best practices in debt management: an overview

Best Practices in Debt Management: An Overview

FGFOA School of Governmental Finance

Sarasota County, Florida

November 14, 2012

GOVERNMENT FINANCE OFFICERS ASSOCIATION

What is the Role of the Finance Officer in Debt Issuance?

Four Primary Rating Criteria Financial Condition Debt Structure Economics/Demographics Management

Management = Creditworthiness Finance Officers responsible for variety of duties How each is managed impacts the cost of funds when it comes time

to issue enter capital markets


Best Practices Five-year capital improvement plan integrating operating

costs of new facilities

Debt policies and debt affordability reviews

Pay-as-you-go capital funding policies

Fund balance reserve policy/working capital reserves

Contingency planning policies

Policies regarding nonrecurring revenue


More Best Practices … Multi-year financial forecasting

Monthly or quarterly financial reporting and monitoring

Superior debt disclosure practices

Financial reporting and budgeting awards

Compliance with Governmental Accounting Standards Board standards


The Debt Component of Your Capital Improvement Plan


Debt Issuance Integration with Capital Improvement Plan

GFOA recommends that governments adopt comprehensive multi-year capital improvement plans (CIP) to ensure effective management of capital assets

CIP should cover at least 3 year period, preferably 5 years or more



Prudent capital plans do the following: Identify needs

• Long-term horizon

Determine project costs

Prioritize capital projects• New outlays, maintenance, replacement, renewal

Develop financing strategies



Financing strategies Cash Flow projections Consider all funding alternatives Reliability and stability of funding sources Affordability of strategies, including impact on debt ratios, taxpayers,

ratepayers, etc. Have to consider debt management policy



Debt management policy and CIP Use policy to establish parameters for issuing debt relative to capital

projects Particularly with respect to objectives to be achieved before and after

issuance Also use for guidance with respect to debt affordability – use debt

policy as control points relative to managing CIP


Debt Capacity Considerations

Legal Limits

Internal Policy Limits

Financial Limits


Debt Capacity – Precious Commodity Determining “capacity” is an art not a science

Debt capacity is limited; make it count Funds borrowed for project today can’t be used for other projects

tomorrow Funds committed for debt repayment today can’t be used to fund

services tomorrow

Long-term capital planning key to managing debt capacity


Developing a Debt Policy


Importance of Developing a Debt Management Policy

A debt management policy improves the quality of decisions, provides justification for the structure of debt issuance, identifies policy goals, and demonstrates a commitment to long-term financial planning, including a multi-year capital plan.


Importance of Developing a Debt Management Policy

Adherence to a debt management policy signals to rating agencies and the capital markets that a government is well managed and should meet its obligations in a timely manner.

An effective debt management policy provides guidelines for a government to manage its debt program in line with available resources.


GFOA Best Practice – Debt Policies

Purposes for which debt may be issued

Legal debt limitations

Types of debt permitted

Structural features preferred

Credit objectives

Methods of sale

Methods for selecting outside professionals


Developing Debt Policies Identify Comparable Governments

Collect Example Policies and Borrow Ideas

Construct Indicators For Peer Group For Self / Compare


GFOA Tools Available to Issuers – Publications

GFOA Publications Guide to Preparing a Debt Policy Benchmarking and Measuring Debt Capacity Elected Official’s Guide to Debt Issuance Elected Official’s Guide to Tax Increment Financing Budget Practices: A Framework For Improved State and Local

Government Budgeting Capital Project Planning and Evaluation: Expanding the Role of

the Finance Officer


Method of Sale: Competitive vs. Negotiated


Competitive vs. Negotiated Sales: The Decision

The finance officer’s decision or recommendation regarding the method in which bonds will be sold will be a leading factor in determining the financing cost of the bonds.

Method of Sale decision should be addressed in the issuer’s debt or financial policies.


Competitive vs. Negotiated Sales: Definitions

Competitive Sale: Bond issue is prepared by the issuer and financial advisor and then offered for sale to underwriters at specified date and time. Bonds are awarded to the firm that offers the lowest True Interest Cost (TIC). Bids usually submitted electronically.

Negotiated Sale: The underwriter of the bonds is selected in advance of the sale and the pricing of the bonds (coupons, yields, spread) is negotiated by the underwriter and the issuer (with their financial advisor).


GFOA Best Practice on Selecting the Method of Sale

“Method of Sale” Best Practices provides guidance to issuers regarding choosing between a competitive and negotiated sale.

Method of Sale Best Practices were the result of sometimes contentious discussions among GFOA Debt Committee members over two years.


Key Components of Method of Sale BP

Issuers should select the method of sale most likely to achieve the lowest cost of borrowing.

Decision should be based on analysis of the relevant rating, security, structuring and other features of the bond issue.

If an issuer does not have dedicated, experienced debt management staff, it should hire a financial advisor to assist in making the method of sale decision.



Due to the inherent conflict of interest, issuers should not use a potential underwriter to assist in the method of sale decision unless that firm has agreed not to underwrite the bonds.

Due to inherent conflicts of interest, a firm acting as an issuer’s financial advisor should not be allowed to resign in order to serve as underwriter for the proposed bonds. MSRB Rule G-23 now prohibits.



Favors which favor a competitive sale include:

Bond rating of “A” or higher.

Bonds are general obligations of the issuer, or are secured by a strong, known and long-standing revenues stream (e.g. water, sewer, or electric revenues).

The structure of the bonds does not include unusual or new financing features that require extensive explanation to the bond market.



Favors which favor a negotiated sale include:

Bond rating less than “A”.

Bond insurance or other credit enhancement not available or not cost-effective.

Bond structure has unique features such as pooled bonds, variable rate debt or deferred interest bonds.

The issuer desires to target underwriting participation.

Other factors that the issuer, in consultation with its financial advisor, believes favor the use of negotiation.



If a negotiated sale is deemed appropriate:

Engage the services of a financial advisor, unless the issuer has extensive in-house bond pricing experience and access to current bond market data.

Select underwriters through a Request for Proposals (RFP).

Remain actively involved in each step of the negotiation and sale process. (BP on “Pricing Bonds in a Negotiated Sale”)

Be aware that the relationship between the issuer and the underwriter is one of common purpose, but also competing objectives, especially at time of bond pricing. YOUR UNDERWRITER IS NOT YOUR FINANCIAL ADVISOR.


Refunding Analysis


Optional Redemption

Most tax-exempt municipal bonds have an optional call feature which allows issuers to repurchase bonds at a specified price on certain dates in the future

Call date usually 8-10 years

Par call is most common (as opposed to premium call – 101% of par)

Notification: typically 30 to 60 days prior to call


Types of Refundings

Less than 90 days Call 2002A BondsSeptember 1, 2012

Bond proceeds used to

fund Defeasance

Escrow

Call Outstanding

Bonds

DefeasanceEscrow

Refunding Bonds

Current: Refunding bonds sold within 90 days of Call Date of refunded bonds

Escrow Yield unrestricted No limit to number of current refundings

Refunding BondsJune 1, 2012


Types of Refundings Advance: Refunding bonds sold more than 90 days to the

1st Optional Call Date of refunded bonds Escrow yield restricted to arbitrage yield of refunding bonds 1 Advance Refunding allowed per IRS Regulations.

More than 90 days

Call 2004A BondsAugust 1, 2014

Bond proceeds used to

fund Defeasance

Escrow

Pay Principal & Interest due on Refunded Bonds until the Call Date

Call Outstanding

Bonds

DefeasanceEscrow

Refunding Bonds

Refunding BondsJune 1, 2012


Economics of Refunding Bonds

Absolute difference in interest rates on old “refunded” bonds vs. new “refunding” bonds

Remaining term and amount of refunded bonds

Length of the escrow period

Efficiency of the escrow Ability to earn the escrow yield limit Investment dates vs. refunded bond payment dates

Cautions: Negative arbitrage (earnings) in escrow Extension of call date


Issuer Objectives Meet Savings Threshold

GFOA recommends 3-5% NPV as starting point Debt Policy should discuss Threshold Savings

Cash Flow Structuring

Consolidation of Debt

Remove Restrictive Covenants

Or Combination of Above Objectives


Savings Targets Establish guidelines in debt policy

Opportunity cost analysis

Different perspective for current and advance refunding

Net present value as % of par value (refunding or refunded par)

Absolute savings

Savings in excess of COI


How to Evaluate a Refunding Current vs. Historical Interest Rate Levels

Shape of yield curve

Term to maturity (years remaining)

Absolute level of savings: minimum $ threshold (e.g. $1 million)

NPV Savings as % of par

Consider future “opportunities lost”


Historical & Current Interest Rates are Useful for

Understanding Market Trends

Historical interest rates provide context to current rates and insight into how rates change Compare current rates to historical ranges Identify current trends Establish how rapidly rates have moved up or down


Continuing Disclosure


SEC Rule 15c2-12 Effective January 1, 1996 Designed to prevent fraudulent, deceptive, or manipulative acts

or practices Requires municipal debt issuers to file updated financial

information and operating data annually with EMMA (Electronic Municipal Market Access System) by a specified date and file material event notices.

Requires underwriters to reasonably determine that the issuer has complied with the rule prior to offering for sale the related securities


The issuer must enter into a written agreement for the benefit of the bond holders to do the following:

Provide through a filing to the Electronic Municipal Market Access (EMMA) and to the appropriate State Information Depository (SID), if any, annual financial information or operating data presented in the Official Statement

Submit audited financial statements to the EMMA system and respective SID when available, if not provided as part of the annual financial information listed above

Submit a notification to the EMMA system and respective SID of any material event occurrence in a timely manner

Submit a notification to the EMMA system and respective SID of failure to comply in a timely manner

Requirements


Material events related to bonds issued after 12/1/10, but submit the material event to the EMMA system within 10 business days of the event occurring.

Some events need to be disclosed regardless if they are ‘material’ or not: Principal and interest payment delinquencies Unscheduled draws on debt service reserves reflecting financial

difficulties Unscheduled draws on credit enhancement reflecting financial

difficulties Substitution of credit or liquidity providers, or their failure to

perform Adverse tax opinions Defeasances Rating Changes

Material Events


New Material Events Updated in May, 2010: New Material Events

IRS proposed or final determinations of taxability Tender officers Bankruptcy, insolvency, receivership, or similar event of the

obligated person Consummation of a merger, consideration, or acquisition, or certain

asset ales, involving the obligated person, or entry into or termination of a definitive agreement to the foregoing (if material)

Appointment of a successor or additional trustee or the change of name of a trustee (if material)


If the issuer fails to meet its annual filing requirements, the issuer must: Submit a notice of failure to comply with EMMA and the appropriate

SID Complete and submit all past due filings prior to issuing debt Create procedures to ensure the failure to file will not reoccur Disclose its failure to comply in every Official Statement for 5 years

Notice of Failure to Comply


If the issuer fails to meet its annual filing requirements, the ease of selling its securities diminishes

The underwriter is prohibited from bidding on or offering for sale the primary offering

Rating agencies could assign a lower rating if the failed filings were deemed to be caused by poor management

The investors may not show interest in securities where the required disclosure filings are not available

In the event of a default, the investor could argue the required disclosure filings were not available for due diligence review

Higher borrowing costs

Risks of Non-Compliance


Exemptions from annual filings and material event notices

Debt issues with a total par amount of $1,000,000 or less Debt issues authorized in denominations of $100,000 if,

• Sold to no more than 35 persons who are believed to capable of evaluating risk and who are purchasing the securities for one account

• Have a maturity of 9 months or less, or• May be tendered to the issuer at par value or above every 9

months until maturity Exemptions from annual filings but not material event notices

Debt issues with a maturity 18 months or less

Debt Issue Exemptions


Prior to bidding on or offering for sale municipal securities the underwriter must review the preliminary official statement (“POS”) and reasonably determine that issuer has complied with the rule

The underwriter must send a POS no later than 1 business day after the request of a potential customer, if available

The underwriter must receive the final official statement 7 business days after the purchase agreement and in sufficient time and quantity to accompany any confirmation that requests payment from any customer

Issuers may now submit POS documents to EMMA.

Requirements on Underwriters


Continuing Responsibilities of the Finance Officer – Post Issuance

Compliance


Post Issuance Compliance

Post-issuance tax compliance begins with the debt issuance process itself and provides for a continuing focus on investments of bond proceeds and use of bond-financed property. It will require identifying existing policies, the responsible people, the applicable procedures, and the affected population.

The National Association of Bond Lawyers and the Government Finance Officers Association have jointly developed a checklist to assist with issuers post issuance compliance matters (found at below website).

http://www.gfoa.org/downloads/PostIssuanceCompliance.pdf


Investment of Bond Proceeds

Principals of good investment management and understanding of inherent risks in investing bond proceeds critical Establish good guidelines for permitted investments to reduce credit

risk – SAFETY Good cash flow estimates mitigate market risk – LIQUIDITY Integration of knowledge of expected and future market conditions

with other cash flows to reduce opportunity risk – YIELD



Obtain projected cash flow schedules from project managers Inform internal investment officer of incoming funds Bid Investment Agreements as needed Develop process for monitoring balances in trustee held

accounts Actively monitor construction activities Develop procedures for reinvestment of bond proceeds (see

handout)



Initial investment – generally the “easier part” Project cash flows Capitalized Interest Debt Service Reserve Fund Cost of Issuance

Reinvestment – generally the “really hard part” Develop process to monitor and make reinvestment decisions Use of cash flow expectations v. reality


Record Retention

Establish Record Retention Requirements and Procedures IRS record retention requirements

Term of bonds + 6 years Types of records

IRS Website www.irs.gov/taxexemptbond/index.html FAQ’s -- Record Retention Requirements (handout)

www.irs.gov/taxexemptbond/article/0,,id=134435,00.html

http://www.irs.gov/taxexemptbond/article/0,,id=134435,00.html


What is Arbitrage?

Arbitrage is the ability to earn profit by capitalizing in differences between investments or markets.

In the case of public finance, Arbitrage refers to ability to profit from investment of tax-exempt bond proceeds in taxable securities.

The ability to earn arbitrage depends on the relationship between taxable and tax-exempt rates and the shape of the yield curve.

Positive arbitrage represents earnings above the arbitrage yield. Negative arbitrage represents earnings below the arbitrage yield (i.e., “losses”).


Arbitrage Rebate Compliance Activities

Internal monitoring of rebate compliance Recommend annual calculations during construction period

Set aside annual rebate liability in Rebate Fund Get it out of the Construction Fund

Paying rebate is not bad, just need to monitor and pay as required

Pay attention to requirements in Tax/Arbitrage Certificate


Compliance with Bond Covenants and Agreements

Develop internal tickler system from beginning Keep up-to-date Don’t reinvent the wheel with every deal; similar reporting

requirements are okay and always preferred Keep as simple as possible


Bond Project Monitoring

Critical to complete reinvestment activities Active involvement with project staff

Regular conversations Understanding of current and future capital needs

Review project encumbrance and expenditure needs Understand project delays

Implications for timely commencement of debt service Develop contingency plan if significant project delays


Questions

best practices in debt management: an overview

Documents

debt relative

debt component

debt ratios

debt repayment

debt issuance integration

science debt capacity

debt affordability reviews

capital projectsparticularly