11/8/2013 Bonds 101 Gary Olsen, Senior Financial Advisor/Vice - - PDF document

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Bonds 101

Gary Olsen, Senior Financial Advisor/Vice President Jodie Zesbaugh , Financial Advisor Ehlers

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2013 MASBO Fall Conference – November 15, 2013

Presentation Overview

• Introduction and Background Information
• Participants Involved in Issuing Debt
• Debt Options, Rules and Regulations
• Bond Ratings
• Methods of Bond Sales
• Questions

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What is a Municipal Bond?

• A pledge to repay a debt issue
• Contract between the issuer and the bond

holder

• Typically, the pledge is a “general obligation”

which is a full faith and credit debt pledge

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Guiding Principles

• Debt Issuance and Management is most successful

when you, the issuer

• Understand your financing options
• Receive clear information on implications of decisions
• Have a basic understanding of the rules and regulations
• Know who the participants are, their roles, whom each

party “works” for, and how they are compensated

• Generally understand how “bonds” are sold in the market

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Why Borrow?

• May be the only way the district can afford the cost
• f a project, improvement, or equipment
• Few districts have sufficient funds available to pay for

larger capital expenditures

• Cost is spread out over a number of years
• May allow for better management of tax rates
• Avoids “roller coaster” effect on taxes
• Matches the useful life of asset or improvement with

who pays

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Tax-Exemption

• Interest paid to holders of many municipal
• bligations enjoys exemption from federal income

taxation

• An implicit subsidy exists from the U.S. Treasury to tax-

exempt issuers

• IRS has extensive rules and regulations regarding the

issuance of tax-exempt obligations

• In Minnesota, exempt from State income taxes

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Tax Exempt vs. Taxable Rates – 11/04/13

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Bloomberg, Municipal Market Data Yields 0.00 1.00 2.00 3.00 4.00 5.00 6.00 Tax-Exempt AAA Taxable AAA Difference

Debt Planning – Basic Topics to Discuss

• Amount to borrow
• Include all construction, cost of issuance, and soft

costs

• May be other items to capitalize
• Sources of revenue
• Tax levy (impact on taxes)
• Other funding sources (impact on budget)
• Term of repayment
• Type of bond or borrowing and sources of revenue

may dictate longest available term

• Should not exceed useful life of asset financed

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Debt Planning – Basic Topics to Discuss

• Call provision
• Determining which bonds can be “called” (redeemed

prior to maturity), when they can be called and at what price

• Existing and future debt considerations
• Debt service impact on tax levy
• Flexibility based on future financing needs

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Key Participants in Issuing Municipal Debt

• Issuer (School District)
• Financial Advisor / Municipal Advisor
• Bond Counsel / Attorney
• Rating Agencies
• Purchaser (Underwriters, Broker/Dealers, Commercial Banks)
• Paying Agent
• Bond Insurers – Insurance for bond payments
• Investors

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What are their roles, whom do they represent, and how are they paid?

Financial / Municipal Advisor

• Professionals who offer advice on financial matters
• Assists issuer in developing a finance plan and conducting

the bond sale

• Conducts a detailed assessment of client’s financial position,

preferences, and objectives

• Advises appropriate action(s) to meet client's objectives
• Recommends one or more suitable financial solutions to match client’s

needs

• Coordinates financing and debt issuance process
• Prepares official statement on behalf of issuer
• Receives and evaluates proposals (competitive sale) or negotiates with

purchaser (negotiated sale)

• Coordinates closing of issue

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Financial/Municipal Advisor

• Represents the interests of the issuer exclusively in

dealing with financial markets

• Has a Fiduciary Duty to Issuer
• Duty of Loyalty
• Duty to deal honestly and in good faith with the municipal

entity and to act in the municipal entity’s best interests

• Duty of Care
• Duty to exercise due care in performing its responsibilities
• Advises in both debt and non-debt solutions
• Provides official documentation for the bond issue

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Bond Counsel

• Drafts required legal documents (i.e. notices, resolutions,

certificates, etc.) on behalf of Issuer

• Provides various legal opinions to the benefit of both

Issuer and Buyer of debt obligations

• Legal, valid and binding obligation of Issuer (valid contract)
• Interest on bonds is exempt from federal and state income taxation
• Opinions as relates to state and federal securities laws
• Assists in preparation of closing documentation and

actual closing of the transaction

• Issuer pays Bond Counsel a flat fee for services, but the

firm’s opinions accrue to the benefit of all parties to a transaction in one form or another

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Rating Agencies

• Three major rating agencies
• Moody’s Investors Service
• Standard & Poor’s
• Fitch Investors Service
• Provides an independent evaluation of the credit

quality of each municipal debt issue

• Called a bond or credit rating
• Credit rating attempts to measure the risk of default
• n a debt issue

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Purchaser

• Firms that are initial purchasers of bonds are

called Underwriters

• Includes Broker/Dealers and Commercial Banks
• Purchases bonds from issuer and generally resells to

investors

• Underwriter has financial and other interests that

differ from those of issuer

• Represents interest of investors, not issuer
• Does not have a fiduciary duty to issuer

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Paying Agent

• Tracks and coordinates debt service payments for

issuer

• Submits invoices to issuer for principal and interest

payments

• Receives debt service payments from issuer
• Makes principal and interest payments to

bondholders on behalf of issuer

• Required for Minnesota school districts participating

in the state’s credit enhancement program

• Not required if issuer is not participating in credit

enhancement program

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Debt Options, Rules and Regulations

• Issuing Authority Comes from State Law
• Spread throughout statutes based on issuer and
• bligation type
• Tax Exemption Comes from Federal Tax Code
• IRC Sections 103 and 141-150

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Statutory Authority To Issue Debt

• Building Bonds
• MN Statutes Chapter 475
• Authorized by voter approval at special election /

referendum

• Used to finance purchase or construction of school

buildings & facilities, renovation & improvement projects, infrastructure, and equipment

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Statutory Authority To Issue Debt

• Alternative Facilities Bonds
• MN Statutes Section 123B.59
• Authorized by approval of the Commissioner
• Two programs
• Full: repairs, maintenance, improvements and health &

safety projects

• Limited: health & safety projects greater than $500,000

per site

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Statutory Authority To Issue Debt

• Capital Notes / Certificates of Indebtedness
• MN Statutes Section 123B.61
• Authorized by resolution of the Board
• Used to purchase vehicles and equipment
• Capital Facilities Bonds
• MN Statutes Section 123B.62
• Authorized by approval of the Commissioner
• Used to finance improvements to existing buildings,

facilities, and sites

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Statutory Authority to Issue Debt

• Tax and Aid Anticipation Certificates
• MN Statutes 123B.78
• Authorized by resolution of the Board
• Used to cover cash flow operational deficits
• Lease Purchase
• MN Statutes 465.71
• Authorized by resolution of the Board
• Used to finance the purchase of buildings, facilities, land,

and equipment, construction & improvement projects

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Other Statutory References – Chapter 475

• 475.52 – Bond Issue Purposes
• 475.53 – Limit on Net Debt
• 15% of full market value of taxable property
• 475.54 – Limitation on Term and Amount Maturing

in Each Year

• Generally 30 years
• Complex rules regulating bond structure

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Other Statutory References – Chapter 475

• 475.58 – Elections to Determine Issue
• 475.61 – Tax Levies
• Assess tax levy at 105% of debt service payments,

less available funds

• 475.67 – Refunding Bonds
• For tax exempt general obligation refunding bonds

issued more than 90 days prior to call date (advance refundings)

• 3% present value savings requirement OR
• Extend the maturity by at least three years

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• Credit Enhancement Program
• Bank Qualification
• Arbitrage
• Continuing Disclosure
• Reimbursement Regulations
• Municipal Advisor

State and Federal Regulations

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• Program adopted in early 1990s by State of MN
• No cost for district to participate
• State guarantees principal & interest payments on bonds
• Bonds assigned credit enhancement program rating
• Moody’s: Aa2
• S & P: AA+
• Lower interest rates
• Paying agent required as part of program
• Simple process
• Resolution
• Application
• District required to make debt service payments 3 days

in advance

State Credit Enhancement Program

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• District may designate tax exempt debt as “bank

qualified” if issuing $10 million or less in total during a calendar year

• Bank qualification creates tax advantages for

financial institutions purchasing debt

• When purchased by a commercial bank for its portfolio,

bank may receive a tax deduction for interest cost

• Can expand the number of potential buyers
• Bank qualified debt generally has lower interest

rates than non-bank qualified debt

• How much lower depends on the market

Federal Regulations - Bank Qualification

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• Arbitrage is profit that results from investing proceeds of

tax-exempt issue in higher yielding taxable securities

• Complex federal rules; failure to comply could lead to

penalties or even loss of tax exemption on the bonds

• District may need to “rebate” (pay to IRS) arbitrage

earned in construction funds; “exceptions” to requirement

• Small issuer exception – issue no more than $15M in tax-exempt

debt in a calendar year

• 24 month spending exception
• Other less commonly used exceptions
• Investment earnings in debt service funds may also be

subject to arbitrage rebate

Federal Regulations - Arbitrage

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• Increasing Federal role in regulating disclosure

(SEC Rule 15c2-12)

• Disclosure requirements are determined at time of

sale, based on

• Size of issue
• Total debt outstanding
• For many issues, district must provide annual

financial reports and updates of other information

• Can contract for this service
• Information is posted on MSRB web site (emma.msrb.org)

Federal Regulations - Continuing Disclosure

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• Issuer may reimburse itself with proceeds of tax-

exempt bonds only if it complies with complex rules

• Rules generally don’t apply to “preliminary

expenditures” (e.g. architect, engineering, surveying fees)

• Different attorneys recommend slightly different

procedures and practices

Federal Regulations - Reimbursement

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• July 21, 2010 – Dodd-Frank Act Signed
• Amended Section 15B of the Securities Exchange Act of 1934
• Includes Section 975 – Regulation of Municipal Securities
• October 1, 2010 – Temporary Rules
• Required “Municipal Advisors” to register with SEC & MSRB
• About 1,150 municipal advisors are registered
• December 20, 2010 – SEC Proposed Rules with Concerns
• Treatment of appointed board members of municipal entities
• Investments of all municipal funds (versus bond proceeds)
• Impact on traditional banking activities
• Lack of guidance on what is “advice”
• September 18, 2013 – Final Rules Adopted
• Rules effective 60 days after publication in the Federal Register
• July 1, 2014 – Phase-in of Permanent MA Application

Federal Regulations – Municipal Advisor

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• “Municipal Advisor” Definition – Rule 15Ba1-1(d)
• Provide Advice OR Solicitation
• To a Municipal Entity OR Obligated Person
• RE: Muni Securities Issue OR Muni Financial Products
• Includes Advice Regarding Structure, Timing, Terms,
• r Other Similar Matters

Federal Regulations – Municipal Advisor

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• “Municipal Entity” Definition – Rule 15Ba1-1(g)
• State and political subdivisions
• Agencies, authorities and instrumentalities
• Plan, program, or pool of assets sponsored or

established by State or political subdivision

• Any other issuer of municipal securities

Federal Regulations – Municipal Advisor

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• Exclusions and exemptions from MA definition
• Public Officials, Boards, Committees, employees of a

municipal entity or obligated person (conduits) while acting within the scope of their official capacities

• Registered Investment Advisors providing investment advice
• Registered Commodity Trading Advisors providing advice

related to swaps

• Banks providing investment and credit advice
• Accountants providing audit opinion or other services (e.g.

preparation of financial statements, issuance of letters for underwriters)

• Engineers providing services related to certain feasibility

studies, cash flow modeling, and projections (e.g., output capacity, utility project rates, project demand or revenues)

• Attorneys providing services of traditional legal nature

Federal Regulations – Municipal Advisor

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• Intended to provide protections and benefits to

municipal issuers and obligated persons

• Fiduciary duty
• Reduced Borrowing & Issuance Costs
• Better Financing Terms
• Positive Impact on Taxpayers
• Regulatory oversight over standards, training and conduct
• Requirements regarding maintenance and storage of

books and records

Federal Regulations – Municipal Advisor

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Bond/Credit Ratings

• Ratings Are
• Indicators of
• Risk
• Willingness and ability to pay bonds in full and on time
• Probability of default
• Independent opinions
• Ratings Are Not
• Indicators of quality of life
• Static

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Bond/Credit Ratings

• Who uses ratings?
• Institutional investors, individual investors, issuers, media,

politicians, political candidates

• Impact on
• Investor
• Better / Higher rating = less risk
• Ultimately for you, the issuer
• Better / Higher rating = lower interest costs

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Bond Rating Scales

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Rating Impact on Yield Curve

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Municipal Debt Yield Curves 11/1/2013

0.00 1.00 2.00 3.00 4.00 5.00 6.00 2014 2016 2018 2020 2022 2024 2026 2028 2030 2032 2034 2036 2038 2040 2042 Tax Exempt AAA Tax Exempt AA Tax Exempt A

Bond Rating Factors

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Management Debt Profile Financial Operations Economy

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Methods of Debt Sales

• Competitive Bid
• Process coordinated by financial advisor
• Issuer solicits multiple bids
• Sells issue to underwriter that offers lowest financing cost

to the District

• Intended to result in lower financing cost than other sale

methods, due to competitive nature of bidding process

• Preferred method of sale of most school bonds
• General Obligation
• ‘A’ or better rating

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Methods of Debt Sales

• Negotiated Sale
• A financial advisor may or may not be involved
• Issuer selects an underwriter with whom to place the debt
• Negotiates the terms and conditions with underwriter
• Beneficial for unique circumstances or low credit rating
• Debt may carry unusual features, structure, or other

provisions

• “Story” Bond – requires active marketing efforts of

underwriting firm to draw investor interest

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Methods of Debt Sales

• Limited Proposal
• Involves a financial advisor to coordinate
• Issuer selects several underwriting firms from which to

solicit proposals

• Accepts proposals from firms at a specified time
• Incorporates a moderate level of competition into

purchasing process

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Methods of Sales - GFOA Recommendations

• “Due to the inherent conflict of interest, issuers

should not use a broker/dealer or potential underwriter to assist in the method of sale selection unless that firm has agreed not to underwrite that transaction.”

• If a negotiated sale is selected, the Issuer should, in

consultation with its Financial Advisor

• Select the underwriter(s) through an RFP process
• Utilize a Financial Advisor unrelated to the underwriter(s)

to provide advice on all aspects of sale

• The Financial Advisor should not be allowed to resign and

serve as underwriter for transaction

Source: GFOA Recommended Practice, “Selecting and Managing the Method of Sale of State and Local Government Bonds” (1994 and 2007)

(651) 697-8513 golsen@ehlers-inc.com

Gary Olsen Ehlers

(651) 697-8526 jzesbaugh@ehlers-inc.com

Jodie Zesbaugh Ehlers

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