bonds and basics-lauren lowe-tn economic development finance course

© 2014 Public Financial Management, Inc.

Council of Development Finance Agencies

Bonds and BasicsFebruary 20, 2014

530 Oak Court Drive, Suite 160Memphis, TN 38117P: 901-682-8356F: 901-682-8386www.pfm.com

1© 2014 Public Financial Management, Inc.

Bond Topics

Bond Basics

The Players

Structuring Features/Considerations

The Process


Bond Basics


What is a Bond?

Debt investment in which an investor loans money to an entity (corporate or governmental as the issuer) that borrows the funds for a defined period of time at a fixed (typically) interest rate.

Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities.

Bonds are commonly referred to as fixed-income securities.

The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date).

Interest on bonds is usually paid every six months (semi-annually).

Main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply “Treasuries.”


General Municipal Bond Purposes

Issued to pay off existing debt(bonds or notes). The old debt service payments are replaced with new debt service payments.

Create debt service savings by issuing new bonds at a lower interest rate. “High to Low”

Remove restrictive requirements of an indenture (which sets the parameters for which they can issue bonds and requirements for funding them) on outstanding bonds

New Money Bonds Issued to fund capital projects: roads, bridges, stadiums, schools, power

plants, etc. Refunding Bonds


General Bond Terminology

• Amount of the Bond Issue or the indebtednessPrincipal or Par

Amount

• Repayment Date of Bond IssueMaturity Date

• Interest rate paid annually on the Bond Issue• Usually expressed as a percentage of Par AmountCoupon Rate

• Amount an investor will invest in consideration of future receipt of principal and interest payments Price

• Income return on an investment• Usually expressed annually as a percentage of Par AmountYield

Maturity

Principal

Price

Annuity of Interest


CITY OF HYPOTHETICAL, TENNESSEE

$26,495,000 GENERAL OBLIGATION BONDS, EXAMPLE SERIES

Due PrincipalMarch 1 Amount Rate Yeld CUSIP No.

2014 $1,770,000 3.000% 0.350% 654 123 7Q62015 1,770,000 4.000% 0.380% 654 123 7R42016 1,770,000 4.000% 0.500% 654 123 7S22017 1,765,000 4.000% 0.680% 654 123 7T02018 1,770,000 1.500% 1.000% 654 123 7U72019 1,765,000 2.000% 1.250% 654 123 7V52020 1,765,000 3.000% 1.550% 654 123 7W32021 1,765,000 3.000% 1.850% 654 123 7X12022 1,765,000 4.000% 2.160% 654 123 7Y92023 1,765,000 4.000% 2.310% 654 123 7Z62024 1,765,000 2.500% 2.500% 654 123 8A02025 1,765,000 3.000% 2.800% 654 123 8B82026 1,765,000 3.000% 3.100% 654 123 8C62027 1,765,000 4.000% 3.130% 654 123 8D42028 1,765,000 4.000% 3.250% 654 123 8E2

Terminology Reference – Example Series

Par Amount

Principal Amount

Maturity Date

Coupon Rate


Types of Bond Sales

• Public Offering – Bond(s) sold by an underwriter through a public sale Competitive Sales: An Issuer procures bids from a variety of Underwriters on the

obligations they are planning to issue and select one bid (i.e., the lowest costing bid).

Negotiated Solicitation: An Issuer selects an Underwriter or a group of underwriting firms and works with the selected Underwriter(s) to price obligations through negotiation with the Underwriter(s) and Investors.

• Privately Placement - Bond(s) purchased directly from the Issuer.

Negotiating a price for their obligations directly with the Investor(s). Usually more expensive as the universe of potential investors is reduced.

Factors such as security type and transaction size typically help determine the best method of sale to utilize.


The Players


Participants to the Transaction Team

Issuer

FinancialAdvisor

Bond/TaxCounsel

Underwriter /Lender

Rating Agencies

Moody’sS&PFitch

CreditEnhancers

VerificationAgent /

Accountant

Registrar/Paying Agent/

Trustee

EscrowAgent

Every issue

As needed

UnderwriterCounsel

TrusteeCounsel Financial/

Feasibility Consultant

Swap Advisor


Issuer & Their Counsels

• Issuer – Issuing body with the authority to issue bonds.

City/County/State and their Agencies

Can serve as the conduit between the developer/private company and the bondholder/investor

• Bond Counsel – Every bond issue must be reviewed by a lawyer or law firm known as bond counsel.

The legal opinion is an authorization of the debt and covers two main issues:

It ensures that the bonds are legal, valid and binding obligations of the issuer

It verifies the tax status of the debt; that is, interest on the bonds is exempt from federal income taxes (as well as state and local taxes in some cases).

• Other Counsels –may include special tax counsel, disclosure counsel, and issuer's counsel. Such special counsel may be necessary for specific issues that are more complex and diverse than standard offerings.


Advisors/Consultants

• Financial Advisor – Advises the Issuer through the bond issue process with a specific role as to provide advice on structuring the debt, obtaining a rating and pricing negotiations.

• Swap Advisor – Advises the Issuer on structuring and procuring any interest rate swaps (derivatives) on both a competitive and a negotiated.

• Feasibility Consultant – Evaluates and analyzes the potential of a proposed project which is based on extensive investigation and research to support the process of decision making.

• Engineering Consultant – Provides consulting related to the construction and operations of the financing project; typically specializes in infrastructure development in energy, water, telecommunications, and environmental markets.


Underwriter/Underwriter Counsel

• Underwriter – Securities dealer who helps government entities bring bond issues to market. The key role it plays is to buy the bonds from the issuer and then resell them to investors. In doing so it assumes a financial risk and thus expects to make a profit on the transaction.

• Underwriter Counsel – Represents the underwriters in a negotiated issue. Performs a due diligence review of the issuer. In other words, underwriter's counsel ensures that the issuer's financial condition and plans and other matters that are important for an investor to know are accurately disclosed.


Trustee/Paying/Escrow/Verification Agents

• Trustee – Financial institution with trust powers that is given fiduciary powers by a bond issuer to enforce the terms of a bond indenture. An indenture is a contract between a bond issuer and a bond holder. A trustee sees that bond interest payments are made as scheduled, and protects the interests of the bondholders if the issuer defaults.

• Paying Agent – Agent who accepts payments from the issuer of a security and then distributes the payments to the holders of the security

• Trustee/Paying Agent Counsel – Counsel to such entities and assists in monitoring bond documents and any amendments to documents

Refunding Bond Specific

• Escrow Agent – Serves as custodian of funds and holds securities to pay debt service on refunded bonds

• Verification Agent – Verifies cash flow sufficiency to the call date of the escrow securities to pay principal and interest on refunded bonds


Rating Agencies/Credit Enhancement

Rating Agencies (Moody’s, Standard & Poor’s and Fitch) rate municipal bond issuers on a scale in order to rank or categorize the credit worthiness and proximity to default of an Issuer and their obligations.

While many sophisticated investors do their own credit research, ratings play a critical role in the minds of most market participants and are perceived by the market as a guide of an Issuer’s credit worthiness.

Ultimately, credit ratings play a significant role in broadening the investor base for an issuer and usually having a strong rating enhances an Issuer’s access to Investors, helping to lower their cost of capital.

Credit Enhancement – Supports an issuer’s credit in exchange for a fee or a premium, in the form of enhancement such as bond insurance or a letter of credit

Moody's Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3

S&P/Fitch AAA AA+ AA AA- A+ A A- BBB+ BBB BBB-

Investment Grade Rating Scales


Structure Features/Considerations


Common Bond Security Structures

Revenue Pledge Specifically Defined Revenue Source No Property Taxing Power Covenants to Ensure Revenue Sufficiency Not Subject to Appropriation

General Obligation Bonds

Appropriation (Lease) Bonds

Revenue Bonds

Full Faith and Credit Pledge All legally Available Revenues Taxing Power Not Subject to Appropriation

Special Obligation Pledge All legally Available Revenues No Taxing Power Subject to Appropriation


Tax-Exempt, AMT, and Taxable Bonds

Governmental Bonds

(Tax–Exempt)

Private Activity Bonds

(Taxable)

Alternative Minimum Tax

(AMT)

Highest cost Interest is included in gross

income for federal income tax purposes

Projects are deemed taxable if they do not provide a significant benefit to the general public

Lowest cost Interest is federally tax-

exempt Issued by State and Local

governments Finance projects owned,

operated, or used by a government for its own purposes

Slightly higher cost

Interest is subject to the federal alternative minimum tax

Private Activity Projects –outside the realm of pure governmental functions• Airports• Not for profit 501(c)(3)• Housing Agencies


Tax-Exempt Bonds – Historical Interest Rates

Cost of financing is generally lower for issuers Theoretical rate: ≈67% of Taxable Rate Interest paid to bondholders is not includable in their gross income for federal income tax

purposes.

Benefit of Tax-Exempt Bonds

0

1

2

3

4

5

6

7

Interest Rate (%

)

AAA 30 Yr Tax‐Exempt

AAA 30 Yr Taxable

AAA 30 Yr Tax‐Exempt

AAA 30 Yr Taxable

Max 5.08 5.72Min 2.47 3.29Average 3.74 4.48Current 3.81 4.37


Fixed Rate vs. Variable Rate

The rates (coupons) are set on the day of the pricing and do not change

The issuer will pay the exact same interest payments (usually twice a year) for as long as they own the bonds

Fixed interest cost and amortization facilitate budgetary certainty and administration

Fixed Rate

The interest rates are reset to different coupons at predetermined points throughout the year

The Issuer’s interest payments will vary for the life of the bonds based on market conditions

Having a portion of an issuer’s capital structure as variable rate debt creates a better match and a natural hedge between short-term assets and liabilities

Variable Rate

Fixed Rate Bond

0

2

4

6

8

10

12

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013Year

Dol

lars

($00

0)

Interest Principal

Variable Rate Bond

0

2

4

6

8

10

12

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013Year

Dol

lars

($00

0)Interest Principal


Interest Rate Swaps (derivatives)

Interest Rate Caps – an agreement which insures the interest rate will not exceed a predetermined rate (the “strike rate”) for a predetermined period of time (e.g. 3 years, 5 years, etc.).

Interest Rate Swap - the Borrower exchanges their variable rate payment obligation with a third party for a fixed payment obligation for a specified period of time. At the end of that time, the Swap can either be extended or the bonds will revert to the variable-rate mode.

Bondholders

Swap Counterparty

Ancillary Fees:• Remarketing Fees• Letter of Credit

Variable Bond Rate

Variable Swap Rate

Fixed Swap RateIssuer


Principal Amortization Structures

Serial Bond Structure

0

0

0

Term Bond Structure

Bullet Maturity Structure

Term Bond Sinkers


Call Options

Call Options Call is exercised only at the option of the issuer not the investor Calls typically exercised to achieve savings or restructure debt Issuers typically issues Bonds with a 10 year call option or refinancing opportunity

Par Premium Make-whole

Mandatory Call

Extraordinary Call

Redemption Prices for Call Vary

Call must be exercised on specified date/during specified timeline May be required by law May be required by legal structure of transaction

Call exercised upon occurrence of certain events May be optional


Bond Pricing Mechanics

Price is often quoted as a percentage of face value. A bond priced at 101, for example, will be worth 101% of the face value of the bond. This is known as a premium. Similarly, a bond priced at 95 will be worth only 95% of the face value of bond. This is known as a discount. The types of bonds are outlined below:

Par Bonds

Coupon Rate is equal to Yield; investor pays the stated price, or “Par”Discount Bonds

Coupon Rate is less than Yield; investor pays less than the stated price, or “discount” Premium Bonds

Coupon Rate is greater than Yield; investor pays more than stated price, or “premium”


Credit Ratings and Cost of Borrowing —Credit Spreads

*Ten Year Maturity

MMD = Municipal Market Data Index

0

50

100

150

200

250

300

350

400

Basis P

oints

AA A Baa/BBB

23

80

150


The Process


Tao of Municipal Bond Modeling

Refunding

Escrow(s)

Construction

Fund

Other

Elements

of Size

Capitalized

Interest

YieldStructureBond

Structure

Debt

Structure

Bond

Insurance

Debt Service

Reserve Fund

Size

Underwriter’s

Discount

Costs of

Issuance


Bond Sale Process

Negotiated Bond Sale Process

Financing Team Selected: Bond Counsel, Financial Advisor, Underwriter and Underwriter’s Counsel

Applications/Request made to necessary parities

Certain types of bonds require special authorizations and/or allocations made to local and state level governments

Initial and Authorizing Resolution (20 day wait period on New Money Bonds)

Resolutions presented to local government body (City Council, Board of Mayor and Alderman)

Bond Structuring Financing Team evaluates security structure, interest rates, terms, call features, swaps, etc.

Seek Credit Rating and/or Credit Enhancement

2-3 week process to coordinate with creditors

Offering Document Distribution (Preliminary Official Statement)

Document describing the bond structure, credit , flow of funds to the investor community

Bond Marketing to Investors Typically 1 week - Underwriter markets the bonds to potentialinvestors

Bond pricing Negotiations with Underwriter and investors

Finalize Offering Document (Official Statement)

Finalize Offering Document (Official Statement)

Closing Funds received


Post Issuance Compliance Requirements

Issuer covenants to provide ongoing disclosure of both routine financial information on an annual basis and periodic notification upon certain events, e.g., defeasance of bonds

Continuing Disclosure

Issuer is required to provide ongoing updates to the rating agencies

Arbitrage Rebate (if tax-exempt or AMT)Issuer may be required to rebate investment earnings in excess of the bond yield to the federal government every five years

Rating Maintenance


Bonds and Basics - Questions

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