qscbs sinking fund investment strategies - region one esc iii. pfm... · psfy is based upon the...

One Keystone Plaza, Suite 300

QSCBs Sinking Fund Investment Strategies

April 2012

PFM Asset Management LLC

Harrisburg, PA 17101

Region 1 Finance Council Meeting

North Front & Market Streets

www.pfm.com


Contact

Matthew Eisel, CFA Senior Managing Consultant

[email protected] (717) 232-2723

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Contents

I Background

II Investment Options

All data as of 12/31/2011 unless otherwise indicated.

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I Background


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Qualified School Construction Bonds

Designed to allow qualifying schools to borrow at or near 0% to rehabilitate, repair, and equip schools

A type of tax credit bond – others include BABs, QECBs, and CREBs

Section 148 of Internal Revenue Code applies (arbitrage regulations)

Commonly referred to as:

“Q-scabs”

“Q-scibs”

“Q-scoobies”

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I Background

PFM Asset Management LLC 5

American Recovery and Investment Act

I Background

PART III – TAX CREDIT BONDS FOR SCHOOLS

SEC. 1521. QUALIFIED SCHOOL CONSTRUCTION BONDS.

“(a) QUALIFIED SCHOOL CONSTRUCTION BOND.

“(1) 100 percent of the available project proceeds of such issue are to be used for the construction, rehabilitation, or repair of a public school facility or for the acquisition of land on which such a facility is to be constructed with part of the proceeds of such issue.

“(c) NATIONAL LIMITATION ON AMOUNT OF BONDS DESIGNATED. – There is a national qualified school construction bond limitation for each calendar year. Such limitation is –

“(1) $11,000,000,000 for 2009,

“(2) $11,000,000,000 for 2010, and

“(3) except as provided in subsection (e), zero after 2010.

“(d) ALLOCATION OF LIMITATION. –

“(1) ALLOCATION AMONG STATES. – Except as provided in paragraph (2)(C), the limitation applicable under subsection (c) for any calendar year shall be allocated by the Secretary among the States in proportion to the respective amounts of each Elementary and Secondary Education Act of 1965 (20 U.S.C. 6333) for the most recent fiscal year ending before such calendar year. The limitation amount allocated to a State under the preceding sentence shall be allocated by the State to issuers within such State.

Source American Recovery and Investment Act (recovery.gov/About/Pages/The_Act.aspx).

“(e) CARRYOVER OF UNUSED LIMITATION. – If for any calendar year –

“(1) the amount allocated under subsection (d) to any State, exceeds

“(2) the amount of bonds issued during such year which are designated under subsection (a) pursuant to such allocation, the limitation amount under such subsection for such State for the following calendar year shall be increased by the amount of such excess. A similar rule shall apply to the amounts allocated under subsection (d)(4).”.

“SEC. 54F. QUALIFIED SCHOOL CONSTRUCTION BONDS.


2010 Texas QSCBs Allocation

Amount reserved for charter schools

$100,000,000

Amount reserved and used by LEAs* $131,873,000

Carryover balance from 2009

$22,402,337

Available allocation for districts

$338,203,337

Total = $547,674,000

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I Background

Source Texas Educational Agency (tea.state.tx.us). * LEAs include Dallas ISD, Pasadena ISD, Pharr-San Juan-Alamo ISD, and San Antonio ISD.


Unique Characteristic of QSCBs – Sinking Fund

Sinking fund used as budgetary tool to build principal balance through time

Annual deposits accumulate in an amount equal to the par amount of the bond issue

No interim cash flows owed to bondholders before the maturity date of the bonds (similar to CABs)

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Aug-12 Aug-14 Aug-16 Aug-18 Aug-20 Aug-22 Aug-24 Aug-26 Aug-28 Aug-30

(mill

ions

)

Deposit Rolling balance Interest



Permitted Sinking Fund Yield

Investment of sinking fund limited to Applicable Permitted Sinking Fund Yield (PSFY)

Since March 2009, monthly resets have ranged from 3.25% to 5.02%

PSFY is based upon the pricing date of the bonds

Current PSFY is 3.32% (as of April 1, 2012)

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© 2011 PFM Asset Management LLC

I Background

5.02%

3.25%

3.32%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

Mar

-09

Apr-0

9M

ay-0

9Ju

n-09

Jul-0

9Au

g-09

Sep-

09O

ct-0

9N

ov-0

9D

ec-0

9Ja

n-10

Feb-

10M

ar-1

0Ap

r-10

May

-10

Jun-

10Ju

l-10

Aug-

10Se

p-10

Oct

-10

Nov

-10

Dec

-10

Jan-

11Fe

b-11

Mar

-11

Apr-1

1M

ay-1

1Ju

n-11

Jul-1

1Au

g-11

Sep-

11O

ct-1

1N

ov-1

1D

ec-1

1Ja

n-12

Feb-

12M

ar-1

2

PSFY 30-year Treasury

Source Bloomberg, Treasury website (treasurydirect.gov/GA-SL/SLGS/selectQTCDate.htm).


Safe Harbor and IRS Bidding Regulations

Despite negative arbitrage environment, prudent course of action is to undertake a safe harbor-compliant bidding process for the purchase of investments

At least three bids from providers with no material financial interest in the bonds

All providers have an equal opportunity to bid

No courtesy bids are provided (cannot coerce an entity to submit a bid)

Commercially reasonable terms (no intent to reduce yield on any investments)

Award to lowest cost bidder

Document bidding process including record of bids received and solicitation used

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Authorized Investments in the State of Texas

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I Background

Source State of Texas Government Code – Title 10, Subtitle F, Chapter 2256, Subchapter A. Authorized Investments for Governmental Entities.

Other regulations/policies may be more restrictive and should also be consulted:

Investment policy

Governing bond documents

Permitted investments for sinking funds tend to be quite limited (sometimes exclusively Treasuries)

Investment Notable Criteria

Treasuries

Government-sponsored Enterprises

Municipal Bonds Rated A or better

Certificates of Deposit Insured by FDIC/NCUSIF

Repurchase Agreements Secured by cash and/or obligations of governmental entities

Banker’s Acceptances Maturity of 270 days or fewer

Commercial Paper Maturity of 270 days or fewer, rated A-1/P-1 or better

Mutual Funds Dollar-weighted average maturity of 90 days or fewer

Guaranteed Investment Contracts Secured by obligations of governmental entities

Investment Pools


I Background


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Attractive Time to Borrow

Municipal borrowing rates are close to historic lows

Lower investment returns indirectly increase borrowing costs

Temptation exists to hold funds in cash but market conditions likely demand a more tailored approach

Steep slope of yield curve provides targeted investment opportunities

0%

1%

2%

3%

4%

5%

6%

7%

8%

Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10

Borrowing and Investment Rates at Historic Lows

Fed Funds 3-year Agency Index 20-year AA MMD

Source Bloomberg, TM3.

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Yields Low and Expected to Stay Low

Fed's commitment to keep rates low through late 2014 limits returns on short-term investments

0%

1%

2%

3%

4%

5%

6%

Mar

-07

Jun-

07

Sep-

07

Dec

-07

Mar

-08

Jun-

08

Sep-

08

Dec

-08

Mar

-09

Jun-

09

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09

Dec

-09

Mar

-10

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10

Sep-

10

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-10

Mar

-11

Jun-

11

Sep-

11

Dec

-11

U.S. Treasury Yields

6-month 2-year 10-year

Fed

Cut

s R

ates

to 0

%

QE1

Ope

ratio

n Tw

ist

QE2

Source Bloomberg, TM3.

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0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

10-Year U.S. Treasury Yields 1965 - 2012

Long-Term Treasury Yields Have Fallen Dramatically

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Longest Bull Market in History


Source Bloomberg.


Drivers of Investment Strategy

Historically low interest rates

Fed has announced its intent to keep the Fed Funds Target range unchanged through 2014

Outlook uncertain

Steep yield curve provides incentive to extend maturity

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Sinking Investment Options

U.S. Treasuries & Direct Obligations – include SLGS, T-Notes, T-Bills, and T-STRIPS

Government-guaranteed Securities – include obligations such as Resolution Funding Corporation Interest STRIPS

Government-sponsored Enterprise Securities – obligations issued by government-sponsored enterprises (such as FHLMC and FHLB); not direct obligations

Money market funds – highly liquid, invested in short-term securities with the goal of maintaining a constant net asset value of $1

Forward Delivery Agreement (FDAs) – agreement stipulating the outright purchase of securities from a counterparty through time; typically provided by sophisticated broker-dealers and banks

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Money Market Funds/LGIPs

Maintain a net asset value (NAV) of $1 per share

Due to historically low short-term interest rates, money market funds have recently been yielding very close to 0%

Element of credit and liquidity risk

Subject to ongoing reinvestment risk (will interest rates rise?)

An aggressive bet that interest rates will rise in the future

No budgetary certainty

Must be monitored on an ongoing basis for yield compliance

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SLGS

United States Treasury Securities, State and Local Government Series (SLGS)

Purpose is to provide issuers of tax-exempt securities with investments for any amounts that:

Constitute gross proceeds of a tax-exempt bond issue

Assist in complying with applicable provisions of the Internal Revenue Code relating to tax exemption

Direct, non-callable obligations of the U.S. Government

Subscribed for directly from the Treasury; no secondary market and no bidding concerns (IRS regulations)

Rates set each morning, fixed all day (one basis point below open-market Treasuries?)

Coupon-bearing securities

Lower-yielding than non coupon-bearing securities

Reinvestment of coupons must be addressed every six months – inefficient

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© 2011 PFM Asset Management LLC



Open-market Fixed-income Securities

Treasury Bills

Treasury Notes

Treasury STRIPS

“Separate Trading of Registered Interest and Principal Securities”

Sold at a discount, mature at par

Do not bear coupons

Obligations of government-sponsored enterprises

Resolution Funding Corporation Interest STRIPS

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Structured Investment Types and Market Update

Guaranteed Investment contract (GICs) – unsecured pledge to pay principal and interest on investment; historically provided by insurance companies

Flexible Repurchase Agreement (Flex Repos) – agreement to purchase securities and resell back to counterparty in the future at a guaranteed yield; typically provided by broker-dealers and banks

Forward Delivery Agreement (FDAs) – agreement stipulating the outright purchase of securities from a counterparty through time; typically provided by sophisticated broker-dealers and banks

Historically a robust and viable investment alternative for municipalities

Before the most recent recession, each product had between 5 and 12 active providers

After the recession, due to a renewed focus on credit risk and new financial regulations, many providers have dropped out of the market

Difficult – if not impossible – to reach safe harbor requirements in 2011

GICs – 2 active bidders

Flex Repos – 3 to 5 active bidders (depending upon structure, credit quality)

FDAs – 3 active bidders

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Provider Update

Provider GIC FDA Repo Moody’s Rating Outlook

S&P Rating Outlook Unique Challenges

AEGON x x A1 Stable AA- Stable ABCP FDAs, Low Ratings (GICs)

Bank of America NA A2 Negative A Negative De-Leveraging

Barclays Bank x Aa3 Negative A+ Stable Active; Some Credit Sensitivities

Bayerische Landesbank x Baa1 Stable NR Ratings; Prefer to post SBA Collateral

Calyon (Credit Agricole) Aa3 Negative A Stable Ratings

Citigroup x x A3 Negative A- Negative Active

Credit Suisse x Aa2 Negative A Negative Going Through Approval Process

Deutsche Bank x x Aa3 Stable A+ Negative Active

Dexia / FSA Aa3 Negative AA- Stable Managing GIC Portfolio

JPMorgan Aa3 Negative A Stable Managing FDA Portfolio

Merrill Lynch Capital Services Baa1 Negative A- Negative MLCS did not transfer to BANA upon acquisition

Morgan Stanley x x A2 Negative A- Negative Can only do CP FDAs; Repo

Natixis x Aa3 Stable A Stable Ratings

RBC Capital Markets x x Aa1 Stable AA- Stable Selectively Bid on Repos

Societe Generale A1 Negative A Stable Managing GIC and FDA Portfolio

SunTrust Bank x Baa1 Stable BBB Stable Ratings

Trinity (GE Capital) A1 Stable AA+ Stable Left Reinvestment Market

Wachovia (n/k/a Wells Fargo) x A2 Negative A+ Negative Negotiated and/or Taxable Only



Forward Delivery Agreement (FDA) Mechanics

Rolling delivery of Treasury and government-sponsored enterprise securities (if permitted) – interest accrues on sinking fund payments and rolling fund balance

School District is always in possession of cash or a security

New security delivered to account at least every twelve (12) months – matures prior to next deposit

Credit exposure of principal limited to underlying securities

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Provider

Bondholders

School District

Sinking Fund Payments and Rolling Fund Balance

Fixed-Income Securities

Final Payment of Principal

Sinking Fund Payments

Periodic Purchase of Securities

The securities, held by the trustee, mature every twelve months, at which time the funds are used to purchase a new security

(Every 12 months) Trustee



FDAs for Sinking Funds

FDAs are the only vehicle that provides a guaranteed rate of return if held to maturity

Lock in the rate today on all future deposits to the sinking fund

Structured to match future deposit dates and final withdrawal to pay principal to bondholders

Allows the issuer to lock in yields well above short term interest rates

FDA structure is bankruptcy remote – issuer purchases and maintains outright ownership of securities delivered under the contract

Tested during the Lehman Brothers bankruptcy


Advantages Disadvantages

Locks in yield

Higher yield than short-term investments

Secured by short-term Treasury or government-sponsored enterprise securities (if permitted)

School District owns securities

Limited market value fluctuations

Bidding agent fees often can be netted from earnings

Underlying security risk – can be mitigated via limiting the eligible deliverables

Reinvestment risk in the event of counterparty default

No ability to reinvest at higher rates


Sample Sinking Fund FDA Cash Flows

Assumes annual deposits made into the FDA beginning in August of 2012

Cumulative principal balance builds over time as deposits are made (shown as rolling balance below)

Interest on all previous deposits is compounded on a semi-annual basis at rate specified by the FDA

Treasury and government-sponsored enterprise FDA yielding 2.20% (sample investment yield)

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Aug-12 Aug-14 Aug-16 Aug-18 Aug-20 Aug-22 Aug-24 Aug-26 Aug-28 Aug-30

(mill

ions

)

Deposit Rolling balance Interest



FDA Investment – Required Discussion Topics

Difficulty meeting safe harbor

In the current market, it may not be possible to procure 3 disinterested bids

Market observation letter – outlines background to bid process and general market conditions

Overall rate of return on investment must be below PSFY

Previous investments

QAC incorporation

Legal fees – not QAC; must be backed out of FDA yield to determine “true yield”

Yield compliance methodologies

Solicit bids at PSFY with an “earliest maturity” award basis – 0% SLGS from maturity of the FDA to the final maturity of the QSCBs

Proportional deposits into 0% SLGS securities to blend yield down over time

Initial up-front deposit into 0% SLGS to blend yield down from structuring date is preferred

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25 © 2011 PFM Asset Management LLC



Investment Options in the Current Market

Investment Yield Risks Considerations

Money market fund 0.10% Reinvestment Flexibility to extend duration

SLGS 2.55% Some reinvestment Coupons

Treasury Note 2.55% Some reinvestment Coupons

Treasury STRIPS 2.95% Effective asset-liability match

Resolution Funding Corporation Interest STRIPS

3.15% Effective asset-liability match

FDA 2.40% Credit of deliverables Safe harbor issues Budgetary certainty

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All market yields estimated as of 4/11/2012 and representative of 15-year maturities except for the money market fund.


Summary of Investment Options

Money market fund yields are at historic lows with no end in sight

SLGS provide a low rate of return and are not ideal for sinking funds because they are coupon-bearing securities

One-time purchase of non-coupon bearing securities provides upfront yield benefit

Efficient for sinking funds because the maturity date of the investment is chosen to closely match the maturity date of the bonds

The amortization of the discount (difference between the par amount and purchase price) could be used to reduce future sinking fund deposits (pending bond counsel approval)

FDAs provide a guaranteed rate of return if held to maturity

Lock in the rate today on all future deposits to the sinking fund

Structured to match future deposit dates and final withdrawal to pay principal to bondholders

FDA structure is bankruptcy remote – issuer purchases and maintains outright ownership of securities delivered under the contract

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Disclaimer This material is based on information obtained from sources generally believed to be reliable and available to the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities.

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