What is a Municipal Bond? General Session: Basic Structure & Documentation & Financial Aspects of Municipal Bonds. Why Are We Here?

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1 General Session: Basic Structure & Documentation & Financial Aspects of Municipal Bonds Why Are We Here? To understand the basic elements, financial aspects and law relating to the issuance of municipal bonds. What is a Municipal Bond? Debt instrument A security An obligation

2 Debt Instruments Typically Specify an obligation to pay a stated amount (the principal ) at a given time (the maturity ) with interest at a stated rate. Four Important Areas of Law Securities Law 1933 Tax Law 1913 State Law 1783 Law of Contracts (yore) Four Key Questions What is the agreement? Is it valid under state law? Is it tax-exempt? What are the securities law implications? These questions are key considerations in rendering the bond opinion. Bond Counsel bases the bond opinion on an examination of material legal and factual sources regarding the subject addressed therein.

3 Basic Debt Transaction Lender (loans $) $ Loan Proceeds $ Loan Repayments (usually evidenced by a note) Borrower (borrows $) Basic Municipal Bond Transaction Bondholders ( purchasers ) (loans $) $ Bond Proceeds $ Bond Repayments Bond Issuer (Governmental) (borrows $) (usually evidenced by a Bond) Basic Municipal Bond Transaction Bond Issuer (Governmental) (borrows $) Paying Agent (acts in an agency capacity for the Issuer) $ Bond Proceeds $ Bond Debt Repayments Bondholders ( purchasers ) (loan $)

4 Why An Issuer Uses Tax-Exempt Bonds Taxable Rate 7.00% Multiply by 1 minus marginal tax rate (assume 33%) x.67 Tax-exempt Rate 4.69% Annual Interest Example Taxable: $10,000,000 x 7.00% = $700,000 Tax-Exempt: $10,000,000 x 4.69% = $469,000 On $10,000,000, savings would be $231,000 in the first year alone. Why An Investor Buys Tax-Exempt Bonds Taxable Bond Rate 7.00% Tax-exempt Rate 4.69% Investor s Assumed Tax Rate 33% $10,000,000 Bond Example Interest Income Tax Liability Net Interest Income Taxable: $700,000 ($231,000) $469,000 Tax-Exempt: $469,000 N/A $469,000 A Brief Detour: Tax Credit and Direct Subsidy Bonds Low cost financing for targeted assets or programs Instead of tax-exempt interest, IRS permits: Federal income tax credit to bondholder Direct subsidy payment to issuer Most provisions have expired, but could be revived

5 Anatomy of a Transaction 1. Initial Communications and Analysis 2. Deal Team 3. Bond Documents 4. Bond Sale 5. Closing Initial Communications and Analysis Initial Communications & Analysis What is the deal being proposed? What is the security/source of payment? Initial Due Diligence tax and disclosure Timeline of required actions & hearings Ethical obligations Who is your client? Engagement letter

6 The Project State Law Concerns Is the Project within the issuer s jurisdiction? Are there limitations on the client s ability to purchase/finance the Project? What approvals are required? The Project (cont.) Initial Tax Inquiry Who will own/use/manage the Project? Does the Project require volume cap? What is the anticipated timing of expenditures (use of bond proceeds)? The Project (cont.) What is the appropriate security for the Project? Will the Project produce revenue? Will the Project produce net revenue? Will the net revenue be sufficient? Is another source of funding readily available?

7 Types of Security General Obligation Special Taxes or Assessments Revenue Pledge Utilities Airport Hospitals Leases or Installment Payments Payments from Conduit Borrowers Additional Security Mortgage/Security interest in specific assets Credit Enhancement General Obligation Bonds Know the requirements of your state / local laws Backed by the full faith and credit of the issuer Often supported by the ability of issuer to levy taxes (particularly ad valorem taxes) Often requires voter approval Revenue Bonds Generally, not a tax pledge but there are exceptions to the rule Supported by the revenues of the facility/enterprise/system being financed (can be rents, tuition, revenues, etc.) Collateral may include the project itself or various rights as to the project

8 Revenue Bonds (cont.) Bondholders $ Bond proceeds $ Debt service Project/System and Revenue Pledge $ Bond proceeds $ Bond proceeds Trustee Issuer Project $ Debt service Revenues Covenants Parties - Issuer and Trustee, on behalf of Bondholders Conduit Bonds Governmental entity issues bonds to benefit another entity (public or private) Conduit Borrower: the entity borrowing the bond proceeds and responsible for paying debt service Examples: small issue manufacturing facility (or industrial development ) bonds, 501(c)(3) bonds, various exempt facility bonds Conduit Bonds (cont.) Bondholders Debt Service Trustee Debt Service Conduit Issuer Bond Proceeds Revenues Conduit Borrower Bond Proceeds Project

9 Conduit Bonds (cont.) Bondholders Trustee Various collateral / security possibilities Conduit Issuer Conduit Borrower Project Refunding Bonds Refundings: Use new bond proceeds to pay debt service on outstanding bonds Current within 90 days Advance more than 90 days Defeasance: Gross fully funded at amount needed to pay debt service Net invested in obligations (like SLGs) sufficient to pay principal, interest and premium Key Considerations of a Refunding Debt Service Savings Usually, the higher the interest rate and the earlier the call date on the refunded bonds, the greater the savings Redemption Provisions Current versus Advance Refunding Call provisions with respect to the bonds being refunded will govern whether you have a current or advance refunding Escrow Investment Yield and Other Factors

10 Debt Service Savings Usually, the higher the interest rate on the refunded bonds relative to today's market, the greater the savings The earlier the call date, the greater the savings Deal Team Possible Members of the Deal Team Bond Counsel Issuer Counsel Tax Counsel Disclosure Counsel Financial Advisor Engineer/Feasibility Consultant Borrower Borrower Counsel Bond Purchaser Purchaser s Counsel Trustee or Paying Agent Trustee Counsel Letter of Credit Bank/Bond Insurer/Credit Provider Counsel to the Credit Provider

11 Bond Documents The Basic Bond Document Contract between Issuer and Bondholders. Two basic types (lots of different names): Indenture/Loan Agreement Bond Ordinance or Resolution General or Master Document for Parity Bonds Typical Document Provisions Security pledge Sale of bonds Terms Registration

12 Typical Document Provisions (cont d) Reimbursement Tax covenants & Designations Use of proceeds/construction of project Example Redemption Provision The Bonds maturing on or after April 1, 2025 will be callable for redemption by the Issuer, in whole or in part, on any date on or after April 1, 2024, at a price of par plus accrued interest to the date fixed for redemption. Example Redemption Provision (cont.) The Bonds maturing on or after April 1, 2025, will be callable for redemption by the Issuer, in whole or in part, on any date on or after April 1, 2024, at the redemption prices, expressed as a percentage of the principal amount of the Bonds redeemed, as set forth below, together with accrued interest to the date fixed for redemption: Redemption Date Redemption Price April 1, 2024 to March 31, % April 1, 2025 and thereafter %

13 Typical G.O. Bond Covenants Pledge of full faith and credit Maintenance of revenue Priority/exclusivity of payment Typical Revenue Bond Covenants Limitations on Additional Debt Rate Covenant Flow of Funds Maintenance Covenants Limitations on Asset Dispositions Role of Purchasers in Structuring Transaction Who purchases municipal bonds? What is important to them?

14 Official Statement Securities Law Implications: Section 17(a) of Securities Exchange Act of 1933 Rule 10b-5 of Securities Exchange Act of 1934 Rule 15c2-12 of Securities Exchange Act of 1934 Preliminary versus Final Official Statement Official Statement (cont.) Contains material information on: Issuer and obligated persons Bonds being offered Past compliance with continuing disclosure undertakings Role of Credit Enhancement in Structuring Transaction Who provides credit enhancement for municipal bonds? What is important to them?

15 Bond Sale Methods of Sale Private Placement vs. Underwritten transaction Competitive vs. Negotiated Fixed Rate vs. Variable Rates Underwritten Transaction Bond Issuer (Governmental) (borrows $) Trustee or Paying Agent (acts in an agency capacity) Bond Proceeds Debt Instrument Debt Service Underwriter Bond Proceeds Debt Instrument Bondholders ( purchasers ) (loan $)

16 Debt Service Structure New Money Issues Often tied to assets being financed Possible capitalization of interest during construction Refundings Up front vs. level savings Wrap Around of Existing Debt Principal payments are typically made annually; interest payments are typically made semiannually (fixed rate) or monthly (variable rate). Fixed Rate Bonds Interest rate is fixed for term of bonds, but typically have different interest rates for each maturity (especially in a public offering) Principal matures in stated amounts at stated intervals (generally annually) Issuer knows exact amount of principal and interest payments at closing Variable Rate Demand Obligations (VRDBs) Interest rate adjusted periodically (typically weekly) Typically offered in minimum denominations of $100,000 and sold mostly to institutional investors Typical put feature that provides option of bondholder to put bond back to tender agent with seven days notice Remarketing agent sets weekly rates (generally based on an index) and remarkets bonds tendered by bondholders Interest typically paid monthly with annual or semiannual principal or mandatory sinking fund redemption payments Bonds typically secured by letter of credit or liquidity facility arrangement (credit rating requirements) Typical structure for conduit borrowings but also used for governmental bonds

17 Direct Bank Placement (DP) Interest rate may be fixed or adjusted periodically (typically monthly based on percentage of 1-month LIBOR index plus a fixed credit spread) Generally structured as a single bond with principal installments sold to one financial institution No optional put feature but generally subject to mandatory tender at end of negotiated holding period (3,5,7, etc. years) Interest typically paid monthly with annual or semiannual principal installment payments Bonds held directly by financial institution subject to limited transfer provisions Subject to additional terms, provisions and covenants set forth in separate credit agreement No built-in remarketing features, but may have ability to convert to other variable rate modes All-In Variable Rate VRDBs Base Rate: 0.30% LOC Fee: 0.75% Remarketing & Other Fees 0.15% Total All-In Variable Rate 1.20% DPs 70% (+/-) of 1-mo. LIBOR: 0.20% Credit Spread: 0.75% Total All-In Variable Rate 0.95% Bondholder Risks Interest Rate Risk Default Risk (Credit Risk) Reinvestment Rate Risk Inflation Risk Call Risk Maturity Risk Liquidity Risk

18 Yield Curve Graphical representation of yield and maturity (the term structure of interest rates) Yield Curves Bond Yields Current Yield Yield calculated using coupon rate and current price Yield to Maturity Yield calculated to maturity date, equates present value of cash flows to current market price Yield to Call Yield calculated to a particular call date rather than maturity using the call price as opposed to the face value

19 Yield vs. Interest Rate April 1, 2015 $5,000 6% April 1 & October 1 April 1, 2016 Interest Payments: Dated Date Principal Amount Coupon Rate Compounding interval (interest payment dates) Maturity Date ($5,000 = 6% x 1/2 yr.) = $150 on every interest payment date Yield Yield vs. Price Bond Yields & Bond Prices Move in Opposite Directions Price Par, Discount and Premium Bonds Par = Stated Principal Amount or Face Value Discount/Premium = Price not stated principal amount Importance of price in yield calculations Example Bond (6.00% coupon; 10-year maturity) Price 98% Yield of 6.27% Price 100% Yield of 6.00% Price 102% Yield of 5.73%

20 Example Bond Pricing Maturity Bond Component Date Amount Rate Yield Price Yield to Call Call Premium Maturity Date Price (-Discount) Takedown Serial Bonds: Serial Bonds 2: 04/01/2016 1,325, % 0.300% , / ,380, % 0.590% , /01/2018 1,070, % 0.910% , /01/2019 1,955, % 1140% , / ,065, % 1410% , /01/2021 2,165, % 1.640% , / ,305, % 1.920% , / ,460, % 2.140% , /01/2024 2,615, % 2340% , / ,775, % 2.500% , /01/2026 2,840, % 2.670% % 04/ , /01/2027 3,015, % 2.780% c 3.068% 04/01/ , /01/2028 1,600, % 3.120% , / ,580, % 3.180% , /01/2030 1,555, % 3.230% , /01/2031 1,535, % 3310% , /01/2032 1,515, % 3360% , ,755,000 4,468, /0l/2028 1,380, % 2.870% c 3.251% 04/01/ , ,135,000 4,723, Example Sources & Uses Series 2014 Series 2014 Taxable Water Tax-Exempt New Money Water and and Sewer Water and Sewer Revenue Revenue Sewer System Refunding Refunding Sources: Revenue Bonds Bonds Bonds Total Bond Proceeds: Par Amount 20,485, ,870, ,730, ,085, Premium 2,669, ,772, ,441, ,154, ,642, ,730, ,526, Other Sources of Funds: Equity Contribution 2,439, ,439, ,154, ,642, ,169, ,966, Uses: Series 2014 Series 2014 Tax-Exempt Taxable Water New Money Water and and Sewer Water and Sewer Revenue Revenue Sewer System Refunding Refunding Revenue Bonds Bonds Bonds Total Project Fund Deposits: Project Fund 23,000, ,000, Refunding Escrow Deposits: Cash Deposit SLGS Purchases 44,342, ,132, ,475, ,342, ,132, ,475, Delivery Date Expenses: Cost oflssuance 78, , , , Underwriter's Discount 74, , , , , , , , Other Uses of Funds: Additional Proceeds 1, , , ,154, ,642, ,169, ,966, Credit Enhancement Letter of Credit $ Bond Proceeds Bondholders Underwriters $ Bond Proceeds Trustee $ Bond Proceeds Issuer $ Debt Service $ Debt Service Debt Service Reimbursements Direct Pay Letter of Credit

21 Credit Enhancement Bond Insurance Bondholders $ Bond Proceeds Underwriters $ Bond Proceeds $ Bond Proceeds Trustee Issuer $ Debt Service $ Debt Service (if necessary) $ Debt Service Premium Bond Insurance Policy Vanilla Interest Rate Swap floating swap rate* Issuer Counter- Party fixed swap rate floating interest rate Bondholders * A floating swap rate is intended to mirror or closely correlate with floating interest rate on the bonds, resulting in a synthetic fixed rate issue. Closing

22 The Closing Documents The certificates executed at closing support the opinions rendered by counsel: General/Incumbency Certificate Tax Compliance/Non-Arbitrage Certificate Registration Certificate Parity Certificate Official Statement/15c2-12 Certificates The Closing Documents (cont.) Other documents delivered at closing memorialize promises made to Bondholders: Continuing Disclosure Agreement Escrow Agreement Ratings Reports Deed of Trust/Mortgage Feasibility Study/Engineer s Report Common Tax Documents Tax Certificate Underwriter s Certificate (a.k.a. Issue Price Certificate) IRS Forms 8038 Written Policies and Procedures

23 Opinions Good Delivery under MSRB Rules requires delivery of the bond opinion at closing. The Bond Opinion is addressed to the issuer. Primary focus of the Bond Opinion is validity/enforceability and tax exemption of the Bonds. Supplemental opinions address other topics (securities law, specific documents, reliance). The Bond Opinion Bonds duly authorized and executed Bonds valid and binding obligations (enforceability opinion given for revenue bonds) Lien on revenues Federal tax opinion (includes AMT/ACE opinion) State tax opinion Other Opinions Underwriter s Counsel Opinion Effect of CDA Exemption from securities laws 10b-5 opinion vs. 10b-5 comfort letter Trustee s Counsel Opinion Valid, binding and enforceable Due authorization and execution No conflict Credit Provider s Counsel Opinion

24 Common Limitations on Opinions Limited to federal law and law of 1 state Speaks only as of its date No obligation to update Not a guaranty or warranty May only be relied upon by addressee The Money Who sends money? Purchaser wires bond proceeds less underwriter s discount. Issuer wires equity contribution (excess reserve fund moneys, sinking fund deposits, other funds on hand) Who receives money? New money: Issuer or trustee Refunding: Escrow agent or refunded bonds paying agent/trustee Credit Provider What is the Rounding Amount? The Money (cont.) Series 2014 Series 2014 Taxable Water Tax-Exempt New Money Water and and Sewer Water and Sewer Revenue Revenue Sewer System Refunding Refunding Sources: Revenue Bonds Bonds Bonds Total Bond Proceeds: Par Amount 20,485, ,870, ,730, ,085, Premium 2,669, ,772, ,441, ,154, ,642, ,730, ,526, Other Sources of Funds: Equity Contribution 2,439, ,439, ,154, ,642, ,169, ,966, Uses: Series 2014 Series 2014 Tax-Exempt Taxable Water New Money Water and and Sewer Water and Sewer Revenue Revenue Sewer System Refunding Refunding Revenue Bonds Bonds Bonds Total Project Fund Deposits: Project Fund 23,000, ,000, Refunding Escrow Deposits: Cash Deposit SLGS Purchases 44,342, ,132, ,475, ,342, ,132, ,475, Delivery Date Expenses: Cost oflssuance 78, , , , Underwriter's Discount 74, , , , , , , , Other Uses of Funds: Additional Proceeds 1, , , ,154, ,642, ,169, ,966,490.90

25 The Money (cont.) Purchaser retains $239, Purchaser wires: $23,000, to Issuer for project costs $49,035, to Escrow Agent for refunding $252, for costs of issuance/rounding Issuer wires: $2,439, to Escrow Agent for refunding The Depository Trust Company / DTC Bondholders $ Debt Service Brokers/Banks Indirect Participants Trustee Issuer $ Debt Service DTC Participants DTC ( Cede & Co. ) is typically the only registered Bondholder to the Trustee. DTC Participants are registered and typically are known underwriting and investment firms.