedule of o/s debt more easily
 payment schedule may be lengthened to better match stream of revenues or revised to
reduce debt service payments
 ability to relieve the issuer of onerous bond covenants
The Marketing Process
2 methods of sale:
 competitive sale – awarded at an auction to the underwriting firm; the underwriter
does not know whether it will have bonds to sell until after the bids are opened
 negotiated sale – issuer chooses the initial buyer (usually underwriter) of its
securities; can be preferable if the issue requires a stronger market effort; timing less
critical b/c it is easier to reschedule the sale of the bonds until market conditions are
more favorable
State statutes often require certain types of muni bonds, usually general obligation bonds,
to be sold through the bidding process.
Factors to consider:
 relative complexity of the issue
 volatility of the municipal market – govt usually use negotiated sale when municipal
securities market is subjected to abrupt changes in interest rates demanded by
investors
 familiarity of the underwriters w/ the credit of the issuer – impacts the willingness of
the underwriters to bid aggressively
 size of the issue – unlikely for bigger issues that the competitive process results in
lower costs of capital
Basis of award:
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To determine effective interest cost of each bid:
 calc the bid’s effect upon the net interest cost (NIC) = average interest cost rate of a
bond issue on the basis of simple interest; divide aggregate amount of bonds sold
times average life of the issue – NIC has major drawback – treats a dollar of interest
paid today in the same was as a dollar paid twenty years from now – was usually
applied to term bond
 calc the true interest cost (TIC) – will produce a present value precisely equal to the
amount of money received by the issuers in exchange for the bonds when it is used to
discount all the future debt service payments – forces the bidders to eliminate high
interest rates or penalty yields on early maturities
NIC = total coupon interest payments + discount (less premium)
number of bond years
Scheduling issuance:
Rules of thumb:
 chosen date should not conflict w/ the scheduled sale of govt that compete for
investors
 sale date should not fall on a date when the US Treas is selling its obligation b/c this
may distract potential investors – outcome of sale may adversely affect all fixedincome inv
 usually sold in the beginning of the week – permits the market to sell the obligation
before the next spate of issues the ff week
 Tuesday most popular days
 holiday – reason enough not to schedule a bond sale for the same week
Issuance team: players and roles:
 Primary roles are clear.
 Players and procedures will differ depending on the market, size of issue, type of sale
employed, use of proceeds and other variables.
 Minimum team: government issuer represented by CFO; bond counsel (specialist in
municipal securities); financial advisor.
 If negotiated sale – underwriter selected by issuer – underwriter will be present
during presale period.
 If competitive sale – underwriter joins when sale is consummated.
 Larger issues – team may also have engineer, project-related consultant, auditor,
attorney (representing underwriter if negotiated sale), credit enhancer; legal counsel
of credit enhancer; specialist in tax law.
 Issuer or financial advisor allocates and coordinates duties of team in competitive
sale; bond underwriter if negotiated sale.
 Role of participants – not subject to direct federal regulations.
 Official statements and other sales documents – play pivotal role in providing info
about the issuer and issuances for investors to make informed inv decisions.
 Disclosure roles in muni bond market – flexible
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Sale-related documents:
Notice of sale – essential in competitive sale – official publication by the issuer about
terms of sale – contains date, time and place of the sale; amount of issue; nature of
security; info on official statement and delivery of bonds; and method of delivery –
serves as the basis for an official advertisement. Custom, law and individual
circumstances dictate length of documents.
Official statement: document or series of documents prepared in certificate form – needs
to be submitted to bond printer. For bonds sold in book-entry form (w/o certificates)
repository must be notified of the results to set up records.
Closing – usually three weeks after the sale; for short-term date, could be the day after
the sale.
Securing Specialized Services:
Most common outside advisors in debt issuance process:
bond counsel – provides opinion on the validity of issue and its tax status – determines if
there is legal authority to issue bond; drafts ordinance, reso or trust indenture (in case of
revenue bonds); examines transcripts of proceedings to determine if bonds were legally
offered and sold; determines that bonds were properly executed; answers legal questions
about bonds by prospective purchasers – may be supplemented by underwriter’s bond
counsel in case of negotiated transactions
financial advisor – provides assistance to state or local govt about issuance of muni
securities; nature of assistance depends on the method of sale – in competitive sale,
assists issuer in designing structure, preparing official statement and marketing the
securities to potential investors; in negotiated sale – acts as advocate for the govt to
assure that the underwriter is treating the govt fairly; may also assist in selecting an
underwriter; provide assurance that the interest rate scale is reasonable – fee can be based
upon a flat retainer or hourly charges based on services or percent of total dollar amount
of financing – most common is hourly – by separating fee from bond issuance, govt is
assured of impartiality of advice
underwriter – sometimes called “banker” – purchases bonds from the issuer and sell (reoffer) them to investors – role depends on method of sale, i.e., competitive or negotiated
– if negotiated, may perform many of consulting and support roles performed by the
financial advisor – in cases where the underwriter also services as the financial advisor,
underwriter is subject to MSRB rules to avoid or disclose potential conflicts of interest
between the two roles – underwriters or syndicates bid against each other in competitive
sale – decide on bids based on how comparable issues are doing; canvassing potential
purchasers; noting overall bond supply in the market and making judgment about the
level of competition. Compensation: negotiated sale – gross spread or discount that is a
percentage of the face amount of the bonds – often expressed in so many dollars per
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thousand; in competitive sale – buying bonds at a discount or buying bonds at par and reoffering them at a premium. In either case, the lead underwriter will be paid more
(management fee) than other members of the syndicate and also gets reimbursed for
issue-related expenses.
fiscal agent/trustee – (paying agent) – maintain interest and redeption funds; pay out
interest and principal when due – usually performed by financial institutions – maintain
list of registered owners (required by federal law since July 1, 1983) – hired by issuer but
has fiduciary responsibility to protect the interest of the investors – oversee execution of
trust indenture
Cost of issuance – use of specialized services in a bond sale; includes fees of advisors
listed above, printing, professional (accounting) – may be capitalized into the issue and
paid from bond proceeds – as issue grows, costs tend to decline on a per dollar borrowed
basis – largest component to the underwriter
Chapter 15 – Debt Markets and Instruments
short term debt – has stated final maturity at time of sale of 13 months or less; declined
b/c of long term debt with short term features
tax exempt debt – traditionally used for public facilities – non traditional used increased
for industrial pollution, residential home mortgages, nonprofit hospitals and industrial or
commercial enterprises – severely curtailed by Tax Reform Act of 1986
GO bonds – funded mostly traditional uses – govt pledge taxing powers as security –
eclipsed by rapid use of revenue bonds (limited liab obligation)
Increase of using revenue bonds:
 need or desire to finance traditional proj w/o pledging power to tax and reserving this
power for other services
 based on belief that those who benefit should be responsible for the repayment
 product of practical expediency as do not require voter approval
 nature of borrowers changed – govt supplanted by statutory authority, e.g., a conduit
like housing bond authorities
statutory authority – established to accomplish purposes beyond the normal purview of
general govt activity; sometimes created to circumvent debt of expenditure limitations
that restrict general units of govt; serves as a conduit for financing of nongovernmental
activities
3 major investors for tax tax exempt debt: commercial banks, property and casualty
insurance companies and higher-income households
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The dominance of household sector as primary buyers of tax exempt – major factor in the
development of new financing techniques. The tax exempt borrower can offer lower
interest rate than if interest rates subject to tax.
The Components of Risk
yield curve – relationship between the maturity of debt and the interest rate it carries –
generally slopes upward; the longer the debt is o/s, the higher rate of interest to
compensate investors for use of their money and for variety of risks as time goes by
For borrowers, the ratio of tax exempt to taxable is more favorable in the short end of the
yield curve – attributed to several factors: investors much more certain about tax status
in the near term than in the distant future; tax laws favor institutional investment in the
short term securities market (involves little risk of capital in return for tax exempt
income); short term investment mature quickly which expose investor to relatively little
danger.
credit quality/credit ratings – important element in determining the interest rate; rating
agency primarily interested in the strength of the security pledged for the repayment of
debt; borrowers can frequently control or at least influence factors that can enhance or
impair the quality of their credit
repackaging traditional debt – accommodate changing market conditions and shifting
investor preferences
Traditional package in w/c tax exempt bonds are sold is that of an annual cash flow of
fixed interest payments (usually semiannually) – most issues are made of sets or strips of
serial bonds maturing each year and each having its own coupon; e.g, a 20 yr bond is a
collection of 20 distinct securities w/ its unique price and maturity characteristics.
Traditional package associated w/ long term debt not popular b/c of 3 pervasive
uncertainties:



uncertainty of present values – consequence of the greater volatility of interest rates
in recent years – w/ fixed coupon rates, the only way that an o/s bond can be sold to a
new investor to provide a current yield, when market rates rise is thru a discount in its
price
uncertainty over future accumulated wealth
uncertainty over future value
Financing techniques – alter the traditional risk/reward between borrowers and lenders:
 shift interest rate from the lender to the borrower
 enhance the creditworthiness of the borrowers by shifting credit related risks to third
parties
 increase the types of return available to investors beyond those available from the
regular receipt of interest income payments
25
Methods of reducing borrowing costs:
 shorten the maturity
 improve the credit quality and rating of the obligation – either by taking steps to
strengthen the credit pledged from its own resources or by using third party credit
enhancement, e.g., insurance, guarantees, or various types of credit stopgaps
3 major varieties of financing techniques:
 borrower changes the nature of the interest payments to protect the investors against
reinvestment risk
 design transactions that take advantage of various tax preferences other than the tax
exemption of interest income
 structure the transaction to take advantage of the opportunity to earn interest thru the
investment of assets, including investment in bond proceeds and in taxable securities
that yield more than the interest cost of tax exempt borrowings or arbitrage
Short Term Securities – Debt Markets and Instruments:





TAN – tax anticipation notes
BAN – bond anticipation notes – interim financing during construction progress –
upon proj completion replaced with long term bond financing
Tax exempt commercial paper – short term unsecured promissory note (usually 30-60
days); continuous offerings available frequently on a daily basis; maturities a matter
of negotiation and set to coincide w/ issuer and investor preferences – b/c of
flexibility, paper is backed up by a credit facility (line or letter of credit) from a
commercial bank; same day settlement
Variable rate securities – interest rates allowed to fluctuate in response to changing
markets – new rate is assigned to the o/s paper w/o maturing – allowed investors to
cash their investments by putting it back to the issuer for repayment – interest cost
savings – allow issuers to convert long term fixed rate issues at any interest reset date
at the election of the issuer – obligations can be called at any interest adjustment date
at the election of the issuer w/ no call premium – underwriting charges tend to be
lower
Putable securities – greatly enhance the liquidity of the investor, who upon notice,
can get back the principal amount of the investment and is not exposed to the risk of
capital deterioration found in fixed coupon obligation – allows bondholders the
choice of holding or redeeming at par their investments at specified future intervals –
effectively allows investors to convert long term bonds to short term securities; while
it seems simple, a “put option” can require elaborate supporting cast of players:
tender agent, remarketing agent and a credit facility.
Disadvantages of put option:
 interest rate risk borne by the issuer – can be hedged by stating interest rate
maximums or building interest reserve or guard to smooth out fluctuations
 if issuer needs credit facility, cost of borrowing could escalate sharply b/c the
lending rate is typically pegged to the bank prime rate or higher
26

risk that credit rating of the credit facility may drop and force a substantial putting
back of the issue to the remarketing agent, who will have to increase interest rates
Both TAN and BAN are equivalents of working capital loans that provide temporary
sources of funds to bridge cash flow gaps between revenue collections and operating
outlays.
Call options: key to refunding – will result in higher rate on redeemable bonds.
Refunding permits issuers the flexibility to reduce remaining debt service costs at some
future date.
The market routinely places a higher value on the call option when interest rates are
near cyclical peaks.
Most often, bond indentures carry “call protection” which prohibits the exercise of a call
option for a certain period after the sale of the bond.
Refunding strategies (when interest rates decline):
 refunding – involves the sale of new bonds, the proceeds of w/c are used to redeem
the old bonds – usually done to save interests costs but may be undertaken to
overcome restrictions in bond covenants.
 advance refunding – sale of new bonds as in a refunding, but the proceeds are not
used immediately to redeem o/s bonds – instead, proceeds are typically invested in
US govt securities and placed in escrow – escrow used to meet debt service payments
of old bonds
 under traditional advance refunding technique – old bondholders look to the
escrow fund for their security – bondholders enjoy an elevation of the credit
quality of their holdings
 under straight refunding – bondholders look to the original pledged revenue
source
Zero coupon bond – does not pay interest coupons – sold originally at a discount –
accumulates interest over its life – attractive for investors interested in future wealth –
can be viewed as a way of avoiding reinvestment risk
Most common way to market bonds – use underwriting syndicate – most securities are
first bought by investment bankers then redistributed to the ultimate investors – this way
usually restricted to specialized or small issues – exception: use of direct issuances
where govt decides to offer from its own offices securities to its own citizen-investors
Registered form of security – replaced the bearer form
Capital accumulator instrument – recent offerings of minibond w/c eliminates need for
issuing semi annual interest checks
27
1986 TRA – restricted arbitrage – removed advantages of delaying bond issuance and
quickened the interest of issuers in issuing bonds as a hedge against future interest
increases – also precluded large volumes of tax exempt bonds o/s from advance
refunding – imposed state volume caps for tax exempt
Hedging – borrowing designed as a hedge against future increases in rates – proceeds
placed in escrow at a restricted yield to avoid arbitrage – fees contingent and paid only
when funds are actually expended as planned
Forward - REDs – refunding escrow deposit securities – investors enter into forward
purchase agreements to buy tax exempt refunding issues when the old issues were
eligible for call – placed in escrow designed to mature just before the maturity of the olds
bonds to be refunded
Interest rate swaps – major impetus evolved from the need to accomplish debt
management goals (e.g., changing interest rate payment pattern) w/o resorting to new
issues (e.g., advance refunding might not be possible) – usually involves an exchange of
floating for fixed rates – neither original obligation nor the principal payments are
affected – payments made on net basis – whichever parties owes more pays the difference
Economic development bond – leading example of taxable financing – carries higher
interest rates but has advantages since interest income is exempt from state income taxes;
govt may extend certain pledges that improve the creditworthiness of the issue; financed
improvement may enjoy sales and property tax exemptions
Three Types of Credit enhancements:
1. bank credit supports – mostly in short term markets – called in the aggregate two
generic types are line of credit and letter of credit:
line of credit – primarily short term market – only temporary – two charges are
commitment fee and draw-down rate – commitment fee is like insurance premium;
draw-down fee is like loan rate
letter of credit – more impt form; commitments between the bank and the investor –
have direct claims against the bank for payment in the event the debt service is not
paid in full and on time – generally shorter life than the life of the bonds; banks can
place interest rate guards (puts maximums on interest rates in case of variable rate
securities)
2. bond insurance – an unconditional promise to pay over the life of the bond issue –
three major insurers: MBIA, AMBAC and FGIC – regulated by the state insurance
commissioner – savings by purchasing insurance vary w/ the level of interest rates;
the relative spreads on interest rate between the grades of bonds and the insurers –
premium is usually paid up front so interest costs savings (usually spread over several
years) s/b compared to the cost of the premium in present value terms
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3. state sponsored credit assistance for local govt – are in the form of guarantees, loan
pools, banks and other special purpose lending authorities to assist in marketing bonds –
simplest and most straightforward is a state guarantee, by pledging state’s full faith and
credit in support of local debt – direct guarantees are rare b/c of constitutional restraints,
counts against state’s own debt limit
State’s guarantee provides recourse:
 a lien on revenues of local project
 a lien on the general obligation (taxing power)
 a lien on state assistance payments
 a lien on the debt service reserve
State’s softening of degree of credit support: common technique is “moral obligation” –
state is not legally bound w/c is a weaker form of obligation. Most popular form is
special purpose lending authority
Chapter 16: Leasing and Service Contracts
Lease – contract or agreement that allows one party (lessee) the right to use and possess
equipment or property of another party (lessor) for a special period of time – could be for
a single transaction or a master lease – either way, lessee to make period payments
True lease – lessee acquires use but not ownership – in the public sector, payments are
not treated as principal and interest so no exemption to the lessor from federal and state
taxes for any part of the lease payments – usually defined as operating leases for
accounting and financial reporting purposes (FASB 13) – true leases are appropriate
when financial considerations are not as important as other factors
Operating lease – covers 75% of leased property’s useful life – another form is service
lease – requires lessor to maintain property
Lease purchase agreements – tax exempt leases – under municipal lease purchase
agreements, financing may be provided by third party – periodic lease payments may be
separable into principal and interest (considered tax exempt – must meet requirements of
govt obligation as defined by IRS) – tax exempt includes a nonappropriation or fiscal
funding clause w/c allows a govt lessee to terminate w/o penalty – b/c it can be cancelled
by lessee, the lease is a weaker pledge than a bond.
Leasing growth due to blend of expediency and efficiency:
 not included in long term debt in calculating legal debt limits
 not generally subject to voter approval
 cost of bond sale may be avoided (compensates for higher interest rates)
 suitable method for financing capital assets that are too expensive to fund for one
period but have useful lives too short for bond issuance
 rapid changes in technology
29
Master lease – lessee can acquire several types of assets over a period of time that extend
beyond the initial financing date – one set of document controls and sets forth the
conditions – can be used for real property or equipment - the govt can:
 reduce overall financing cost
 consolidate financing of equip of several depts into one transaction
 centralize financing procedure
 reduce market risk and exposure inherent in multiple financings
 eliminate unnecessary exp and labor involved in repeated financial bids and analysis
 utilize one standard document package
Sale leaseback and asset transfers – financing arrangement in w/c owner of a cap asset
sells the asset to another party and simultaneously executes an agreement to lease the
asset back from the buyer – can be used to eliminate the need to build up reserve funds or
capitalize interest
Certificates of participation (COPs) – title to the leased asset is assigned by the lessor to
a trustee that holds it for the benefit of the investors – COPs usually for capital needs of
$5 million and above
3 factors for higher costs of COPs:
 issuance
 higher interest rates
 requirement of debt service reserve funds
Service contract – legal contract bet. a private company and a govt entity that requires the
private company, in return for a specified fee, to provide certain services that would
otherwise be provided by the govt entity – factors to consider:
 provision of a service not available under existing constraints
 potential for high quality service
 sharing the risks of operation
 ability to establish the service in a shorter time than if govt were to develop the
project
Govt entities primarily utilize short term operating arrangements when use and access to
the capital asset or facility is impt for only a short period of time.
Disadvantage of full service contract:
 loss of control of the facility
 complicated legal proceedings to structure and finance the proj
 reduction in the municipal workforce
 ongoing need for monitoring the quality of service provided
 difficulty in determining the net cost of the proj on an equitable basis
 requirement to buy the facility at end of term of agreement
30
Tax benefits of true lease: provides dep’n benefits for private lessor – dep’n may not be
accelerated if lease involves govt lessor and exceeds a short term arrangement – use
straight line method over mid point life of asset or 125% of lease term – interest
component is tax exempt but not capital recovery



Key characteristics of tax exempt leasing from bond indebtedness include: nonappropriation clause – means payments of the lease are dependent upon an annual
appropriation by the governing body – present year govt’s action does not bind
succeeding ones to pay the obligation
nonsubstitution – govt declares that it won’t substitute a new facility or equip for that
which is leased – may not be enforceable since enforcement of the govt liab means
that the govt is stripped or its ability to perform essential function (e.g., using school
buses or police vehicles)
essential purpose – equip or facility must be for essential purpose – not to be taken at
face value and need not be substantially backed in fact – questions to ask:
 vital to community – comm. can’t function w/o it?
 how does it tie to govt’s service delivery system
 impact of not providing the proj or terminating lease agreement
 practical (in terms of time and dollars) to replace prop or equip leased
 needs assessment study been done
Security of interest – assurance lessor has right to take possession if lessee fails to make
lease payments w/o legal contest – some states however restrict municipalities from
granting lessor security interest
Insurance – is particularly impt in states where there may be abatements in rent if the
facility is not operating – also provides coverage b/c of limitations under 1986 TRA in
which funding of bond reserves from tax exempt bonds may not exceed 10% of the initial
offering
Economies of lease purchase contract:
 elimination of the expense and delay b/c of a bond referundum
 usefulness to small govt that have limited access to capital markets
 ability to finance relatively small capital needs that are too large to be funded from
current revenues
An evaluation of a “lease vs. borrow” should be undertaken using “total present value
cost analysis” – done by adding all costs that occur over time under each alternative to
adjust them for the time value of money thru discounting to present values and then to
compare the net present value costs to each other.
The hallmark of the lease over the years has been its great flexibility.
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III. SOURCE: A PRACTITIONER’S GUIDE – HOW TO CHOOSE THE
METHOD OF SALE FOR TAX EXEMPT BONDS – COMPETITIVE VS.
NEGOTIATED
Bonds sold three ways: (method impt factor in determining the overall cost of the
financing) – most sold thru the first two options
 competitive – predominantly used for long term tax exempt bonds – issuer determines
the size and other characteristics of the issue, prepares bond documents, obtains
ratings and complete all other necessary tasks prior to soliciting bids – each bid takes
into account both the interest paid to the investor and the compensation to the
underwriter
 negotiated – underwriter selected well in advance – issuer selects firm for lead role or
senior managing underwriter who will take active role in sizing and structuring the
issue
 private placement – rarely used – issuer sells bonds directly to a limited number of
sophisticated investors w/o public offering
discount of gross spread – underwriter’s compensation – may include a risk component
w/c increases cost to the issuer
Purchase agreement signed and approved by legislative body usually within one or two
days of the sale date.
Advantages of competitive bids:
 assurance bonds are sold at the lowest interest rates given market conditions
 underwriter’s compensation usually lower
 promotes an appearance of open, fair process
Disadvantages of competitive bids:
 issuer may have less flexibility
 underwriters may build risk premium in their compensation
 complex financing or a weak or unknown credit may have difficulty attracting bids
 issuers have less control in selecting underwriting syndicate
Advantages of negotiated sale:
 greater incentive for underwriter to engage in pre-sale marketing
 flexibility – structure and timing can be adjusted as necessary to respond to market
cond
 issuer has greater control in allocating bonds to underwriting firms
Disadvantages of negotiated sale:
 may result in charges of favoritism and reduce public confidence
 require issuers to make greater effort to remain informed of dev. in muni market and
may not have resources (can be mitigated by hiring good financial advisor)
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Factors to consider in choosing method of sale:
 decide w/c method is likely to result in lowest costs and achieve impt policy
objectives
 base decision on characteristics of the issuer, market conditions and type of financing
contemplated
 decide w/c one generates the most interest for the bonds among underwriters &
investors
Debt structure – consider the nature of securities to be offered and evaluate ff issues:
 is debt widely understood and accepted
 is a complex or unique security provision or revenue stream used to support debt
 does proj generate cash flows that require a unique financing structure
 will the issue be combined with use of innovative financing techniques, e.g,
derivatives
 will bonds be targeted to specific investor groups for w/c special structure is
beneficial
Plain vanilla bond offerings - frequently issued and widely understood e.g., general
obligation bonds and commonly issued revenue bonds – using competitive sale can result
in very favorable interest rates
Credit quality questions:
 has issuer experienced recurring difficulty in balancing its budget
 has issuer been downgraded or placed on credit watch
 has issuer’s financial outlook improved considerably since the last bonds were rated
 will the issue be non rated
Competitive effective for bonds rated “A” – Negotiated advantageous if issuer’s
credit quality is low or rapidly deteriorating or for infrequent issuers – consider for
large issue
Issuer characteristics – contribute to investor demands for the bonds:
 issuer new or infrequent issuer
 issuer well-known and regular participant – stable financial quality
 concerns – e.g., pending litigation, previous default, unfavorable court rulings
 how favorably have prior issues been received
 size of issue contemplated
Evaluating market conditions:
 events creating market uncertainty – war or other crisis, pending legislation
 federal reserve board contemplating actions that may affect market conditions
 refunding issue being contemplated
 are there other large issues coming to the market
During periods of real or expected interest rate fluctuation, maybe favorable to sell
bonds by negotiated method.
33
Request for qualifications (RFQ) – enables issuers to increase underwriter support
Notice of sale – enables issuer, using competitive process, to achieve some of the
flexibility of negotiated process – e.g., permitting underwriters to group various
maturities into term bonds instead of serial bonds – term bonds have mandatory
redemption provisions
Request for proposals (RFP) – enables issuers to solicit qualified underwriting firms to
serve as managing underwriter – gain understanding of the firm and the individuals who
would work on the account, firm’s financial position, its understanding of issuer’s needs,
indication of components making up the underwriting spread
Takedown – amount of underwriter’s compensation for selling the bonds
Issuers should not rule out competitive sale to meet policy objective. Regardless of the
method of sale chosen, issuers need to look for opportunities to achieve greater
flexibility, competition, and knowledge to obtain lowest cost of debt financing. Issuers
should require their underwriter or financial advisors to provide market date and results
of comparable sales both prior to the sale and after the sale.
34
IV. SOURCE: GFOA RECOMMENDED PRACTICES – DEBT MANAGEMENT
Securitization of Leases: There is nothing inherently wrong with lessors securitizing
their lease holdings.
GFOA recommends:
 govt entity should centralize all information on leases so finance officer has full
knowledge of any lease agreements
 original lease documents should explicitly state what is and is not permissible
regarding secondary lease securitization – which should clearly indicate:
 role and responsibility, if any, of govt as part of the lease offering
 that the offering is a secondary offering and whether all requirements relating to
the tax exemption of the securities have been met
 require all necessary legal opinions are obtained by the lessor prior to a public
offering of a secondary lease transaction
Selecting & Managing the Method of Sale of State & Local Govt
Use method that is expected to achieve the best sales results, taking into account both
short-range and long-range implications for the taxpayers and ratepayer. GFOA
recommends policies be adopted to ensure the most appropriate method is used.
GFOA recommends competitive method when following conditions are present:
 market is familiar w/ issuer – issuer is stable and regular borrower
 active secondary market is present w/ a broad investor base
 issue has enhanced credit rating of A or above or can obtain credit enhancement prior
to sale
 debt is backed by issuer’s full faith and credit or historically strong revenue stream
 issue not too large to be easily absorbed by the market nor too small to attract
investors w/o concerted sales effort
 issue not viewed by market as complex or has innovative features
 interest rates are stable, market demand is strong and market is able to absorb buying
or selling reasonable price changes
DBE – disadvantage business enterprise – may be reason for negotiated sale to address
public policy issues
If issuer chooses negotiated method, GFOA recommends:
 promote fairness by using competitive underwriter selection process
 remain actively involved in each step of the negotiations
 ensure that either an employee of the issuer or an outside professional othern than the
issue underwriter is available to assist in the structuring, pricing and monitoring
 avoid using a firm that serves both as the financial advisor and underwriter
 require that the financial professionals disclose names of any person or firm
compensated to promote selection of underwriter, etc.
 review the “agreement among underwriters”
35
Analyzing an Advance Refunding:
GFOA recommends govt issuers undertake an analysis of their debt capacity prior to
issuing bonds – analysis to cover:
 statutory or constitutional limitations – tax or exp ceilings
 other legal limitations – e.g., coverage requirements
 measure of the tax and revenue base
 trends relating to the govt financial performance
 debt service obligations – debt per capita, percentage of personal income/assessed
property value, overlapping debt
 measure of debt burden on the community
 tax exempt market factors affecting interest costs
Development of a Debt Policy
debt policy – sets forth the parameters for issuing debt and managing the debt portfolio
and provides guidance to decision makers – adherence to policy helps to ensure govt
maintain sound debt position and protect its credit quality – should strike an appropriate
balance between establishing limits and providing sufficient flexibility to respond to
unforeseen circumstances
GFOA recommends following elements on debt policy:
 purpose of debt
 legal debt limitations
 use of moral obligation pledges
 types of debt permitted
 structural features to be considered
 credit objectives
 authorized methods of sale
 method of selecting outside finance professionals
 policy on refunding debt
 primary and secondary market disclosure practices
 compliance w/ federal tax law provisions – arbitrage
 integration of capital planning and debt financing activities
 investment of bond proceeds
Sale of Derivative Instruments by State and Local Governments
State and local govt may use a wide range of financial derivative products.
Derivative – a financial instrument created from or whose value depends on (is derived
from) the value of one or more separate assets or indexes of asset values – govt may use
floaters/inverse floaters, collateralized mortgage obligations (CMO’s), forwards, futures
and options – may be useful debt management tool if used prudently – use with extreme
caution
36
Derivative products do not have large markets – issuers s/b concerned w/:
 may create uncertainty to issuer’s future debt service obligation
 undesirable effect on issuer’s credit quality
 issuer may be exposed to counterparty risk
 may be difficult to terminate once issued
Derivative attributes:
 high price volatility
 illiquid markets
 not market tested
 highly leveraged
 require high degree of sophistication to manage effectively
Investment of Bond Proceeds – may include construction fund, debt service fund, debt
service reserve fund and escrow fund in a refunding – will depend in part on federal and
state statutes and regulations, yield, drawdown – each has different objectives
Risks involved:
 credit risk – instruments that may default
 market risk – selling investment prior to maturity or less than book value
 opportunity risk – investing long term vs short term w/ rates fluctuating
GFOA recommends ff. policies and procedures for investment of bond proceeds to
ensure legal and regulatory requirements are met, fair value bids are received and issuer
objectives are attained:
 investment policy to include investment of bond proceeds
 timely coordination of issuer’s debt management and investment activities
 duties of the individual designated by issuer for investment of bond proceeds are
specified
 investment officer’s decisions conform w/ all legal, statutory and regulatory req. est.
by trust indenture
 underwriters and financial advisors report to issuers any finders fees or fee sharing
arrangements
 issuer to seek competitive bids where required – minimum 3 bids – all fees disclosed
 in negotiated trans. – issuers should not agree to accept a reduction in the
underwriter’s management fee in exchange for allowing underwriter to invest bond
proceeds
Maintaining an Investor Relations Program
An effective investor relations prog. that responds to investor needs and concerns can
lower borrowing costs for issuer.
37
GFOA recommends:
 identify individual responsible for speaking on behalf of the issuer
 dev. procedures for identifying and selecting info, both positive and negative,
available to investors
 dev. procedures for disseminating info to ensure it gets to all parts of the market
simultaneously – not just to select investors
 dev. procedures to ensure potential investors receive copy of the prelim official
statements at least one week in advance of a bond sale
 identify ways to stay abreast of issues that are likely to concern investors
 dev. and maintain good relationship w/ rating agencies
 dev. procedures to ensure that financial stmts. or other info for disclosure purposes
are completed on a consistent schedule from year to year and prior to the date est. in
any contractual commitments
 delineate clearly the roles and disclosure responsibilities in conduit borrowings
 engage in marketing activities to alert investor of a pending bond sale – esp. if
competitive sale
 identify investors who hold the bonds to improve communication – caution: check if
list of investors s/b confidential
 be aware that securities law issues may exist regarding electronic info – consult
counsel
Payment of the Expense Component of Underwriter’s Discount
Compensation of underwriters in negotiated sale:
 takedown
 management fee
 underwriting risk
 expenses – incurred in behalf of issuers – u/w counsel (set cap); travel to and from
issuers’ offices; communications; printing; closing costs, etc. (do not allow travel to
and from offices by U/W staff)
Permitting U/W to charge members of the U/W syndicate for exp. w/o knowledge of
issuer, by reducing takedown or management fee, may compromise issuer goals such as
rewarding sales or other efforts of the members of the syndicate.
GFOA recommends to ensure expenses are reasonable and explicitly identified:
 require U/W to present itemized list of expenses they expect to incur and how they’ll
be paid
 clarify w/c expenses are regarded as legitimate and reasonable
 pay attention to U/W fees for their counsel – set cap
 require U/W to document all expenses
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Pricing Bonds in a Negotiated Sale
Bond pricing in a negotiated sale, unlike competitive sale, requires greater issuer
involvement – success depends on issuer’s ability and willingness to devote time to
understanding the market and historical performance of its bonds. Issuers strive for best
balance bet. the yield for each maturity and the takedown (sales commission) to achieve
overall lowest cost of financing.
GFOA recommends:
 communicate to U/W specific goals in pricing of bonds/expectations re roles of each
member of financing team
 prior to final pricing, manage compensation of U/W
 understand prevailing market conditions – supply and demand for muni bonds; key
indicators; interest rates/current yields
 premarketing efforts to gauge and build investor interest
 U/W to propose consensus pricing scale on the day prior to the pricing
 evaluate structural features that reduce TIC but limit future flexibility in managing
debt – result in greater overall borrowing costs
 direct how bonds s/b allocated
 approve all info sent by U/W
 be present on the trading floor of the lead manager, if possible, when bonds are sold –
issuer presence may serve as catalyst to improve overall marketing effort
 evaluate bond sale after its completion – assess level of up-front costs of issuance
 develop database on each issue re pricing performance
Securitization of Tax Exempt Bonds
securitization – creates secondary market – financial inst. places govt sec. with a
custodian
Potential prob. in calc. arbitrage yield for a bond offering may result for a govt issuer if a
connection is established bet. the primary offering and the instruments being created for
the secondary market, esp. if bonds are securitized w/o issuers’ knowledge.
To prevent secondary market trans. from adversely affecting tax exempt status, issuers
must ensure that bond counsel has info re the facts and expectations needed to calc
arbitrage yield and to verify compliance w/ tax rules; e.g., 2% limit on cost of issuance
for private activity bonds.
GFOA recommends: establish certification procedures – appropriate calc of arbitrage
yield including:
 bond issue directly offered to the public or thru securitization format
 securitized bonds s/b identified by maturity and by the % of each maturity to be
securitized
 identify date when securitization is expected to occur
39
Preparing RFPs to Select Financial Advisors and U/W
RFP – promotes fairness and objectivity; compare respondents to obtain best price/level
of service – include:
 scope of work
 objective selection criteria
 require three references
 relevant experience of the firm and individuals assigned
 respondent’s ideas how issuer should approach financing, etc.
 analytical capability of the firm/individuals
 availability of source of info
 amount of uncommitted capital available – ability and willingness to purchase entire
offering
 level and types of insurance carried
 finders’ fees - fees paid to FA s/b on an hourly or retainer basis – should not be
contingent – may want to restrict firm from engaging in act. on behalf of issuer to
produce a direct or indirect financial gain w/o issuer’s consent
 maximize number of respondents
 at least one week for firms to develop responses to RFP
 evaluation procedures and rating process and document how ranked
Evaluating the Use of Pension Obligation Bonds
unfunded actuarial liability – difference bet. the present value of all benefits est. to be
payable to plan members and the actuarial value of plan assets available to pay those
benefits.
Pension obligation bonds (POB)must be issued on a taxable basis b/c current federal
tax law restricts the investment of the proceeds of tax exempt bonds in higher yielding
taxable securities – issuing these bonds can produce savings for govt if interest rate on
the bonds is less than the rate of return earned on proceeds placed in the pension plan.
Govt to use caution in issuing POB – be sure legally authorized – should not become
substitute for prudent funding of pension plans – govt should analyze ff. before issuing
POB:
 expected saving can be reduced or eliminated if expected rate of return on the bond is
not significantly higher than rates paid on the bonds
 even if bonds are sold, govt could still face unfunded liab. in the future
 structuring POB to take savings up front by deferring principal payments will result
in a higher TIC – w/c lowers overall savings
 issuing POB increases debt burden – could be used for other purposes
 POB liab. reported on balance sheet while actuarial liab. is not
 analysis should extend out thru the amortization period of the unfunded liab on a cash
flow basis – total pension related cash outlays on a net present value basis s/b less
than would have been the case had the bonds not been issued
40
Even if analysis indicates financial benefits outweigh the risks, further consider:
 loss of flexibility during diff. economic times b/c of debt service requirements
 policymakers may misunderstand that unfunded liab. may reappear in the future
 potential pressures for addtl benefits by employees if plans are “fully” funded
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V. SOURCE: TAX-EXEMPT FINANCING /A PRIMER
Chapter 1 – Fundamentals of tax exempt financing
3 means of financing cip and other projects used by govt:
 pay as you go
 grants or intergovt revenues
 borrowing – issuing bonds
bond – debt instrument bearing a stated rate of interest that matures on a certain date at
w/c time a fixed sum of money plus interest is payable to the bondholder
municipal bonds – unlike corporate debt issues, are exempt from federal and maybe from
state and local taxes – so investors accept a lower rate on tax exempt issues to
compensate for reduced tax burden – lower rate reduces borrowing costs for govt
2 general types of tax-exempt bonds:
 general obligation bonds – backed by full faith and credit of issuer – general taxing
power is pledged
 revenue bonds – issued for specific project – not backed by full faith and credit and
therefore pay slightly higher interest rate than GO bonds
All citizens benefit from tax exempt bonds – primary beneficiaries are citizens of issuing
community but national interest is well served by keeping state and local govt borrowing
costs low w/c provide incentive for public investment in infrastructure and other
facilities.
Most tax exempt bonds are purchased by individuals.
2 categories of tax exempt bonds (categories have been incorporated in the federal
income tax code to reduce volume of tax exempt bonds)
 governmental bonds – no specific definition in the tax code – definition of the
private activity bonds and the application of the two private business use tests that
determine if a bond is a govt or private activity bond
 private activity bonds – more than 10% of the proceeds is to be used in a trade or
business of a person or persons other than a govt unit (except for non profit org) and
w/c is to be directly or indirectly paid from, or secured by, revenues from a private
trade or business
Not all interest in private activity bonds is taxable – there are exempt facilities like docks
and wharves, mass transportation, water/sewer facilities for example. Also, mortgage
revenue bonds, IDB, RDA, etc. – these used to carry sunset dates but OBRA of 1993
extended exemptions on a permanent basis.
42
Bonds for governmentally owned and operated facilities (like airports, docks, wharves)
are classified as private activity bonds b/c usually result in more than 10% or proceeds
are used by a private business and payments from these businesses are pledged to repay
the bonds.
Govt bonds and tax exempt private activity bonds are treated differently. Tax exempt
private activity bonds are subject to ff. tax code:
 statewide volume cap – ceiling is the greater of $50 per capita or $150 million
although there are exceptions like airports, docks and wharves.
 alternative minimum tax (AMT) – interest earned on tax exempt private activity
bonds must be included in an individual’s or corporation’s calculation of AMT –
however, not taxed to the individual but corp. must include in their adjusted current
earnings
 limitations on advance refunding – in general, since 1986, tax exempt private activity
bonds may not be refunded and govt bonds may be advance refunded once
 other restrictions – e.g., no substantial user or related person; maturity may not
exceed 120% of economic life of facility; no more than 25% for land acquisition; no
more than 2% for issuance costs
State govt place controls on the use of tax exempt financing but mainly the federal govt
regulates tax exempt financing.
Chapter 2 - Constitutional and Policy Issues
U.S. Constitution does not prevent Congress from taxing the interest on tax exempt
municipal bonds – state and local govt must find their protection from congressional
regulation thru the national political process.
1988 Supreme Court ruling (South Carolina vs. Baker - w/c ruled that the fed. govt may
tax the interest paid on state and local bonds) had no immediate consequence on the
status of outstanding tax exempt bonds but opened increased restrictions by Congress.
State and local govt are prohibited by federal statute to tax interest on federal securities
but states and local govt rules vary on taxing muni bonds.
Chapter 3 – Congressional Actions and Their Effects
1986 Tax Reform Act – contained the most substantial changes in tax exempt financing –
major objective = to reduce the benefits of tax exemption – consequences: many no
longer exempt; some subject to limitations; sound financial management has been made
more difficult b/c of rules like advance refunding and arbitrage rebate requirements.
43
Forces that pushed changes in tax exempt bond laws: curtail abusive practices (e.g.,
bonds issued for sole purpose of earning arbitrage) and b/c of mounting federal budget
deficits – impact of changes = volume fell; before investors were mostly commercial
banks; after, individuals – if issuers depend on single market, would result in more
volatile market – also b/c of arbitrage rebate requirement, bond issues more costly
Changes needed per Anthony Commission on Public Finance:
 arbitrage restrictions – currently limited
 restoration of bank interest deductions – previously permitted to deduct all – except
for 80% of the costs of purchasing and carrying bonds of issuers that do not issue
more than $10 million annually
 repeal of AMT – were designed to ensure that taxpayers could not avoid paying taxes
entirely – bonds subj to AMT pay roughly 25 more basis points in interest
 new rules to distinguish govt from private activity bonds
 modify volume caps – current imposes unified volume caps – in addition to the
greater of $50 per capita or $150 million, if private use portion exceeds $15 million,
the excess of over $15 million is subj to the volume cap even if the private use
portion does not exceed 10% private use and security tests
 authority for more advance refundings
 reclass of tax exempt organization, e.g., 501©(3) like hospitals, nursing homes –
altho’ not subj to volume caps, these orgs may not have more than $150 million in
non hospital beds
Chapter 4 - Responses to Criticisms of Tax Exempt Financing
Tax exempt financing – not subsidy for special interests ; muni bonds are tax exempt b/c
of historical and traditional tax immunity bet. fed., state and local govt (altnough not
consititutionally protected) – tax exempt reduces borrowing costs by about 25% w/c
benefits the public.
Tax exemption is not the same as tax preference – these investments are from after tax
dollars, not as tax shelters – high income families has six other tax preferred investments
that outranked muni bonds. By investing in after tax dollars, muni bond investors pay an
implicit tax by accepting lower rate of interest.
75% of muni bond holders are individuals, as household, mutual fund or money market
fund.
Bond that met the private use test and security interest test was defined taxable:
 private use – if all or a major of bond proceeds were used in a trade or business of a
non exempt person (neither govt or 501©(3) organizations)
 security interest test – if all or a major portion of the debt service was to be secured
by property used in or payments derived from a trade or business of a non exempt
person
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Arbitrage bond – an issuance in w/c all or a major portion (85%) of the proceeds are used
directly or indirectly to purchase securities producing a materially higher yield – except
for temporary (3 years) investments.
To remain tax exempt. bonds must be issued in registered form.
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VI.
SOURCE: A PRACTITIONER’S GUIDE - STRUCTURING & SIZING
THE BOND ISSUE
Options re structure of the issue: (Sizing & structuring are closely interrelated – identify
all costs then determine how much to issue – sizing and structuring are closely related to
the method of sale)
 security provisions of the offering
 maturity
 how debt service will be paid
 redemption provisions
 specific marketing features
Issuers required to obtain voter approval will need to estimate these costs before the
election so the bond referendum reflects the necessary amount of bond proceeds.
Advance refunding – a technique to refinance existing debt and is undertaken to achieve
specific objective of the issuer – mostly taken to take advantage of lower interest rate –
also to remove effects of burdensome bond covenants.
Characteristics to be determined: (first is examine legal or statutory provisions)
 purpose of issue
 type of securities
 repayment source
Parity bonds – bonds with the same priority of claim against pledged revenues.
Security pledge and fast debt is retired are important considerations in the ratings process.
Structuring the issue: take into account legal, policy and financial objectives – elements
to be considered:
 security provisions – nature of pledged revenues – long term bonds fall into 2
categories: GO and revenue bonds – property tax usually main source to repay GO
bonds for local govt; sales tax for state – unlimited security on GO means govt agrees
to raise taxes w/o limit so that principal and interest are paid on time; limited, state
may levy up to only a predetermined amount to make debt service payment – on
revenue bonds, for gross pledge, pledged revenues are used first to make debt service
payments before paying operating and maintenance costs or other expenses – net
revenue pledge requires debt service to be paid after operating and maintenance costs
are met
 use of fixed and variable rate bonds – fixed is predetermined; do not benefit if interest
rates fall; variable – rates can be reset periodically – in a positively sloping yield
curve environment, issuers of variable rate can expect to pay lower rate of interest;
variable rate advantages b/c almost always result in lower total cost of financing over
the long run; also provides flexibility – have risks but can be mitigated by putting
caps
 debt service payments
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



serial and term bonds
zero coupon/capital appreciation bonds
premiums and discounts
redemption provisions
Credit enhancements: provide assurance that service payments will be made in full and
on time – issuers pay premium for these – save money and enhance marketability of an
offering
 bond insurance
 letter of credit
Coupon rates for bonds secured by a guarantee from a highly rated third party will be
lower b/c investors are willing to accept lower returns in exchange for less risk.
Special considerations for revenue bonds:
 provisions for flow of funds – order and timing when pledged revenues must be used
 bond covenants – legal provisions that impose certain restrictions on the issuer for the
benefit of investors (e.g., net revenues provide in the range of 1.10-1.25 times debt
service coverage)
 Common provisions: rate covenant; debt service covenant; operate and maintain the
financed facility to provide adequate casualty insurance; additional bonds test to
prohibit issuer from issuing parity bonds; list of permitted investments
 debt service reserve requirements – may be tapped if pledged revenues are not
sufficient to make timely debt service payments (bond proceeds are often used for
reserve)
Potential disadvantages in funding debt service reserve with either bond proceeds or
cash: issuer must increase size of the issue w/c depletes debt capacity – could be
problematic for issuers subject to statutory limits – issuer may opt to purchase LOC
or security bond (a financial instrument in w/c third party guarantees debt service
payments)
put or demand feature – allows investor to require the issuer to purchase his/her bonds in
accordance w/ specific terms and receive the par amount of the bonds – when interest
rates are reset, investors decide whether to keep the bonds at the new rate or put them
back to the issuer – issuers need to be sure they have enough cash, that’s why issuers
typically obtain a LOC – purchasing LOC also presents risk since LOC usually matures
sooner than may be the maturity of the bonds and may not be renewed
One way to decide how much variable rate to issue – consider how much to put on short
term investments, in w/c a hedge is created to mitigate the impact of interest rate
fluctuations.
Entering into a fixed to floating interest rate swap may be more cost effective than
directly issuing floating or fixed rate debt – swap = issuer of fixed rate debt can exchange
the payment it makes on its fixed rate debt for floating rate payments and vice versa.
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average life = total bond years
total number of bonds
total bond years = sum of (amount of $1,000 bonds per maturity x number of years to
maturity)
total number of bonds = total amount of $1,000 bonds
The issue’s average life provides one measure of issuer’s ability to repay debt.
Three approaches to debt service payments:
 level debt service – creates equal debt service payments over the life of the bonds –
results in higher interest payments and lower principal payments – advantage is easier
for issuers to budget and may be consistent with the flow of pledged revenues; makes
financing costs in the early years more affordable
 level principal payment – equal annual principal and declining interest payments over
the life of the issue – issuers pay higher total debt service costs in the early years
relative to level debt structure – results in shorter average bond life – enables issuers
to recover debt capacity rapidly
 ascending debt service – principal and interest deferred in the early years – can be
appropriate for certain types of projects such as revenue generating facility
One way to approach developing a maturity schedule is to match useful life of the
projects being financed with the term of the bonds. Most issues pay interest semi
annually and principal annually. In general, date of issuance will not coincide with the
schedule of debt service payments so that the first interest payment will either be sooner
than six months from the issue date (short coupon or stub period) or later than six months
(long coupon or stub period)
serial term bond – certain amount of principal comes due in annual installments
term bond – bundles principal payments into one large maturity
In the muni market, the yield curve is generally positively sloped with a steeper slope in
early years and flattening out in longer maturities – as a result, having some serial bonds
w/ shorter maturities and lower interest rates can help reduce the true interest cost if
term bonds are used in longer maturities.
Issuers may find that trustee or paying agent fees will be higher if various maturities of
bonds are grouped into a term bond b/c of the added adm. requirements involved in
calling bonds subject to mandatory redemption.
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Zero coupon bonds are issued at a deep discount from par and they accrete to their full
value at final maturity – b/c they are issued at a deep discount, the amount of proceeds is
significantly less than the par amount of the issue – issues of zero coupon bonds have to
issue a higher par amount relative to CABs – Note: issuers subject to statutory
limitations requiring that debt be issued at a price equal or near the par amount are
prohibited from issuing zero coupon bonds. – b/c par amount may be counted towards
limit even if less proceeds are received
Capital appreciation bonds (CABs)are issued at par and interest accrues at the bond’s
stated interest rate until the final maturity and is paid in a lump sum – issues receive the
par amount less issuance costs
Both zero coupon and CABs lock in a reinvestment rate for the life of the issue –
investors in these bonds are subject to market risk (a concern for securities that pay
interest periodically) – both subject to greater price volatility compared with conventional
full coupon bonds.
OID bonds sold at original issue discount – have initial offering price below the par –
investors agree to accept lower coupon interest rate in exchange for a discount on the
price of the bonds – conversely, bonds sold at premium have offering price that exceeds
par value that’s why investors agree to pay higher price for higher coupon interest rates.
The decision to issue bonds at premium or discount may be based on legal issues, market
conditions or other factors such as use of an OID to reduce true interest cost relative to
issue at par. Bonds sold at discount offer call protection to investors.
Govt issue premium bonds to squeeze additional proceeds from issue – premium bonds
bear higher coupon rates so more debt service costs for issuers.
In a competitive offering, decisions on use of OID or premium reoffering the bonds made
primarily by winning underwriting firm or syndicate.
Mandatory redemption provisions usually connected with term bonds – typical call
option after 10 years, and sometimes at premium if redeemed in the 10th or 11th year.
Issuers likely to exercise call option when interest rates decline – in low interest rate
environments, issuers may consider giving up their call right in exchange for potentially
lower coupon rates for the non-callable bonds.
Call premium provides protection to investors by making it more difficult for issuers to
refund bonds when interest rates decline – call premium reduces the present value
savings of a refunding – the higher the call premium, the lower the present value savings
of the refunding – bonds issued before 1985 that are advance refunded must be called if
the call premium is 3% or less; i.e., bonds callable at 103% or less.
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Elements in the bond sizing process (structural features):
 underwriter’s discount
 original issue discount/premium
 accrued interest
 capitalized interest
 contingency fund
 construction cost/draw schedule
 other issuance cost
 other sources/uses
 debt service reserve fund
 credit enhancement fees
A project is said to be net funded if it relies on the investment earnings to generate
sufficient funding for the project – as a result, the amount of bonds issues will be less
than the total cost of the project.
Issuers are permitted to keep arbitrage profits if any of the ff. conditions are met:
govt entity is a taxing authority that expects to issue $5M or less of tax exempt debt each
calendar year
 issuer able to expend all proceeds of tax exempt debt w/in 6 months
 issuer able to expend all proceeds of an issue for capital projects over an 18-month
period according to ff. schedule: 15% in 6 months; 60% in 12 months and 100% in
18 months.
 issuer able to expend proceeds for governmental purpose or private activity bonds for
governmentally-owned facilities accdg. to ff. schedule: 10% in 6 months; 45% in 12
months; 75% in 18 months and 100% in 24 months.
IRS considers ff. as overissuance of tax exempt debt:
 proceeds in excess of what is reasonably needed to construct proj. excluding minor
portion of issue (lesser of 5% of bond proceeds or $100K)
 bonds do not meet ff. condition:
 at least 85% of proceeds exp. w/in 3 years
 issuer has binding obligation to 3rd party to spend at least 5% of proceeds w/in 6
months
 issuer proceeds with due diligence in completing project
 bonds w/c exceed safe harbors against creation of replacement proceeds
In order to avoid overissuance, many jurisdictions issue bonds to meet annual
expenditure schedule of the project rather than total cost of the project – makes sense for
large capital projects or program undertaken over several years – but will also result in
higher overall issuance costs – alternative, use short term bond financing as BANs.
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VII: SOURCE – GUIDE TO ARBITRAGE REQUIREMENTS FOR
GOVERNMENTAL BOND ISSUES
Chapter 1 – Introduction
Principal purpose of Section 148 of IRS Code: to eliminate significant incentives to issue
more bonds, to issue bonds earlier, and to leave bonds outstanding longer than necessary
to carry out the governmental purpose of tax-exempt issue – also, to minimize the tax
arbitrage benefit associated w/ investing proceeds of the bonds in taxable securities.
Arbitrage – by definition, is the purchase and sale of the same or a similar security in
order to profit by price discrepancies between markets – for tax exempt bond purposes,
the ability to obtain tax exempt proceeds and invest them in higher yielding taxable
securities resulting in a profit to the issuer.
Simple rule of arbitrage: in general, issuer may never invest gross proceeds at a yield
w/c exceeds the yield on the bonds. Exceptions – certain specified periods for certain
specified purposes.
Difference between arbitrage restrictions and arbitrage rebate requirements:
arbitrage restrictions – describe the circumstances in w/c investment in materially higher
yielding securities is allowed w/o compromising the tax exempt status of the bond issue
arbitrage rebate – identify what must be done w/ profits earned – rebate requirements are
an addition to the arbitrage restrictions rules, and not a replacement
Gross proceeds – collectively, the amount subject to arbitrage restrictions and rebate
requirements – include any proceeds of the issue and any replacement proceeds of the
issue.
proceeds – original and transferred proceeds of the issue
original proceeds – sale proceeds and any investment proceeds of the issue
sale proceeds – amounts received from the sale or disposition of an issue excluding
amount used to pay accrued interest on the bonds w/in one year
investment proceeds – interest from investing original proceeds
transferred proceeds – proceeds from refunded issue that are allocated to the refunding
issue as a result of refinancing
replacement proceeds – amounts held in sinking fund, pledged fun or reserve or
replacement fund for the issue – subject to rebate requirements regardless of whether they
were funded w/ proceeds of an issue or from revenues of a project
Yield – measure of the rate of return w/c is computed by present valuing the receipts
from, or payments on, an investment to its purchase price
Purchase price (of a tax exempt bond) price to the first buyer who does not include a
bond house, broker, underwriter or intermediary
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Purchase price (of an investment) – is the market price, w/c is the price at w/c a willing
purchaser acquires from a willing seller w/o consideration of arbitrage
Chapter 2 – Arbitrage Restriction Requirements
reasonable expectations concept: issuer reasonably expects certain events will occur w/c
establish that bonds are not arbitrage bonds – subsequent intentional acts by issuer to earn
arbitrage can negate expectations even though such subsequent acts were not foreseeable
at time bonds were issued (therefore won’t qualify as tax exempt)
materially higher yield – 1/8 of 1% greater than the yield on the bond issue
Arbitrage may be earned on tax exempt bond proceeds only if an exception is permitted
by law – exception usually for a temporary period.
Permissible exceptions:
 new money funds – original and investment proceeds – 3 year from date of issue if
expect to spend 85% of proceeds; substantial binding contract (at least 100k) w/in six
months; project to proceed w/ due diligence to completion
 pooled financings – proceeds are used to make loans to 2 or more persons; six months
 debt service funds – 13 months
 interest earnings – one year from date of receipt
 reserve/replacement funds – throughout the life of the bond issue as long as reserve
balance does not exceed 10% of the proceeds of the issue
 minor portion – if issued prior to 8/31/86 15%; after 8/31/86, lesser of 5% of
spendable proceeds or 100k (unless issue was less than 2 million)
Under the temporary regs,(May 1992) if a new money bond issue is subject to the
arbitrage rebate requirements, issuer is permitted to invest remaining proceeds at
unrestricted yield after the expiration of the initial temporary period as long as any profits
earned are rebated to the IRS.
After 5/92, may continue to invest w/o restriction if it complies w/ rebate requirements
and w/ eligible temporary period for new money funds.
Extended temporary period not available to remaining proceeds like: certain refunding
issues; certain refunded issues; certain pooled issues and two-year construction exception
penalty election.
Options after expiration of temporary period:
 request IRS ruling to extend
 purchase US securities/SLGS, e.g., time deposits (most frequently used to fund
escrows for advance refunding); demand deposits (one day certificates issued at
$1,000 minimum – no requirement to be in $100 denominations – not available for
issues greater than 35M); and special zero interest (no interest; issuer need not certify
that all remaining proceeds are being invested in SLGS – only for of SLGS in w/c
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

issuer is allowed to deposit only a portion of the proceeds while investing remaining
portion at other higher yielding securities)
invest in other taxable securities – requires day to day compliance – generally
preferred for funds w/c must be kept more liquid
invest in tax exempt investments – issuer is permitted to earn any yield whether or not
yield exceeds bond yield – maybe most advantageous b/c yields are ignored; however
the combination of low yields and liquidity requirements makes this unattractive
Taxable securities other than SLGS, are subject to the market price rule.
Chapter 3 - Arbitrage Rebate Requirements
Exceptions from rebate requirments:
 small issuer - $5 million or less, if 95% of proceeds used for govt activities (does not
apply to private activity bonds or 501©(3) issues (count all issues for calendar year,
including advance refunding – disregard current refundings if face amount of
refunding bonds are no greater than face amount of bonds being refunded)
 general six month expenditure – gross proceeds plus interest earnings spent (disregard
reserve fund)
 TRAN six month expenditure – max size is cumulative deficit plus a reasonable
reserve equal to the next month’s expenses w/o regard to revenues received during
that period (safe harbor deems the proceeds of TRAN as expended on the date on w/c
the max deficit (excluding reserve) occurs – if deficit occurs w/in 6 months and equal
to 90% of TRAN proceeds – also, TRANs qualify if 100% of available proceeds
spent w/in 6 months – proceeds are spent last, all available reserves or taxes s/b spent
prior to spending TRAN
 two year construction bond – apply to any bonds issued on or after Dec. 20, 1989 –
applies if at least 75% of proceeds other than reserve fund are used to finance
construction exp. on property to be owned by govt or 501©(3) org. Refunding issues
not eligible for the two yr construction exception. Bifurcation – law permits issuer
to split issue for purposes of exception if issuer elects, prior to delivery of bonds to
split construction from non-construction.
 investment of proceeds in tax exempt bonds
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VIII.
SOURCE: PRICING BONDS IN A NEGOTIATED SALE
In a competitive sale, cost of borrowing is determined thru bids received; in negotiated
sale, issuers have greater involvement since issuer negotiates both the bond yield and the
U/W compensation.
2 components that determine issuer’s borrowing costs:
 up front fees associated w/ selling bonds
 continuing interest payments on o/s bonds
4 components of UW spread:
 management fee – for investment banking services
 expenses – travel, computer fees, counsel, etc.
 UW fee – for risk involved in committing to buy and place securities
 takedown – sales commission - largest element
issuer’s checklist before day of pricing:
 focus on issuer’s goals
 how goals are to be achieved:
 structure of issue
 mix between institutional and retail investors
 firms to be in syndicate
 policy re distribution of bonds and allocation to UW
 UW spread
 expected interest costs
Broadcast upcoming sale in Munifacts (service by The Bond Buyer) w/c provides current
news articles re muni market and financing community in general.
Impt. advantage in negotiated sale is flexibility – structure and timing can be adjusted to
properly respond to changing market conditions.
By requesting and analyzing info about the economy and markets, issuer accomplished
two very impt goals prior to actual pricing:
 issuer develops an understanding of the market in w/c bonds will be prices – issuer
should have sense of supply and demand
 issuer sends impt signal to UW re issuer’s focus on the pricing process and its
involvement
UW spread can be reviewed from SDC (Securities Data Com) w/c maintain up to date
database of all muni market debt offerings.
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Muni market supply and demand:
If there is glut of bonds in market, investors will pay less and bond lower bond prices w/c
result in higher yields – check w/ four sources from The Bond Buyer:
 Visible Supply – estimated dollar volume of long term maturities
 Placement Ratio – compiled every Friday - % of week’s dollar volume of new
competitive issues
 New-Issue Balances – amount of bonds unsold
 bull market – increase demand for bonds and decrease yields or interest
 bear market – decrease demand for bonds and increase yields or interest
 The Blue List – daily lists yields or prices – represents supply of bonds that dealers
have available in the secondary market. If greater supply available in secondary
market, lower bond demands in the primary market.
How economic news will impact yields: High economic growth and lower
unemployment may be a positive announcement for the economy but it is likely to have
an adverse effect on interest rates if financial markets begin to worry about inflation.
Interest rates indicators:
 Treasury Bond Yields – listed daily; most commonly watched measure is the 30-yr
TB
 Treasury SLG Rates – listed daily; particularly relevant on refunding issue
 Municipal Market Date GO Yields – listed daily; 30 yr interest rate scale shown as
AAA, AA, A
 Delphis Hanover Corp. Market Yields – listed each Monday; yields at 5 yr intervals
along w/ 30 yr interest rate scale; shown as Aaa, Aa, A and Baa
 Bond Buyer Indexes – listed daily; computed weekly for long term GO, revenue
bonds and 1 yr notes – 3 most common monitored indexes:
 20 bond index – average yield on 20 GO bonds w/ 20 yr maturities –
average rating is A
 11 bond index – average yield on 11 of 20 GO bonds – average rating AA
 revenue bond index – average yield on 25 revenue bonds w/ 30 yr
 maturities – ratings in the A to AA+ categories
Caution re 3 indexes above: not comparable to the blended yield as measured by NIC or
TIC for a particular issue w/ a 20-30 yr final maturity. In a normal upward sloping yield
curve environment, the blended yield for a particular issue will always be lower than the
yield on the final maturity.
Tactics used to determine levels of investor interest prior to actual pricing:
talking scale – a hypothetical interest rate scale – issuers should not let the UW go out w/
unauthorized price talk
price talk – best done by suggesting to an investor that the issuer believes specific key
maturities are worth certain yields – avoid showing entire scale before formal pricing
Generally not wise to price deals on Mondays or Fridays. Issuers take offensive position.
55
Factors that determine structure of bond issue:
 principal maturity schedule
 use of serial and term bonds at different maturities
 inclusion of CABs and call provisions
 use of derivative products
Generally, takedowns are lower for higher quality bonds; higher for longer
maturities and higher if bonds are being sold to the retail market.
Reasons why issuer s/b present on trading floor on day of bond pricing:
 signal to UW issuer will be actively involved in pricing
 ensure UW and sales force focusing sufficient attention to issuer’s bonds
 available to respond quickly to market forces and UW recommendations
Order period – (initial period usually three to four hours if primary targets are
institutions; one to two hours if to retail); when UW has issuer’s approvals to enter
market and take investor orders at those interest rate levels for a specific span of time
UW syndicate – team of UW often formed by the UW firms or by the issuer to purchase
bonds and to redistribute them to final investors
Selling group – group of firms that are not members of the syndicate assisting in the
distribution of bonds
Generally, adjustments to lower yields are never more than 10 basis points.
Increasing takedown on undersubscribed maturities instead of increasing yield may be a
cost effective way to provide added incentive for sales people to find buyers.
3 types of orders: (group net and net designated receive priorities)
 group net orders – rarest type of order – sales commission is shared among all firms
 net designated orders – where investors most often place – allows investors to control
w/c UW firms will receive sales commission associated w/ orders; must identify at
least 3 designees and no more than 50% to any one designee (must be member of
syndicate)
 member orders – receive lowest priority b/c only the firm placing order will receive
commission – firms place order for their own clients
Priority orders preferred b/c:
 placing bonds w/ investors who are likely to retain the bonds ensures a more orderly
secondary market – impt to investors b/c volatility caused by selling of large amounts
drives the price of those bonds down
 investors placing order for their portfolios may be slightly less yield sensitive than
buyers placing orders to hold bonds in inventory or to quickly resell at a profit
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Resizing issue: if interest rates are particularly low on the day of pricing, may be prudent
to take advantage of the market opportunity by offering more bonds.
Senior UW – accepts bond orders; allocates bonds and corresponding payment of
takedown amount firms – designated to run the books – follows specific rules spelled out
in the Agreement Among UW
The dollar bid price for a fixed rate standard bond issue is a percentage calculated as
follows: Net Bond Proceeds/Par Amount of Bonds =
Par amount of bonds
+ original issue premium (less discount)
- UW discount
= net bond proceeds
When allocating bonds, at times a small portion of the bonds may be allocated as
retentions – the purpose is to guarantee some bonds to specific firms so the UW have an
incentive to work the deal. When there is a variation from the standard Agreement
Among UW, it is most often to accommodate local retail demands for the bonds. This is
accomplished by placing “in-state” order at the top of the priority list. Placing as many
bonds as possible w/ in-state investors can lower borrowing costs.
bond closing – the actual physical sale of the bonds – usually one to three weeks after the
verbal award is made on the day of pricing
After the sale, senior UW should perform “Analysis of Distribution”:
 market conditions at time of pricing
 evaluation of all borrowing costs and compare w/ similar issues – UW use the overall
TIC w/ a bond index
 marketing performance of firms selling bonds
 review of the investors buying the bonds
 evaluation of other relevant items of interest determined by issuer
Factors why bonds price off a particular scale:
 whether it’s a revenue or GO bond
 specific security considerations, e.g., appropriations risk, debt coverage ratios, bond
tests
 tax treatment and tax rates
 structuring factors e.g., use of discount/premium bonds or CABs
 perception of issuer’s credit
 whether it was a bull or bear market
 number of similar issues in the market at the same time
Evaluating yields to indexes becomes more meaningful when an issuer has a long
established procedure for reviewing pricing outcomes relative to indexes.
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Of interest to issuer targeting retail investors is the breakdown of investor types among
bond funds, trust departments, insurance companies and the retail market.
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IX.
SOURCE: PURCHASING CREDIT ENHANCEMENTS
Credit enhancements provide assurance to investors that debt service payments will be
made in full and on time even if the issuer is delinquent in making payments or defaults
on the bonds. Issuers pay premium for this service.
Primary reason in purchasing credit enhancement is to save money on debt service costs.
credit risk – issuer will default on its debt, fail to pay principal and interest to investors
Credit enhancement desirable for bonds w/ complex features. Also alleviates liquidity
risk – investor may not be able to sell a security in the secondary market quickly at
competitive prices due to issuer’s financial or other problems.
Credit enhancements for long term bonds:
 bond insurance – may be purchaser of entire issue or selected maturities
 LOC – unlike bond insurance, for fixed rate bonds, are provided for limited term that
is often shorter (5-10 yrs) than life of the bond, so s/b renewed to cover longer
maturities – LOCs are issued by commercial banks, more common for variable rate
debt issuers
Bond insurance and LOCs are diff in terms of coverage and how premiums are paid.
Bond insurance paid once at time of closing (usually paid out of proceeds); LOCs are
paid annually and s/b budgeted each year.
If issue is insured, it carries rating of the insurer.
Not all insured bonds trade alike in the marketplace b/c investors continue to look to the
underlying credit quality of the issuer since even w/ the insurance, issuer is still liable for
principal and interest payments. Also, there might be a variation of perceptions about
different insurers.
Premiums will reflect general market conditions for bonds of different credit quality and
the degree of risk perceived by the insurer; also issuer required to pay a fee to the rating
agencies for obtaining a triple A rating – often quoted in terms of a % of the total
principal and interest payments for w/c coverage is provided.
Qualifying for credit enhancement – ways to purchase:
 issuer can apply directly to the insurance provider (apply prior to sale of bonds)
 permit UW to purchase credit enhancement
 once bonds are sold to investors
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Bond insurers prefer to insure investment grade quality bonds (rated Baa/BBB/BBB or
higher). In deciding whether to insure GO bonds, insurers interested in historical trends
relating to financial performance, tax collections, economic diversity, and socioeconomic and demographic characteristics..
Evaluating cost effectiveness of bond insurance: determine if insurance lower overall
borrowing costs by comparing present value of the stream of principal and interest
payments if issue not insured w/ present value of principal and interest and insurance if
insured. Critical component of analysis – interest rate scales for insured and uninsured
issue. Cost of insurance premium s/b factored when comparing two debt service streams.
Gross proceeds – par amount of the bonds less any original issue discount or plus
premium. Discount or premium often used to meet particular financing objectives such
as lower interest cost or enhance marketability. To obtain net proceeds for the TIC calc,
the UW discount or spread is subtracted from gross bond proceeds.
Issuers w/ a triple A or high double A rating will probably not save money by
purchasing bond insurance.
Insurer requirements: may not all be met; e.g, changes to issuers’ legal docs (ordinance)
cannot be guaranteed; may place certain restrictions that issuer must determine whether
the benefit of a lower interest cost outweighs the loss of flexibility.
surety bond – financial inst. in w/c a third party guarantees that it will make the required
debt service payments up to the amount covered by the surety bond if moneys must be
drawn from debt service reserve – may also reduce the risk of negative arbitrage on the
debt service reserve fund, w/c would occur if interest earnings on the reserve were at a
rate below the TIC of the bonds used to fund the debt service reserve – cost of surety
bond based on the size of debt service reserve fund requirement paid up front or over life
of bonds
debt service reserve fund – usually equal to at least 10% of the par amount of the bonds
of max annual debt service
If the insurance policy is called upon to make a debt service payment, the issuer remains
liable for all debt service payments including payments made by the insurer (once the
issuer has recovered from its financial difficulties)
Purchasing bond insurance does not relieve issuer from disclosure responsibilities under
the antifraud provisions of federal securities law.
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X. SOURCE: AN ELECTED OFFICIAL’S GUIDE TO DEBT ISSUANCE
Fundamental characteristic of state and local govt debt is tax exempt status and therefore
offer lower rates of interest.
Tax exempt for govt purpose; certain private activity bonds tax exempt. Private activity
bonds are those for w/c more than 10% of proceeds used for private activity and more
than 10% of proceeds secured by payments from private sources.
CIP is a mgmt tool w/c identifies proj to be funded, funding sources and proj exp over the
planning horizon – well prepared CIP viewed as a positive factor by credit rating
agencies.
3 principles in selecting funding source for CIP:
 equity – if beneficiaries of proj pay for it
 effectiveness – provides sufficient amt of funding when it is needed
 efficiency – relative costs of using one financing method over another
Repair and replacement proj w/ short useful lives are not appropriate for debt financing
and s/b on a pay-as-you basis.
Elements of debt policies:
 acceptable levels for short and long term debt
 purpose of debt
 use of tax supported GO bonds vs. self supporting revenue bonds
 mix of pay-as-you go and borrowing
 use of variable rate debt
 debt maturity schedule
Advantages of debt policies:
 help community leaders integrate debt issuance and other long term planning,
financial and management obj
 evaluate impact of each issue on jurisdiction’s overall financial position
 guidance so as not to exceed acceptable levels of debt
Types of Debt Instruments:



GO bonds – used when proj financed benefit whole comm; unlimited tax levy; lower
rates; do not require reserve fund - -- have state limits; require voter approval
Revenue bonds – issued for proj w/ more identifiable revenue base; secured by
specific source of funds; subj to more stringent issuance requirements as may be req.
to have debt service reserve fund – subj to trust indenture
Special assessment – benefit a specific area – limited revenue pledge increases
perceived risk and therefore have higher interest cost
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

Tax increment financing (TIF) – debt service derived from increase in tax revenues
generated as a result of economic growth – can be highly risky during economic
downturn
Leasing – for assets too expensive to fund w/ current receipts but too short to finance
w/ long term debt; ordinarily does not require voter approval – often higher annual
costs compared to tax exempt debt
COPs – type of lease purchase where issuer enters into agreement w/ another party
(lessor) to lease asset over specified period at a predetermined annual cost; lessor then
gets an investor to finance the asset in return for share of lease payments – interest
portion is tax exempt income to investors – major concern is the annual appropriation
requirement – carry lower credit rating than GO bonds therefore higher interest
Financing team: key players = financial advisor, underwriter and bond counsel; others
paying agent, registrar, trustee, auditor, printer
financial advisor – helps issuer financing alternatives and planning debt prog; in
competitive sale, works w/ issuer to determine debt structure, prepare bond doc, rating
agency presentation; in negotiated sale, managing underwriter directs many of the bond
related tasks – best paid on hourly or fixed basis instead of part of bond proceeds
underwriter – purchase securities from issuer and resell to investors – could be a group of
underwriters (syndicate) – compensated as follows: takedown (commission- largest
component determined by market condition); management fee (for advice and doc
preparation); underwriting risk (for committing to buy issue); expenses (travel, etc)
bond counsel – to certify that issuer has legal authority to issue debt and the issue is
qualified to tax exemption – usually compensated on fixed fee or hourly and bond
proceeds (not good measure)
paying agent/registrar – receives funds from issuers and pays bondholders; maintains
records of bond ownership
trustee – fiduciary agent to benefit bondholders; enforces terms of bond contract
securities depository – maintains records of bond w/o physical certificates (book entry
form)
printer – prints and sometimes distributes OS and print bonds
MSRB requires copy of OS be given to each purchase of new debt issue. In competitive
sale, OS and official notice of sale distributed to prospective bidders and once sale is
final, winning bidder gets addendum reflecting any changes to OS; in negotiated sale,
POS is used by UW to obtain investor interest.
Bond resolution – adopted by issuer’s governing body to authorize issuance and sale of
muni securities – states amount, form, maturities, securities, approval of POS and terms
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When trust indenture is used by issuer, the bond resolution approves the trust indenture
and provides for appt of trustee to act in behalf of bondholders.
Bond purchase agreement usually signed w/in 48 hrs of receipt of the final bid for the
sale of a bond issue.
Method of sale:
1. competitive – issues gets bids from UW; issuer takes responsibility for preparing bond
doc, structuring issue, obtaining rating, etc. – two techniques used to calc interest on bid:
 NIC – average interest rate – allows quick calc but impt disadvantage, does not
consider the time value of money
 TIC – preferred method, takes into acct time value of money by giving greater
weight to earlier debt payments
advantages of competitive sale:
 affords assurance bonds sold at lowest interest cost given market condition
 historically resulted in lower gross UW spread
 promotes appearance of an open fair process
disadvantages of competitive sale:
 issuer’s loss of flexibility to respond to market condition changes
 UW may build risk premium into their bids
 issuer less control w/c underwriter is selected and how bonds are distributed among
investors
2. negotiated – UW selected early and has full knowledge of terms of sales
advantages of negotiated sale:
 issuer can delegate to UW a number of bond sale tasks
 UW can engage in extensive pre-sale marketing to assess investor demand
 flexibility to respond to market condition – can postpone sale
 issuer has greater control on bond syndicate and distribution of bonds
disadvantages of negotiated sale:
 (perceived) – lack of competition in the pricing
 difficulty in determining appropriate gross spread
 may result in charges of favoritism
3. private placement issuer directly sells to investors w/o public offering – these are
rare - UW may still be actively involved – reasons for private placement:
 faster sales process
 issue not rated
 limited disclosure is available or unique feature or problem must be disclosed
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Factors to consider in choosing method of sale: (w/c method results in lowest cost and
achieve other impt policy obj)
 credit quality of issuer (investment grade bonds = Baa/BBB or better)
 investor familiarity w/ issuer – frequent issuer w/ established credit history (govt
issuers who are not frequent issuers can benefit the extra marketing efforts associated
w/ negotiated sale)
 complexity of issue (negotiated method may be more beneficial)
 market conditions (negotiated sale provides issuer flexibility)
 size of issue – the larger the issue, the more difficulty the muni market may have in
absorbing the bonds – issuer may want to consider negotiated for large issues)
Sizing the issue: consider cost of proj; costs associated w/ issuance; and interest
earnings on proceeds
capitalized interest – when bond proceeds are used to pay interest on the securities for a
period of time
Purpose of original issue discount (OID) – issuer receives a lower amount of proceeds
than the principal it repays – in exchange, issuer will pay an interest cost on the bonds
that is below market rate for comparable securities. Issuers w/ statutory limitations on
debt issuance and substantial capital needs may want to limit use of OID since they will
be giving up bond proceeds that could otherwise be applied to capital projects.
Bonds sold at premium – issuer receives more proceeds than the principal amount but
pays higher interest rate
Credit enhancement: provides added comfort to investors; bonds sold w/ credit
enhancement carry the rating of the credit provider – could be bond insurance or letter of
credit (LOC)
LOC – term usually shorter than life of bonds; bond insurance generally less costly for
tax exempt issues
Factors in determining final maturity of debt:
 type of proj being financed
 financial circumstances of issuer
 legal constraints on the term of the debt
 long term debt should not be used for operating deficit
 equity consideration s/b balanced w/ credit concerns – encourage issuers to retire debt
more rapidly
Maturity schedule:
 serial bonds – specific principal amt is retired each yr throughout life of the bonds
 term bonds – a large part or all issues come due in one single maturity (often
attractive to specific investors) – usually subject to mandatory redemption
 CABs – do not pay interest periodically; instead interest accrues until the final
maturity and is paid in one lump sum
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Both serial and term bonds pay interest periodically at the coupon interest rate
associated w/ each maturity.
Structures of debt service: (level principal and level total debt service most widely used)
– assuming issuance of fixed rate securities
 level principal – retires principal evenly over life of bonds so that total debt service
(principal and interest) decreases over time
 level total debt service – early payments primarily cover interest and principal
repayment increases over life of the bonds
Redemption provision: (issuers “call” bonds before final maturity) – valuable when
interest rates have declined – issuers pay call premium for this provision.
Types of investors:
 institutional investors – commercial banks, property and casualty insurance
companies
 retail investors – individuals
 retail proxies – mutual funds - purchase bonds in behalf of individuals
If issuer wants to place bonds w/ retail investors, should give considerations to
structuring the issue with CABs.
If issue is large in the 20-30 yr maturity, focus marketing to long term bond funds.
If issue has significant amount of bonds in the 10-20 yr maturity, focus at property and
casualty insurance companies.
Investor risks:
 market – interest rate risk – if interest rate levels increase, bond prices decrease; viceversa
 credit – credit quality of tax exempt issuer may fall
 call – if issuer redeems o/s bonds prior to final maturity – mitigated by issuer paying
call premium
Above risks to investors may be mitigated by:
 issuer does not provide for optional redemption
 bond insurance
 other security provisions: debt service reserve fund; coverage test; additional bond
test
Credit rating – provides an easily understandable measure of the degree of risk of an
issuer’s securities – used by investors as substitute or enhance their research when
making decision to purchase bonds.
Rating agencies: Moody’s (Aaa); S&P (AAA); Fitch (AAA) – issues rated below BBB
by S&P and Fitch and Baa by Moody’s are considered below investment grade.
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Factors in evaluating credit quality of issuer: (on GO bonds)
 debt management – use key financial ratios
 administrative issues – org and powers of the govt administration/services responsible
 financial performance – rev/exp trends, adequacy and scope of revenues
 economic base – income, population, employment, diversity, real estate values,
employers
For revenue bonds, same as above plus:
 if service provided by the issuers (reason for the bond) will continue to be demanded
by the public since user fees are often pledged to repay debt
 rate covenants – issuer pledge to keep user fees and charges at level to cover
payments
For short term debt, amt and timing of revenue receipts plus issuance patterns.
Issuer can enhance credit rating by:
 providing security for the bonds
 instituting sound management practices
 preparing CAFT in accordance w/ GAAP and GFOA certificate program
 develop and maintain good relations w/ rating agencies – keep rating agencies
informed
SEC Rule 15c2-12 – stipulates that before UW may enter into agreement to purchase
bonds from issuer, they must obtain and review copy of issuer’s OS deemed to be final
by issuer (may exclude interest rates, maturities, ratings) – SEC has little regulatory
authority over tax exempt issuers but has authority over UW – however state and local
issuers are subject to SEC’s antifraud rules.
Refunding – issuer refinances o/s bond by issuing new bonds – proceeds may be used to
retire old bonds immediately or buy US securities whose cash flows are used to pay
remaining debt service of old refunded bonds until called or matured.
2 types of refunding:
 current refunding – prior refunded bonds are called or mature w/in 90 days of
issuance of the refunding bonds
 advance refunding – prior refunded bonds are left o/s until maturity or their first call
date – TRA in the 1980’s prohibits advance refundings for private activity bonds and
generally limits one advance refunding for governmental bonds
Reasons for refunding: (only if the present value of all refunding costs is less than the
present value of the interest savings should the issuer proceed w/ the refunding)
 reduce interest costs
 restructure debt service
 eliminate old bond covenants that are restrictive
Arbitrage – (applied to tax exempt markets) – difference between the yield on the
issuer’s tax exempt bonds and the investment earned on the proceeds.
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Purpose of arbitrage restrictions
 ensure that proceeds of tax exempt financing are not solely being used to make
investments in higher-yielding taxable securities
 ensure that bond proceeds are spent in an expeditious manner
Exemption from tax rebate requirements:
 small issue - $5 million or less in each calendar year
 6 month – bond proceeds spent for govt purposes w/in 6 months of issuance date or in
case of TRANs, complying w/ specific rules w/in six months
 18 month – govt purpose bond proceeds spent over an 18-mo period in a specified
manner
 2 year – at lest 75% of proceeds used to finance govt purpose construction proj and
where construction proceeds spent over 2 yr period in a specified manner
 bond proceeds invested in tax exempt securities not subj to the alternative minimum
tax
Rebatable arbitrage must be determined and reported at least every 5 years – computation
utilizes a “future value” method – once net investment cashflows associated w/ the issue
are determined, they are future valued at the bond yield to calc the amt of any rebate due.
By: Agnes T. Walker
Financial Services Director
City of Redondo Beach
(Now Revenue Officer for the City of Long Beach, California)
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