Best Practices Show
Issuers should include guidelines and criteria in their debt management policies that address when a refunding is permitted based on potential debt service savings or other criteria, preservation of future refunding flexibility when issuing any new money debt, and monitoring of refunding opportunities on outstanding debt.Bond refinancings or “refundings” are used by state and local governments to achieve debt service savings on outstanding bonds. Though less frequent, refunding bonds can also be issued to remove or revise burdensome bond covenants or to restructure debt service payments. GFOA recommends that governments include guidelines and criteria in their debt management policies that address when a refunding is permitted based on potential debt service savings and other criteria, such as how to monitor refunding opportunities on outstanding debt and other considerations as outlined below. As is stated throughout GFOA best practices, governments that don’t have dedicated debt management staff, expertise in analyzing refunding opportunities, or access to current bond market data should engage the services of a registered municipal advisor. Many unique refunding structures may be presented to governments, and prior to pursuing such refunding transactions, the risks and benefits of each should be thoroughly reviewed by the government with the assistance of a municipal advisor, which has a fiduciary duty to the government. The Mechanics of Refunding Bonds Municipal bonds are typically issued with an optional redemption date or “call date” (i.e., prepayment date without penalty) approximately 10-years from the date of issuance. The optional redemption provision allows the government issuer to refinance the outstanding bonds with refunding bonds. Generally, when enough time passes and the call date approaches, the government will assess current market rates at that time, and if current market rates are below the interest rates on the outstanding bonds, the government can issue refunding bonds at a lower interest rate and realize debt service savings. A refunding bond issuance is generally characterized as either a current refunding or an advance refunding.
Alternatives to tax-exempt advance refundings: With the elimination of tax-exempt advance refunding bonds, some banks and broker/dealers have developed alternative financing structures that realize a portion of the savings previously available through tax-exempt advance refundings have been developed. Governments should be aware these alternative structures may involve additional risks, reduced savings, and other disadvantages. Governments should evaluate the potential risk/benefits of these alternative structures relative to the option of simply waiting until the call date/prepayment date of the outstanding bonds and executing a current refunding with tax-exempt bonds. Debt Policy Considerations Governments should periodically review any existing debt policies for refundings to determine if the policies are still relevant given potential changes in tax law, federal borrowing programs, and other market developments. Guidelines and criteria may include some or all the following and should be discussed with the municipal advisor: Debt Policy Considerations – Refunding Debt Service Savings The debt policy for refunding bonds should include decision guidelines regarding when to refund outstanding bonds based on a minimum savings threshold. Policies should consider whether refunding thresholds will be applied to an entire issue or on a maturity-by-maturity basis. However, governments should also consider including flexibility in their debt policies to provide the ability to refund debt for reasons other than debt service savings, where the circumstances warrant, as further discussed below. Governments may wish to adopt different minimum net present value (NPV) savings criteria for current refundings than advance refundings. When outstanding bonds become currently callable, the value of the call option decreases in value over time. Therefore, governments may be more inclined to have lower savings thresholds for a current refunding than in an advance refunding. Examples of differing approaches to refunding savings thresholds include:
Advance refundings require additional considerations when evaluating the viability of the refunding, which can be informed by analysis performed by the government’s municipal advisor:
Debt Policy Considerations – Refunding Savings Structure GFOA recommends that issuers structure refundings with “level savings,” where savings are realized in approximately equal annual amounts over the life of the refunding bonds. A government’s municipal advisor can also model other savings structures tailored to the government’s specific business and financial needs, any state or local requirements, and/or provisions of existing financing agreements or bond covenants. An analysis of the pros and cons of the structure selected for the life of the financing should be communicated to all stakeholders and should identify any out-years in which debt service increases beyond reasonable revenue growth assumptions, and how these would be funded. Monitor Refunding Opportunities - Governments should establish a process to identify and monitor potential refunding opportunities within their outstanding debt portfolio on a routine basis and as interest rates change. Spreadsheet-based debt tracking, combined with an analysis of current interest rates, can provide “snapshot” looks at refunding opportunities that can then be more rigorously analyzed by the municipal advisor. This tracking should include some or all of the refunding objectives guidelines that are included in a government’s debt policies. Debt Policy Considerations – Other Refunding Matters Preserve Future Refunding Opportunities - Governments should be attentive to providing for future refunding options when issuing new money and refunding bonds. Two key bond structuring elements are critical in preserving and enhancing future refunding opportunities: (1) The optional redemption provision (call date and price). The typical optional redemption (i.e., “call date”) on a tax-exempt bond is generally 10 years from the date of issuance and GFOA recommends that bonds include a call date not later than approximately 10 years. Earlier call dates may be available, but they likely result in higher interest cost. The benefits of an earlier call feature should be weighed against potential negative effects and GFOA recommends that governments request from their municipal advisor an analysis of the benefits of any call structures outside of the conventional 10-year call date. For taxable bonds, the call provisions can vary, and the current and possible future costs of different call provisions should be evaluated. (2) The coupon rate of each bond maturity after the call date. Aside from future borrowing rates, future refunding opportunities depend on the coupon rates on the bonds to be refunded (not the original yields at which those bonds were sold). Bonds with higher/premium coupons (e.g., 5%) are more likely to be refunded than bonds with lower coupons, as a greater range of future borrowing rates can provide refinancing savings. Thus their call option at issuance has a higher value, however the higher value call option comes at a potentially higher cost, as 5% bonds result in a higher yield-to-maturity if the bonds are not refunded. Governments are encouraged to consult with their municipal advisor and others in their finance team to determine market preferences at the time of issuance and whether a high (i.e., premium) or low (i.e., par or discount) coupon structure provides the best cost of capital for the government. Refunding Bonds for Other Purposes - Debt policies should also contemplate when a government will consider a refunding whose primary purpose is not debt service savings. Governments will sometimes pursue refundings to eliminate restrictive bond/legal covenants, restructure the stream of debt service payments, or achieve other policy objectives. In such cases, GFOA recommends that the policy objectives and benefits, along with any economic loss of the refunding, should be clearly understood and articulated to all stakeholders, as well as how such a decision fits into a long-term financial plan. Build America Bonds - Governmental issuers of taxable or tax credit bonds (including Build America Bonds or “BABs”) will, in most cases, be able to issue tax-exempt advance refunding bonds to refinance those obligations. However, the retirement of BABs through a refunding will result in the loss of the federal interest subsidy payments, which should be considered when calculating refunding savings. Refunding analysis of BABs could be further complicated by the presence of make-whole call provisions, which eliminate the possibility of debt service savings. Governmental issuers of tax credit bonds and other taxable debt should consult with bond counsel and their municipal advisor to determine if their bonds are eligible to be advance refunded and to verify call and savings parameters of any advance refunding transaction. Escrow Funding Considerations Proceeds of refunding bonds are almost always placed in an escrow account held by a third-party escrow agent. These funds are held until the call date of the refunded bonds and are typically invested so the investment earnings minimize the escrow cost.
Refunding Bond Financing Team At the outset of any financing, GFOA recommends that governments solicit the advice of their municipal advisor and bond counsel to identify key legal and financial issues early in the financing process. When evaluating the outside financing team members to include in the transaction, factors such as cost, experience, references, ability to meet deadlines and Disadvantaged Business Enterprises (DBE) should all be taken into consideration. Refunding bond transactions also typically involve additional professional service providers.
Which of the following are sources of income that can be used for debt service on municipal revenue bonds?Which of the following are sources of income that can be used for debt service on municipal revenue bonds? operation and maintenance reserve account.
What is municipality collection ratio?A measure of a municipality's ability to collect the taxes it has assessed.
How is a municipality's net total debt arrived at?1 Net debt shows a municipality's overall financial situation by subtracting the total value of the city's obligations and debts from the total value of its cash, cash equivalents, and other liquid assets, in a process called netting.
Which of the following projects would be financed by a revenue bond issue?A subway line, hydroelectric plant, and sewage treatment plant all charge for their use and can be financed with revenue bonds. Which of the following projects would be financed by a revenue bond issue? The best answer is C. General obligation bonds are backed by a taxing power pledge.
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