Bonds and Basics-Lauren Lowe-TN Economic Development Finance Course


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TN Economic Development Finance Course Feb. 20-21, 2014
UT Center for Industrial Services & Council of Development Finance Agencies

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Bonds and Basics-Lauren Lowe-TN Economic Development Finance Course

  1. 1. Council of Development Finance Agencies Bonds and Basics February 20, 2014 530 Oak Court Drive, Suite 160 Memphis, TN 38117 P: 901-682-8356 F: 901-682-8386 © 2014 Public Financial Management, Inc.
  2. 2. Bond Topics  Bond Basics  The Players  Structuring Features/Considerations  The Process © 2014 Public Financial Management, Inc. 1
  3. 3. Bond Basics © 2014 Public Financial Management, Inc.
  4. 4. 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.” © 2014 Public Financial Management, Inc. 3
  5. 5. General Municipal Bond Purposes New Money Bonds  Issued to fund capital projects: roads, bridges, stadiums, schools, power plants, etc. Refunding Bonds  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 © 2014 Public Financial Management, Inc. 4
  6. 6. General Bond Terminology Principal or Par Amount • Amount of the Bond Issue or the indebtedness Maturity Date • Repayment Date of Bond Issue Coupon Rate • Interest rate paid annually on the Bond Issue • Usually expressed as a percentage of Par Amount Price • Amount an investor will invest in consideration of future receipt of principal and interest payments Yield • Income return on an investment • Usually expressed annually as a percentage of Par Amount Annuity of Interest Price © 2014 Public Financial Management, Inc. Principal Maturity 5
  7. 7. Terminology Reference – Example Series CITY OF HYPOTHETICAL, TENNESSEE Par Amount Maturity Date Principal Amount $26,495,000 GENERAL OBLIGATION BONDS, EXAMPLE SERIES Due March 1 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 © 2014 Public Financial Management, Inc. Principal Amount $1,770,000 1,770,000 1,770,000 1,765,000 1,770,000 1,765,000 1,765,000 1,765,000 1,765,000 1,765,000 1,765,000 1,765,000 1,765,000 1,765,000 1,765,000 Coupon Rate Rate Yeld 3.000% 4.000% 4.000% 4.000% 1.500% 2.000% 3.000% 3.000% 4.000% 4.000% 2.500% 3.000% 3.000% 4.000% 4.000% 0.350% 0.380% 0.500% 0.680% 1.000% 1.250% 1.550% 1.850% 2.160% 2.310% 2.500% 2.800% 3.100% 3.130% 3.250% CUSIP No. 654 123 7Q6 654 123 7R4 654 123 7S2 654 123 7T0 654 123 7U7 654 123 7V5 654 123 7W3 654 123 7X1 654 123 7Y9 654 123 7Z6 654 123 8A0 654 123 8B8 654 123 8C6 654 123 8D4 654 123 8E2 6
  8. 8. 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. © 2014 Public Financial Management, Inc. 7
  9. 9. The Players © 2014 Public Financial Management, Inc.
  10. 10. Participants to the Transaction Team Swap Advisor Escrow Agent Financial Advisor Bond/Tax Counsel Registrar/ Paying Agent/ Trustee Underwriter Counsel Issuer Trustee Counsel Every issue Underwriter / Lender Financial/ Feasibility Consultant Verification Agent / Accountant Rating Agencies Credit Enhancers Moody’s S&P Fitch As needed © 2014 Public Financial Management, Inc. 9
  11. 11. 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. © 2014 Public Financial Management, Inc. 10
  12. 12. 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. © 2014 Public Financial Management, Inc. 11
  13. 13. 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. © 2014 Public Financial Management, Inc. 12
  14. 14. 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 © 2014 Public Financial Management, Inc. 13
  15. 15. 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. Investment Grade Rating Scales 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-  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 © 2014 Public Financial Management, Inc. 14
  16. 16. Structure Features/Considerations © 2014 Public Financial Management, Inc.
  17. 17. Common Bond Security Structures General Obligation Bonds  Full Faith and Credit Pledge  All legally Available Revenues  Taxing Power  Not Subject to Appropriation Appropriation (Lease) Bonds  Special Obligation Pledge  All legally Available Revenues  No Taxing Power  Subject to Appropriation Revenue Bonds  Revenue Pledge  Specifically Defined Revenue Source  No Property Taxing Power  Covenants to Ensure Revenue Sufficiency  Not Subject to Appropriation © 2014 Public Financial Management, Inc. 16
  18. 18. Tax-Exempt, AMT, and Taxable Bonds Governmental Bonds Alternative Minimum Tax (Tax–Exempt) (AMT) Private Activity Bonds (Taxable)  Lowest cost  Slightly higher cost  Interest is federally taxexempt  Interest is included in gross  Interest is subject to the income for federal income federal alternative minimum tax purposes tax  Projects are deemed taxable  Private Activity Projects – if they do not provide a outside the realm of pure significant benefit to the governmental functions general public  Issued by State and Local governments  Finance projects owned, operated, or used by a government for its own purposes  Highest cost • Airports • Not for profit 501(c)(3) • Housing Agencies © 2014 Public Financial Management, Inc. 17
  19. 19. Tax-Exempt Bonds – Historical Interest Rates Benefit of Tax-Exempt Bonds  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. 7 AAA 30 Yr Tax‐Exempt 6 AAA 30 Yr Taxable Interest Rate (%) 5 4 3 2 AAA 30 Yr  AAA 30 Yr  Tax‐Exempt Taxable Max 5.08 5.72 Min  2.47 3.29 Average 3.74 4.48 Current 3.81 4.37 1 0 © 2014 Public Financial Management, Inc. 18
  20. 20. Fixed Rate vs. Variable Rate Fixed Rate Fixed Rate Bond 12 Interest 10 Dollars ($000)  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 Principal 8 6 4 2 0 2004 2005 2006 2007 2008 2009 Year 2010 2011 2012 2013 Variable Rate © 2014 Public Financial Management, Inc. Variable Rate Bond 12 10 Dollars ($000)  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 Interest Principal 8 6 4 2 0 2004 2005 2006 2007 2008 2009 Year 2010 2011 2012 2013 19
  21. 21. 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. Fixed Swap Rate Issuer Swap Counterparty Variable Swap Rate Variable Bond Rate Bondholders © 2014 Public Financial Management, Inc. Ancillary Fees: • Remarketing Fees • Letter of Credit 20
  22. 22. Principal Amortization Structures Serial Bond Structure 0 Term Bond Structure Term Bond Sinkers 0 Bullet Maturity Structure 0 © 2014 Public Financial Management, Inc. 21
  23. 23. 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 Mandatory Call  Call must be exercised on specified date/during specified timeline  May be required by law  May be required by legal structure of transaction Extraordinary Call  Call exercised upon occurrence of certain events  May be optional Redemption Prices for Call Vary  Par  Premium  Make-whole © 2014 Public Financial Management, Inc. 22
  24. 24. 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” © 2014 Public Financial Management, Inc. 23
  25. 25. Credit Ratings and Cost of Borrowing — Credit Spreads 400 350 Basis Points  300 250 200 150 150 100 80 50 23 0 AA A Baa/BBB *Ten Year Maturity MMD = Municipal Market Data Index © 2014 Public Financial Management, Inc. 24
  26. 26. The Process © 2014 Public Financial Management, Inc.
  27. 27. Tao of Municipal Bond Modeling Refunding Escrow(s) Other Construction Elements Fund of Size Size Capitalized Costs of Issuance Interest Bond Underwriter’s Insurance Discount Debt Service Reserve Fund Bond Structure Structure Yield Debt Structure © 2014 Public Financial Management, Inc. 26
  28. 28. 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 potential investors Bond pricing Negotiations with Underwriter and investors Finalize Offering Document (Official Statement) Finalize Offering Document (Official Statement) Closing Funds received © 2014 Public Financial Management, Inc. 27
  29. 29. Post Issuance Compliance Requirements Continuing Disclosure 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 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 Issuer is required to provide ongoing updates to the rating agencies © 2014 Public Financial Management, Inc. 28
  30. 30. Bonds and Basics - Questions © 2014 Public Financial Management, Inc. 29