A Land Full of Issuance : Fundamentals of Bond Proceeds Investment

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1 A Land Full of Issuance : Fundamentals of Bond Proceeds Investment Luke Schneider, CFA, Director Duncan Brown, Senior Managing Consultant PFM Asset Management LLC 1200 Fifth Ave. Suite 1220 Seattle, WA pfm.com PFM 0

2 So You Have a Big (or Small!) Capital Project to Fund PFM 1

3 Sources of Project Funding Develop a conservative yet reliable project construction time table Potential sources of funding: Accumulated revenues/reserves Ongoing revenues during construction period Grants and fundraising Debt financing: Low-interest State loans (PWTF, SRF, CERB, etc.) State LOCAL program Federal loans (e.g., USDA-RD) Bank loans Municipal bonds (publicly offered) PFM 2

4 When to Think About Investments? Developing net costs in Funding Plan Critical when determining how much to raise/borrow Investment environment may influence number and timing of debt issues May also influence debt structure (e.g., relative benefit of draw-down feature) When bond documents are being drafted Definition of permitted investments Allows time to implement the investment game plan at bond closing PFM 3

5 Why Is Having a Strategy Important? Increases the potential for higher project fund earnings: Reduce net project costs and/or mitigate unplanned costs Potential to unburden cash reserves if the project is not 100% financed Act as a set aside for future/potential arbitrage rebate liability More likely in other interest rate environments Important to consider the upside of higher earnings Where/how can we apply excess funds? PFM 4

6 Factors Influencing Plan of Finance & Investment Decisions Project draw schedule Type of bonds and related funds Voted GO bonds vs. all other types Debt Service Reserve Fund Refunding escrow Permitted investments State law Bond documents Investment policies Prevailing and expected investment/rate environment Anticipated arbitrage rebate requirements PFM 5

7 4.0% Investment of Various Accounts in Normal Yield Curve Environment 3.5% Debt Service Reserve Account 3.0% 2.5% Advance Refunding Escrow 2.0% Equity Funds 1.5% 1.0% 0.5% Construction Fund + CAPI Current Refunding Escrow + Debt Service Fund 0.0% Subject to Arb Rebate Subject To Yield Restriction No Rebate Restrictions Potentially No Rebate Restrictions Source: Bloomberg. As of March 31, See important disclosures at the end of this presentation. PFM 6

8 Factor: Permitted Investments Investments determined by: Federal Tax Code & Arbitrage Rebate Regulations State Statutes Investment Policies (sometimes) Bond Covenants (bond ordinance or resolution) Bond Insurer Requirements (sometimes even if new bonds are not insured right of prior insurer to consent to document changes) PFM 7

9 Sample Permitted Investments Short-term Investments Local Government Investment Pools Overnight Repurchase Agreements Open-market Securities U.S. Treasuries & Direct Obligations (e.g., Treasury Notes, Bills) Federal Agency Securities (e.g., Fannie Mae & Freddie Mac) Commercial Paper (e.g., General Electric Capital Corp., Toyota) Corporate Notes Structured Investments Guaranteed Investment Contracts (GICs) Flexible Repurchase Agreements (Flex Repos) Forward Delivery Agreements (FDAs) PFM 8

10 Developing an Appropriate Investment Strategy Regulations State Law Bond Covenants Market Conditions Consider rebate rules and possible exceptions Compliance with investment statutes and policies Compliance with bond indenture and tax code elections Consider absolute and relative level of interest rates Bond Yield Cash Flow Liquidity Needs Yield Restriction Evaluate bond yield relative to current market rates Consider draw schedule and timing of cash flows Provide liquidity to meet expected and unforeseeable draws Consider any current or pending requirements Investment Analysis Active Management Passive Strategies PFM 9

11 Active Management vs. Passive Strategies Active Management Ideal for funds with expansive permitted investments or uncertain liquidity needs Strive to enhance investment earnings and manage risk via ongoing active portfolio management Capitalize on changes in sector yield spreads Competitively shop the market for cheap securities while ensuring adequate liquidity Manage duration of portfolio based upon relative value of different portions of the yield curve and changing market conditions Adhere to both client and internal credit standards Passive Strategies Ideal for funds with conservative, straight-forward permitted investments and predictable liquidity needs Options include: One-time purchase of fixed-income portfolio Structured investments PFM 10

12 Active Management Process Top-down Analysis Entity Objectives and Policies Macro-economic conditions Interest rates and trends Inflation expectations Credit outlook Relative value analysis Quantitative security analysis Individual issue selection Asset class expectations Yield curve structure Economic forecasts Political factors Portfolio Construction and Management Employ both strategies to add value to portfolios Bottom-up Analysis Issuer credit research Horizon analysis Yield/return comparison Strategies To Add Value Sector allocation Duration management Maturity distribution Yield curve placement Industry selection Issue selection PFM 11

13 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q Benefits Active Management Credit Monitoring Active management enables the inclusion of higher-yielding securities with a credit component such as commercial paper and corporate notes Independent analysis of: Fixed-income Derivatives Equities Developing news Economic releases Regulatory activity Corporate announcements Quarterly/annual reports Investor updates Third-party research Sell-side analytics Rating Agencies Commonwealth Bank Bank of Montreal Royal Bank of Canada Toronto Dominion American Express Dexia HSBC Finance Corp Aus & NZ National Aus Bank Westpac Mitsubishi UFJ Mizuho Financial Sumitomo Mitsui Bank of Nova Scotia British Petroleum Hewlett Packard Toyota Motor Credit Approve, Hold, Remove. Select credit approval history shown for illustrative purposes. PFM 12

14 Project Funds PFM 13

15 Project Fund Draw Schedule Project proceeds typically spend within 3 years Average life is approximately 1 1½ years Typical Project Fund Expenditure Pattern Average life Time PFM 14

16 If Draw Schedule Is Uncertain Analyze historical capital spending patterns Structure investments around conservative estimates Build in additional liquidity Invest in securities that can be easily liquidated Rebalance based on changes in cash flows and/or market conditions PFM 15

17 If Draw Schedule Is Fairly Certain Ladder investments, targeted to specific cash flow needs Monitor periodically to determine if actual expenditures are in line with expected project fund draws Rebalance based on changes in cash flows and/or market conditions PFM 16

18 Typical Investments for Project Funds Liquidity Vehicle: Local Government Investment Pool Structured fixed-income portfolio Structured investment product/contract Combination strategy PFM 17

19 Typical Investments for Project Funds Convenient Typically overnight liquidity Rate dependent Inherently taking view that rates will rise during construction period Projected expenditures 1 yr 2 yr Time PFM 18

20 Portfolio Strategy Laddered to match project fund schedule Fixed rate of interest for life of the security Reinvestment risk if draw schedule is delayed Interest rate risk if security must be sold prior to maturity Inherently taking view that rates will not rise quickly during construction period Projected expenditures Projected maturities 1 yr 2 yr Time PFM 19

21 Yield Environment as of March 31st, 2017 Maturity WA LGIP Treasury Federal Agency AA Corporate A Corporate A1/P1 Commercial Paper Liquidity 0.82% 3-Month 0.75% 0.87% 0.96% 1.12% 1.08% 6-Month 0.90% 0.95% 1.12% 1.34% 1.30% 1-Year 1.02% 1.09% 1.35% 1.53% 2-Year 1.26% 1.37% 1.65% 1.85% 3-Year 1.49% 1.61% 1.94% 2.14% 5-Year 1.92% 2.02% 2.41% 2.61% Source: Bloomberg BVAL yield curves for Treasury, Corporate and Commercial Paper, TradeWeb for Federal Agency yields. 3 and 6 month corporate yields from commercial paper; A-1+ for AA and A-1 for A. As of 03/31/17. PFM Source: WA LGIP daily yield as of 3/31/

22 Summary Understand the project expenditure needs Strategize about investment options during bond issuance process Assess current market environment Implement strategy Monitor proceeds throughout the life of the project and restructure, if needed PFM 21

23 Refunding Escrows PFM 22

24 Refunding Escrow Securities SLGS SLGS = State and Local Government Series securities issued by the U.S. Treasury, commonly used in refunding escrows SLGS are subscribed for, not competitively procured; can be custom-tailored for particular refunding bond issues P R E V I O U S S L G S S U S P E N S I O N S May 15, 2002 July 8, days February 19, 2003 May 27, days October 19, 2004 November 22, days February 16, 2006 March 17, days September 27, 2007 September 28, hours May 6, 2011 August 2, days Availability of SLGS Program is based on the government s borrowing capability debt ceiling debate December 28, 2012 February 5, 2013 May 17, 2013 October 17, 2013 February 7, 2014 February 14, days 152 days 7 days SLGS Program was suspended on March 15, 2017 March 13, 2015 November 3, days March 15, 2017???????????????????? PFM 23

25 Considerations for Refunding Bonds So long as the SLGS window is closed, issuers contemplating refunding bonds will need to consider alternative approaches to funding the escrow Permissible escrow securities are typically governed by prior bond documents, potentially including bond insurance agreements Cash No interest rate benefit to issuer high negative arbitrage Tax concerns for advance refunding transactions Open-market securities ( OMS ), typically Treasuries Generally higher-yielding than SLGS Must be obtained through specific bidding process; availability may be a concern for smaller issuers / transactions Another approach: economic defeasance, with proceeds invested in the LGIP LGIP generally not a permitted escrow security, so both refunding and refunded bonds would be legally outstanding at the same time PFM 24

26 Rate Interpolation Open Market Securities (Treasuries) SLGS rates are fixed each morning, while open-market securities yields fluctuate over the course of the trading day Monitor relative value of open-markets vs. SLGS Bidding Regulations require open-markets portfolio to be cheaper than most efficient SLGS portfolio at the exact time bids are solicited (when SLGS are available) Cost differential can substantially lower overall escrow cost depending on market conditions S A M P L E P O R T F O L I O Portfolio Cost $165,766, Basis Point Change $38, Escrow Portfolio Earnings $2,019, Benefit Over SLGS Portfolio $101, Open-Market Yield (floating) SLGS Rate (fixed) PFM For illustrative purposes only 25

27 U.S. Government Sponsored Enterprises ( Federal Agencies ) Various spreads to Treasuries depending on location on the yield curve Are not full faith and credit obligations of the U.S. Government Supply continues to decrease as balance sheets are downsized Finding large blocks of Federal Agencies at favorable yields can be difficult, if not impossible G S E s Government Sponsored Enterprises ( GSEs ), often referred to as Federal Agencies, include debt securities of: Fannie Mae (FNMA) Freddie Mac (FHLMC) Federal Home Loan Bank System (FHLB) Federal Farm Credit System (FFCB) PFM 26

28 U.S. Government Guaranteed Securities Supply decreasing, in large part, because of purchases for defeasance escrows Can be 5 to 20 basis points cheaper than comparable T-STRIPS or T-Notes Good match for fixed-liability portfolios (i.e., non-trading accounts such as escrows) Liquidity and bid/ask spread not a prominent concern R E F C O R P s Resolution Funding Corporation Interest STRIPS A I D B o n d s Agency for International Development Bonds PFM 27

29 Capturing Value with Open-Market Securities Seldom, if ever, does one broker win all securities Security-by-security trades often beat all-or-none bidding Captures highest yield and establish fair market value on each security Ability to reject individual securities if they do not produce savings v. SLGS (if available) S A M P L E S E C U R I T Y - BY- S E C U R I T Y P R O C U R E M E N T R E S U L T S S E C U R I T Y M A T U R I T Y T O T A L C O S T B R O K E R #1 B R O K E R # 2 B R O K E R # 3 B R O K E R #4 B R O K E R # 5 TSTRIPS-I 11/15/2013 $5,919, PASS $5,914, $5,914, $5,910, RSTRIPS-I 10/15/2018 $5,376, PASS $5,364, $5,375, $5,351, RSTRIPS-I 4/15/2019 PASS PASS $429, $431, $427, RSTRIPS-I 10/15/2019 $5,198, PASS $5,116, $5,133, $5,135, RSTRIPS-I 4/15/2020 PASS PASS $274, $284, $282, RSTRIPS-I 10/15/2020 $5,056, PASS $4,970, $4,941, $5,018, RSTRIPS-I 4/15/2021 PASS PASS $133, $138, $136, RSTRIPS-I 10/15/2021 $4,906, PASS $4,840, $5,056, $5,020, DEALER LOT TOTAL $26,457, $27,044, $27,275, $27,282, Difference between Best Dealer Lot: N/A N/A $(48,796.45) $(279,604.32) $(286,875.26) T O T A L C O S T H I G H / L O W C O S T D I F F E R E N T I A L A V G. / L O W C O S T D I F F E R E N T I A L B E S T D E A L E R / A C T. C O S T D I F F E R E N T I A L $26,996, $466,324 $230,757 $48,796 PFM 28

30 Reserve Funds PFM 29

31 Comparison of Operating and Reserve Funds OPERATING FUNDS RESERVE FUNDS Relative (Beat the benchmark) RETURN TARGET Absolute (Avoid negative returns) Market, Credit, and Tracking Error MEASURES OF RISK Market, Credit, and Replenishment Relatively Static (Percentage of benchmark) DURATION TARGET Dynamic (Unconstrained) Investment Policy Liquidity Needs CONSTRAINTS Investment Policy Liquidity Needs Valuation Methodology PFM 30

32 Reserve Fund Investment Considerations Investment Decision Factor Considerations Market Outlook Does the strategy account for the interest rate outlook? Risk Management Replenishment Requirements Opportunity Costs Arbitrage Rebate Compliance Is interest rate risk exposure based on the investment valuation methodology and frequency? If investment values decline, must the Reserve Fund be replenished? Are there yield enhancement opportunities within your risk management parameters? Were rebate complexities and liability expectations considered? Accounting Method Is the DSRF a commingled fund or in separate accounts? PFM 31

33 Strategy Development Risk Tolerance Strategy is always viewed within the context of: Valuation requirements Likelihood that reserve will need to be accessed due to debt service fund deficiency Entity's willingness or ability to replenish any shortfalls Valuation at cost Valuation at market with buffer Annual valuation at market Semi-annual valuation at market Monthly/ quarterly valuation at market + Portfolio s ability to take interest risk just past valuation upcoming valuation PFM 32

34 Net Interest Earnings Breakeven Analysis Forward curves used to determine economic indifference between various investment horizons 1.85% 5 years 1.20% 2.36% 2,500,000 2,000,000 5-year Investment 2-year Interim 3-year Breakeven 2 years 3 years 5-year Initial Investment vs. 2-year Interim with 3-Year Breakeven 1,500,000 1,000, , Investment Horizon, Years PFM Rates as of January 6,

35 Sensitivity Analysis It is important to thoroughly evaluate the impact of interest rate changes and design strategies to mitigate interest rate risk The target duration is developed to protect the portfolio against the impact of rising rates while seeking higher yields available from longer maturities 2-year Treasury Yield of 1.203% / Duration of 1.95 (as of January 6, 2017) 10-year Treasury Yield of 2.434% / Duration of 8.94 (as of January 6, 2017) Change in Interest Rates Market Value Change in Market Value Change in Interest Rates Market Value Change in Market Value -1.0% $ 10,196, $ 196, % $ 10,928, $ 928, % $ 10,097, $ 97, % $ 10,452, $ 452, % $ 10,000, $ - 0.0% $ 10,000, $ - 0.5% $ 9,903, $ (96,473.86) 0.5% $ 9,569, $ (430,838.57) 1.0% $ 9,808, $ (191,775.44) 1.0% $ 9,159, $ (840,935.60) Short time to valuation date warrants conservative duration positioning with extension trades once the valuation occurs PFM 34

36 Output Semi-Annual Mark-to-Market $10,000,000 cash balance with an January 1, 2017 mark-to-market date 60% 60% 50% 50% 40% 40% 30% 30% 20% 20% 10% 10% 0% % Results Sensitivity Analysis 6 Months Forward Structure 1 Structure 2 Initial Duration Initial Yield 1.06% 1.13% Total Return, Rates Unchanged 1.48% 1.59% Total Return, Rates +25 bps 0.94% 0.92% Total Return, Rates +50 bps 0.41% 0.26% Total Return, Rates +75 bps -0.12% -0.39% PFM Statistics as of January 6,

37 Structured Investments PFM 36

38 Types of Structured Investments Uncollateralized Guaranteed Investment Contracts Generically referred to as GICs - unsecured pledge to pay principal and interest on investment; historically provided by insurance companies or banks Collateralized Guaranteed Investment Contracts Referred to as Collateralized GICs - pledge to repay principal and interest is secured by collateral posted to a third-party custodian Repurchase Agreements Referred to as Repo, Flex Repo, Term Repo - 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 Agreements Referred to as Forward Purchase (Purchase and Sale) Agreements, FPAs, FDAs - agreement stipulating the outright purchase of securities from a counterparty* through time; typically provided by broker-dealers and banks PFM *Counterparties ( providers ) vary depending on agreement type 37

39 Comparison of Structured Investment Agreements FDA Guaranteed Investment Contract Repurchase Agreement Security for Investment Purchased securities Promissory note from counterparty Collateral held at 3 rd party custodian Mechanism for Interest Payments Difference between purchase price and par amount of securities Credited to account Credited to account Credit Risk Limited to underlying deliverables; very low if UST Depends on agreement counterparty Depends on agreement counterparty; collateral reduces concerns subject to J -Risk Bankruptcy Considerations None clean bankruptcy opinion is market standard Subject to clawback and bankruptcy stay Intended to be exempt; however, clean bankruptcy opinion not possible Other Risks Mark-to-market risk (auditors) and performance risk Overnight bankruptcy risk no collateral J -Risk interpretation of structure under Bankruptcy Code PFM 38

40 Thank You PFM 39

41 Disclosures 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 a specific 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. PFM 40