The changing landscape of the municipal bond market: a four-part series
Throughout 2020, we will take an in-depth look at the changing landscape of the municipal bond market. Not since the Tax Reform Act of 1986, more than 30 years ago, have we seen such change impacting our market, affecting both the structure of issues being offered as well as the composition of investors purchasing these issues.
In a four-part series we’ll release this year, we will address significant changes currently driving municipal bond issuance volume and structure, and provide some insight into how these changes may affect how your organization finances its capital projects. The topics we will discuss in this four-part series include:
- Alternatives to advance refundings after the Tax Cuts and Jobs Act
- Changing investor preferences for municipal bonds
- Increasing use of private placements in the issuance of bonds
- Supply and demand dynamics shaping the market
Alternatives to advance refundings after the Tax Cuts and Jobs Act
The Tax Cuts and Jobs Act of 2017 resulted in the most significant changes the municipal bond market has experienced in more than 30 years. In the months leading up to its passage, concern and speculation regarding what may ultimately be included in the act resulted in a wave of municipal bond issuance unlike anything we have seen in recent history.
December 2017 experienced the largest single month of municipal bond issuance on record with $64.5 billion in bonds issued. This distortion in issuance volume also impacted 2018 as an estimated $35 billion in bonds that would have been issued in 2018 were instead pulled into 2017 to avoid the potential effects of the Act.
As background, tax-exempt advance refundings involved the issuance of tax-exempt refunding bonds more than 90 days prior to the call date for the outstanding tax-exempt bonds being refunded. In a typical advance refunding structure, the proceeds of the new bond issue would be placed into escrow and invested, with the invested principal and earnings being used to provide for the debt service payments on the outstanding bonds until the call date, and then pay those bonds off in their entirety on the call date.
When investment yields for the escrow were close to the yield on the bonds being refunded, this financing structure provided an efficient method for issuers to take advantage of lower interest rates to pay off outstanding bonds carrying higher interest rates even though the call date may have been several months or years away.
This method of achieving interest rate savings had long been a staple for municipal issuers and accounted for approximately 30% of issuance volume in the municipal bond market. The elimination of tax-exempt advance refundings by the Tax Cuts and Jobs Act left issuers without a viable way to take advantage of lower interest rate environments, and created a significant void in the traditional issuance volume of municipal bonds.
Current interest rate environment
Throughout 2019, we experienced an interest rate environment ideally suited for advance refundings. Interest rates in general have been very low and credit spreads have been tighter than we have seen historically.
In addition, the yield curve has been relatively flat as shown in the chart below. A decrease in the difference between short-term rates and long-term rates helps optimize the efficiency of the escrow in an advance refunding.
The municipal bond market in 2019 has provided ideal conditions for market participants to explore alternative structures to achieve a similar economic benefit as an advance refunding, while complying with the new legislation. Through these creative efforts a few alternative structures have emerged in the market to help fill the void left by tax-exempt advance refundings.
The following are a few of the structures that have gained transaction recently in the municipal bond market.
Taxable advance refundings
Although the Tax Cuts and Jobs Act eliminated tax-exempt advance refundings, it is still permissible to advance refund a tax-exempt bond with a taxable bond. The interest rates for taxable bonds are typically higher than comparable tax-exempt bonds, and so the interest rate savings from a taxable advance refunding may not be as great as it would have been with a tax-exempt issue. However, the savings can still be compelling, and it allows issuers to lock in the savings today rather than running the risk that interest rates will increase before the point at which they could pursue a tax-exempt current refunding (within 90 days of the call date for the refunded bonds).
In addition to locking in significant interest rate savings today, there are other potential benefits that may cause an issuer to consider a taxable advance refunding:
- The taxable bonds can be advance refunded in the future without restriction, potentially with a tax-exempt bond after the call date for the prior refunded tax-exempt bonds has passed. This presents a unique opportunity to do a taxable advance refunding in the current interest rate environment and preserve the ability to advance refund the taxable bonds in the future with a tax-exempt bond issue—if it makes financial sense to do so.
- Taxable bond issues don’t have the post-issuance tax compliance challenges to deal with that tax-exempt bond issues require. For example, only a de minimus amount of tax-exempt bond proceeds can be used for “for profit” purposes; the proceeds of a tax-exempt bond issue are required to be spent within a specified period; and, any earnings on tax-exempt bond proceeds in excess of the bond yield typically must be paid back to the federal government in the form of rebate.
- There is a significantly larger pool of buyers for taxable bonds than there is for tax-exempt bonds, which helps to increase demand for the purchase of the bond issue. This was the driving force behind the Build America Bonds authorized by Congress in 2009 and 2010, which proved extremely successful in increasing bond issuance in the years following the market collapse of 2008.
It is not surprising given the attractive interest rate environment we have experienced over the last year, together with the potential benefits outlined above, that taxable municipal bond issuance has surged to $46.2 billion in 2019 – the highest issuance in both dollar terms and market share since the Build America Bond years.
As with any advance refunding structure, issuers must weigh the level of savings achievable in today’s interest rate environment against the possibility that future opportunities to achieve those savings may change as the call date approaches. As the charts above indicate, however, taxable advance refundings are gaining broad acceptance in the municipal bond community, and, absent another change in the tax code, it appears they are here to stay.
Cash defeasance and new money issuance
Another alternative structure available for issuers who budget funds each year to pay for capital improvement projects (pay-as-you-go programs) is a cash defeasance and new money issuance structure. This involves using the cash that would otherwise be used to fund capital improvements over the next 2-3 years to legally defease higher-interest rate bonds that are not yet callable.
Simultaneously with this defeasance, a new series of tax-exempt bonds with lower interest rates are issued to finance the capital improvement projects over the next 2-3-year period that the issuer’s cash would have previously funded. The new bond issue would likely be structured with a similar amortization schedule as the defeased bonds, but with a lower interest rate – allowing the issuer to achieve a comparable level of interest rate savings as a tax-exempt advance refunding.
Forward delivery bonds
A third alternative financing structure that has been used recently is the issuance of forward delivery bonds. With these bonds, the interest rates for a new refunding bond are determined in the same manner as an advance refunding bond issue. However, the bond purchase agreement for the refunding bonds contains a longer than normal delivery date so that the closing occurs within 90 days prior to the call date for the refunded bonds.
The forward period – the time between when the interest rates are determined and when the bond issue is closed – can be several months. Since interest does not accrue on the new bonds during this forward period, there is either a cash settlement or an interest rate premium assessed on the new bonds to compensate the purchasers for locking in the interest rates for the new bond issue several months in advance of closing. This interest rate premium or cash settlement reduces the financial benefit from the refunding, which limits the situations where it can be used effectively. However, several high-profile issuers have issued forward delivery bonds recently, and depending upon the premium required to lock in the interest rates, it can provide a compelling option to consider.
The current low interest rate environment has provided an attractive opportunity for many issuers to consider refinancing their outstanding tax-exempt bonds. However, since the elimination of tax-exempt advance refundings, alternative financing structures must be considered for bonds that are not callable for several more months or years.
As our discussion has indicated, there are now at least a few options available for issuers to consider that may allow them to take advantage of the current low interest rate environment and achieve a comparable level of savings as a traditional advance refunding.
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