Opportunities for Municipal Borrowers
Interest rates are historically low. The anticipated date for the eventual rise in rates has not been formally set by the Fed, and seems to be regularly postponed. Low interest rates present a challenging investment climate for municipalities, hospitals, school districts and colleges or universities. But it’s not all gloom and doom. There are options in which these entities may meet the challenges and seize the opportunities that come from low interest rates when they issue municipal bonds‡.
The Challenges and Opportunities in the Current Marketplace
Let’s say you are a university finance officer and you need to underwrite $10 million in order to build a new library. You raise the $10 million via a new bond issue but the project calls for the cash outflow for the new building construction to happen throughout the next 24 months. This means you have to invest the currently unspent balances in the meantime. Given the current low interest rate environment, the rate you receive on the invested balances will likely be lower than the rate you paid to raise the debt.
This situation, called negative cost of carry‡, occurs when an entity issues debt and then invests all or a part of the proceeds at a rate lower than the rate being paid on the debt issued. Examples of this would include: project construction funds, escrow funds to redeem refunded bonds and debt service reserve funds where not all of the proceeds are immediately used. The interest rate on the bonds, or the borrowing rate, may be substantially higher than the rate which may be earned on proceeds, resulting in a negative cost of carry. Like our library example, if you do an underwriting for $10 million and pay an average of 3 percent interest on those bonds, in many cases, all of your proceeds aren’t put to use immediately for a building or project. Therefore, you would have $10 million in cash for a period of time. Rather than sitting on that cash and earning nothing, you’d probably invest the $10 million. However, since interest rates are so low, you wind up investing the cash you are paying 3 percent interest on into something yielding far less.
While the low return on invested proceeds can create a drag on the financing of the project as the current market provides a substantial tail wind with the low interest rate on the issued bonds. This opportunity is most apparent with refunding bonds. Unlike the corporate bond market‡, the municipal bond market typically allows issuers to embed the right to prepay without penalty on their long-term fixed rate bonds. Issuers can see substantial savings in interest costs by issuing new debt and using the proceeds to redeem, or prepay, the old, higher rate debt on the call date. In 2014, refunding bonds represented nearly 41 percent of all long term municipal issues, up from 33 percent in 2013. We believe this trend will continue in 2015.
Gain Better Timing and Rates through Private Placement
Private placements‡ can be another great alternative to traditional public issues, which might result in negative cost of carry.
Let’s go back to our example of the new university library. Instead of the debt being sold in the public markets, it could be privately placed with one or a small accredited group of investors to allow for additional flexibility as it relates to the structure of the debt. Instead of the university having to deal with negative cost of carry for two years as indicated above, it could instead structure the debt so that it drew the cash in accordance with the construction timeline, potentially lessening the impact of negative cost of carry in a low interest rate environment.
A growing number of issuers have captured the low borrowing rates and then addressed the interest rate gap between the cost of issuance and rate they are able to invest at by structuring issues in the private placement market which offer more flexibility. As private placement purchasers appetite for debt has increased, the spread between publicly issued debt and privately placed debt has decreased, making it an attractive proposition. Here are other possible advantages to private placements:
- Private placement purchasers, frequently commercial banks, are currently offering attractive borrowing rates not far removed from rates bid for publicly-offered issues.
- Private sales avoid the time-consuming and costly work of preparing the disclosure documents required to publicly offer the bonds.
- Issuers will not be required to observe the continuing disclosure rules of 15(c)(2)12 of the Securities Act‡.
- Private placements are not registered with the SEC, so registration and disclosure requirements like the Municipalities Continuing Disclosure Cooperation Initiative‡ are not required.
- Credit ratings, bond insurance and printing costs can all be eliminated with private placements.
Another Advantage: The Draw Feature
In addition to the ease of issuance, only private placements can offer a valuable alternative called the draw feature. At settlement, the initial draw is used to pay cost of issuance, the remaining bond proceeds are paid to the issuer when needed rather than at settlement. Interest will not accrue on the bond until, and only to the extent that, proceeds are drawn. Construction project financings greatly benefit from the draw bond structure. For instance, a $10 million construction project that is financed at 4.00% over 20 years and takes two years to complete, would generate an estimated savings of $380,000 when financed with a draw bond. Interest would accrue on approximately $5 million on average over the two year construction period, or $400,000 of interest, instead of $800,000 of interest accruing on the full $10 million over the same period with a public sale. The public sale would permit approximately $20,000 of interest earnings on the project pending disbursement.
Draw bonds provide similar efficiencies for refunding bonds. For example, assume an outstanding $10 million bond yielding 4 percent which may be called in one year. The delayed draw refunding bond paying 2.50 percent will reduce the size of the escrow requirements and avoid the negative investment earnings in the escrow. These efficiencies result in over $300,000 or 2 percent of the bond size in additional estimated savings compared to a publicly-issued bond in which proceeds are held in escrow and invested during the one year escrow period.
However, what if the issuer has an outstanding bond which may not be called for several months, and has already been advance refunded? The delayed draw structure can be used effectively to lock in today’s low rates on the refunding bonds and still comply with the restrictions on no more than one advance refunding. The privately placed, delayed draw bond simplifies what might be addressed in a public issuance with complicated and expensive swaps and derivatives.
It is important to consider that while the new developments in the private placement of municipal bonds may provide the issuer with more flexible and efficient alternative financing options, current interest rates and uncertainties can be tough for institutions when managing these strategies.
Keep in mind, there are a number of sensible and intelligent ways to take advantage of any economic situation.
The information and opinions expressed in this message are solely those of the author and do not necessarily state or reflect the opinion of UMB or UMB Financial Corporation.
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Mr. Philip Richter is a Senior Vice President for UMB Bank. He is the Manager of the Public Finance Department in the Investment Banking Division. Phil joined UMB in 1997 and has over thirty years of experience in the municipal bond and financial services industry.