The Intersection of Bond Proceeds Investing and Arbitrage Rebate Compliance

Transcription

1 The Intersection of Bond Proceeds Investing and Arbitrage Rebate Compliance Presented by: Matthew Eisel, CFA, Managing Director Michael Steinbrook, Director PFM Asset Management LLC 213 Market Street Harrisburg, PA pfm.com PFM 1

2 Arbitrage Rebate & Yield Restriction It s the Law To prevent abuses, the tax code limits the permitted uses of tax-exempt bonds Prevents issuance of more bonds than are necessary Prevents issuance of bonds earlier than is necessary Prevents bonds from remaining outstanding longer than is necessary In other words, borrow what you need, when you need it, for an appropriate duration based on what is being financed. Tax law and Regulations create financial disincentives (i.e., arbitrage rebate) to prevent issuance of tax-exempt debt for profit-driven reasons Yield restriction IRC Section 148(b) Arbitrage rebate IRC Section 148(f) Overlapping requirements Belt & Suspenders Applies to every tax-exempt borrowing and some taxable subsidy obligations PFM 2

3 Tax Considerations Timeline Arbitrage rebate requirements apply to every tax-exempt borrowing and certain taxable subsidy obligations Compliance begins with pre-issuance planning and continues with post-issuance policies and procedures (does it ever end ) Pre-Issuance Timing Project Draw Schedule Evaluate available exceptions and elections Identify investment options Issuance Invest bond proceeds Purchase securities, establish FMV Revise draw schedule Make elections in Tax Certificate Post- Issuance Arbitrage reporting Monitor draw schedule Monitor investments Record retention PFM 3

4 Positive Arbitrage It s Back PFM 4

5 Arbitrage & Yield Restriction The Basics Arbitrage % = Actual investment earnings yield ( ) average borrowing rate (aka, the Arbitrage Yield) Arbitrage rebate liability = Earnings of bond proceeds invested in taxable securities less (-) Earnings of bond proceeds invested at the Arbitrage Yield Positive Arbitrage = Actual Earnings > arbitrage yield (positive earnings yield spread) Negative Arbitrage = Actual Earnings < arbitrage yield (negative earnings yield spread) Future value methodology Measured on an issue-by-issue basis Arbitrage Rebate begins on the issue date Yield Restriction begins at the expiration of a temporary period PFM 5

6 Yield Restriction Compliance Methods Active Yield Restriction Investments must be purchased at fair market value Yield Reduction Payments Rebate like payments Limited availability for advance refunding issues Other Options Longer construction fund temporary period (5-years vs. 3-years) Waiver of temporary period at issuance PFM 6

7 Calculation & Filing Requirements Payment due no later than 60 days after the computation date No later than 5-years after the issue date, and every 5-years thereafter until the final maturity date At least 90% of the liability As of final maturity date, 100% of the liability Submit check & IRS Form 8038-T Do not submit calculations No filing required if no payment is due Late Payments Refund Requests PFM 7

8 Sources: Bloomberg, Thomson Reuters. See important disclosures at the end of this presentation. PFM 8

9 Investment of Various Accounts in Current Interest Rate Environment Account Fund Maturity Target Duration Investment Yields Arbitrage Condition Bona Fide Debt Service Fund 0 to 40 Years 0 to 1 Year 0.00% to 2.52% No Rebate Restrictions Current Refunding Escrow 90 Days or less Less than % to 2.38% No Rebate Restrictions Construction/Project Fund 1 to 3 Years 1 to 3 Years 2.52% to 2.45% Potentially No Rebate Restrictions Debt Service Reserve Fund 0 to 40 Years 1 to 2 Years 2.52% to 2.47% Subject to Arbitrage Rebate Cash Defeasance Escrow 0 to 10 Years 0 to 10 Years 0.00% to 2.65% Subject to Arbitrage Rebate & Yield Restriction Long-Term Sinking Fund 0 to 40 Years 0 to 40 Years 0.00% to 2.99% Subject to Arbitrage Rebate & Yield Restriction Source: Bloomberg. Yields as of February 8, 2019 and assumes portfolios comprised of exclusively U.S. Treasuries. See important disclosures at the end of this presentation. PFM 9

10 Goal = Maximize Retainable Earnings PFM 10

11 Hot Topics in a Rising Interest Rate Environment Exceptions to Arbitrage Rebate, especially spending exceptions Short-Term Borrowings are Most Susceptible to Positive Arbitrage Typically have very low arbitrage yields Short-term investment rates currently exceed 2% Optimal Investment Valuation Techniques Present Value/Plain Par/Market Value of securities as of calculation dates Market Value can produce optimal paper losses for securities purchased when rates were lower Current Refundings & Transferred Proceeds Waiver of the temporary period PFM 11

12 Exceptions to Arbitrage Rebate The Small Issuer Exception The Spending Exceptions 6-month spending exception 18-month spending exception 2-year spending exception Bona Fide Debt Service Fund exception Electing to pay the 1.5% penalty in lieu of rebate Investing in tax-exempt obligations (eliminating the arbitrage ) PFM 12

13 Small Issuer Exception Calendar year exception $5 million of governmental bonds for municipalities $15 million per year for public school construction Requirements General taxing powers Governmental bonds (not private activity bonds) At least 95% of the proceeds must be used for local governmental activities Exclusion of current refunding issue in certain circumstances PFM 13

14 Funds Subject to Rebate PROCEEDS + REPLACEMENT PROCEEDS = GROSS PROCEEDS Sale Proceeds / Investment Proceeds Project / Construction Funds Capitalized Interest Funds Debt Service Reserve Funds Escrow Funds Costs of Issuance Funds Interest earnings Cash / Equity / Revenue Funded Debt Service Funds Debt Service Reserve Funds Any Pledged Fund All subject to Rebate Exceptions may apply Transferred Proceeds Any of the above PFM 14

15 Spending Exceptions Can Be Internally Monitored Reward for spending bond proceeds quickly Allowed to keep positive arbitrage Simple way to establish compliance (no FV, no yields) Must meet each benchmark, no catch-up allowed * Exceptions for 5% of the proceeds of the issue if spent within one year ** De minimis (lesser of 3% or $250K) and reasonable retainage (5% spent in 12 months) exceptions may apply for last benchmark 6-Month 18-Month 2-Year (ACP) All gross proceeds All new money Construction issues 6 months 100% * 6 months 15% 6 months 10% 12 months 60% 12 months 45% 18 months 100% ** 18 months 75% 24 months 100% ** PFM 15

16 Proceeds Included in Spending Exceptions Gross Proceeds (6-month & 18-month Tests) Includes All Proceeds except: Bona fide debt service fund Reasonably required reserve or replacement fund Not expected at closing, but proceeds after 6 months Repayments of grants financed by the issue Available Construction Proceeds (ACP) Only Includes: (2-Year Test) Proceeds used to pay for the project, including earnings Capitalized Interest Fund deposit plus earnings Earnings on sale proceeds used to pay cost of issuance, but not sale proceeds used to pay costs of issuance Earnings on a debt service reserve fund unless the issuer elects to exclude them from ACP at issuance PFM 16

17 Arbitrage Rebate vs. Yield Restriction Arbitrage Rebate and Yield Restriction are separate calculations Yield Restriction only applies to proceeds that are subject to yield restriction Cannot blend positive arbitrage of yield restricted proceeds with negative arbitrage of unrestricted proceeds Exceptions apply Exception for Reasonably Required Reserve Fund Minor Portion Temporary periods Could the next 5 years produce a similar interest rate environment? PFM 17

18 Yield Restriction Impact Waiving 3-year Temporary Period Situational Awareness A rising interest rate environment No waiver of temporary period = No rebate liability at year 5 Yield Restriction Liability at year 5 Pay IRS excess interest earned in years 4 and 5 Waiver of temporary period = No rebate liability at year 5 No yield restriction liability at year 5 Keep excess interest earned in years 4 and 5 PFM 18

19 To waive or not to waive Even in a rising interest rate environment this may still make sense Consider the following: DRAW SCHEDULE ARBITRAGE YIELD Low (2%) Mid (3%) High (4%+) Short (<18 mos) NO MAYBE MAYBE Medium (18-24 mos) NO MAYBE YES Long (>24 mos) MAYBE YES YES Each bond issue should be examined separately with your advisors and bond counsel. Representation above is based on current market conditions and current expectations of borrowing rates and investment rates for bond proceeds. Tax election to waive the temporary period must be made by the issuer in writing at settlement no ability to change election after the bonds are issued. PFM 19

20 Evolving Structured Investment Landscape PFM 20

21 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 Counterparties ( providers ) vary depending on agreement type PFM 21

22 Uncollateralized Investment Agreement Provider guarantees a rate of return on all invested proceeds Can be used for Project, DSF, DSRF, Cap-I, and Sinking Funds Interest and Draws PROVIDER Proceeds ISSUER Issuer wires Project Funds to Provider Provider Pays interest and returns principal for project costs PFM 22

23 Collateralized Investment Agreement Provider posts collateral to a third-party custodian to secure investment Can be used for Project, DSF, DSRF, Cap-I, and Sinking Funds Collateral CUSTODIAN Interest and Draws PROVIDER ISSUER Proceeds Issuer wires Project Funds to Provider Provider delivers collateral securities to a Custodian Provider pays interest and returns Principal for project costs PFM 23

24 Flexible Repurchase Agreement Provider sells securities to an investor with a pledge to repurchase them in the future Can be used for Project, DSF, DSRF, Cap-I, and Sinking Funds 1. Issuer wires Project Fund balance to Tri-Party Custodian ISSUER 1 Project Fund Deposit TRI- PARTY CUSTODIAN (securities kept by Custodian Bank) REPO PROVIDER ISSUER S Securities 2 PROVIDER S 4 ACCOUNT ACCOUNT (for benefit of the Issuer) Cash 3 Securities 5 Cash 2. Custodian establishes account for Issuer and an account for Repo Provider 3. Repo Provider delivers securities to the Provider s account with Custodian 4. Custodian transfers securities to Issuer s Custodian account and cash to Provider s account as payment for purchase of the securities 5. Custodian sends cash to Repo Provider PFM 24

25 Forward Delivery Agreement Provider is required to sell eligible securities the investor based on a pre-set schedule Can be used for DSF, DSRF, Cap-I, and Sinking Funds; typically not used for project funds due to variability of draws PROVIDER Fixed-Income Securities Sinking Fund Payments and Rolling Fund Balance TRUSTEE Sinking Fund Payments (Every 12 months) SCHOOL BOARD Final Payment of Principal BONDHOLDERS Periodic Purchase of Securities The securities, held by the trustee, mature every twelve months, at which time the funds are used to purchase a new security PFM 25

26 Comparison of Structured Investments GIC COLLATERALIZED GIC REPO FDA Security for Investment Promissory note from counterparty Collateral held at custodian Collateral held at 3 rd party custodian Purchased securities ( deliverables ) Interest Payments Credited to account Credited to account Credited to account Embedded in securities delivery Credit Exposure Agreement counterparty Agreement counterparty Agreement counterparty Underlying deliverables Bankruptcy Considerations Bank-issued GICs may be subject to clawback and bankruptcy stay Clean bankruptcy opinion is market standard Intended to be exempt; however, clean bankruptcy opinion not possible Clean bankruptcy opinion is market standard Other Risks Loss of principal Loss of principal Loss of principal Performance risk PFM 26

27 Reduced Market Participation and Credit Concerns Significant reduction in market participation since credit crisis in 2008 Business continuity decisions, mergers, bankruptcies, downgrades Difficult, if not impossible, to meet the safe harbor for any structured investment* FDAs: 2 4 active providers 1,2 Repo: 2 6 active providers 1,2 GICs: 2 7 active providers 1 *For illustrative purposes only. 1 Dependent upon required credit ratings. 2 Dependent upon security types. PFM 27

28 Structured Investments Required Discussion Topics Differences between structures Credit risk and concentration risk Bankruptcy treatment Bidding regulations In the current market, it may not be possible to procure 3 disinterested bids ( meet the safe harbor ) Market observation letter outlines background to bid process and general market conditions Arbitrage rebate implications Yield compliance for restricted funds (e.g., sinking funds) Overall impact on rebate position PFM 28

29 Transfers of Existing Structured Investments Refunding transactions When permitted, transfer and amendment of an agreement from refunded bonds to refunding bonds Mark-to-market for rebate purposes Present value, par plus accrued interest, or market value Rebate optimization strategies may be utilized depending upon the rebate position of the refunded bonds Credit-related transfers downgrade remedies Obtaining a replacement guarantor Novation of original agreements to new counterparties PFM 29

30 Termination Amount Calculations Make-whole amounts that are owed to/from an issuer as a result of a termination of certain agreements Comprehensive final reports detailing contractual obligations, methodology, and calculation of termination amounts Fair market opinion and certification for use by arbitrage rebate specialists and counsel PFM 30

31 Case Study #1 The Situation: The University of We Really Miss Advance Refundings (the University ) is selling Series 2019A current refunding revenue bonds with the following characteristics: Par Amount $100,000,000 Escrow Fund Deposit $100,000,000 Reserve Fund Transferred Proceeds $10,000,000 Arbitrage Yield 3.500% Current Refunding Escrow Yield 2.500% Reserve Fund GIC Rate 6.000% Questions to consider: 1. Does the University expect to meet a spending exception? Should the spending exception be applied? 2. Does the University expect to earn positive arbitrage? 3. Is waiving a temporary period an option? 4. Should the Reserve Fund GIC be liquidated? How does it transfer? PFM 31

32 Project Fund Considerations PFM 32

33 DEFINE UNIVERSE OF INVESTMENTS Bond indentures, state law, investment policy Sector specialist recommendations Project Fund Investment Process PFM s approved issuer list of credit issuers DEFINE CONSTRAINTS & OBJECTIVES Draw schedule expectations Liquidity buffer INITIAL PORTFOLIO OPTIMIZATION Meet initial expected cash flow needs Horizon and relative value analyses PFM 33

34 Active Management vs. Passive Strategies Active Management Ideal for funds with expansive permitted investments and/or uncertain liquidity needs Advisor goal: generate incremental earnings via swapping amongst individual CUSIPs, sectors, and duration buckets to attempt to offset advisory fees Passive Strategies Includes money market funds and structured investments Ideal for funds with conservative, straightforward permitted investments and predictable liquidity needs One-time engagements with subsequent opportunities to restructure in the future ACTIVE MANAGEMENT Real-time monitoring of holdings through time More frequent trades to manage duration and/or liquidity Greater ability to take advantage of short-term securities mispricings Enhanced ability to add incremental net value Advisor has fiduciary responsibility PASSIVE STRATEGIES Periodic/ad-hoc monitoring Wholesale restructurings to rebalance to target No ability to take advantage of short-term opportunities May require substantial changes in market conditions to add value No fiduciary responsibility once portfolio is structured PFM 34

35 Project Fund Sample Portfolio Credit Instruments Portfolio Statistics Invested Amount $103.6MM Portfolio Duration 2.03 years Average Gross Yield* 2.56% Strategy Overview Portfolio produces cash flows in line with scheduled project draws Portfolio is structured with a 5% liquidity buffer to accommodate for unexpected liquidity needs Gross Earnings (Proj.) $5.30MM Structured 25% of the portfolio in CP to enhance the yield Federal Agencies 6% Money Market 5% Commerical Paper 25% Sector Allocation Snapshot Treasuries 64% Portfolio Cash Flows vs. Draws 25,000,000 20,000,000 15,000,000 10,000,000 5,000,000 CP Reinvestment Opportunity Portfolio Draws Portfolio Cash Flows CP Reinvestment Opportunity Please see important disclosures at the end of this presentation. Yields as of February 15, For illustrative purposes only M 6-12M 12-18M 18-24M 24-30M 30-36M 36-42M 42-48M PFM 35

36 Adapting Investment Strategy Through Time Changes to objectives Active draw schedule monitoring to ensure adequate liquidity if draws accelerate Proactive reinvestment of excess liquidity if draws lag Reporting Monthly statements of holdings, transactions, and market values Quarterly communication with comprehensive strategy review For illustrative purposes only. See important disclosures at the end of this presentation. PFM 36

37 Case Study #2 The Situation: The School District of We Don t Have a Draw Schedule (the District ) is selling Series 2019A new money general obligation bonds with the following characteristics: Par Amount $100,000,000 Construction Fund Deposit $100,000,000 Estimated Draw Schedule =24 mos Arbitrage Yield 2.500% Materially Higher Yield 2.625% Current Investment Yield (and rising) 2.600% Questions to consider: 1. How confident is the District in the draw schedule? 2. Does the District expect to meet a spending exception? Should the spending exception be applied? 3. Does the District expect to earn positive arbitrage? 4. Is waiving the 3-year temporary period an option? PFM 37

38 Case Study #3 The Situation: The City of We Need To Raise Taxes To Pay For All This Snow Removal (the City ) is selling Series 2019A new money general obligation bonds with the following characteristics: Par Amount $100,000,000 Construction Fund Deposit $100,000,000 Estimated Draw Schedule 18 mos Arbitrage Yield 3.000% Materially Higher Yield 3.125% Current Investment Yield (and rising) 2.600% Questions to consider: 1. How confident is the City in the draw schedule? 2. Does the City expect to meet a spending exception? Should the spending exception be applied? 3. Does the City expect to earn positive arbitrage? 4. Is waiving the 3-year temporary period an option? PFM 38

39 Case Study #4 The Situation: The Authority of We Need To Raise Tolls To Repair All These Potholes (the Authority ) is selling Series 2019A new money revenue bonds with the following characteristics: Par Amount $110,000,000 Construction Fund Deposit $100,000,000 Reserve Fund Deposit $10,000,000 Estimated Draw Schedule ~40 mos Questions to consider: Arbitrage Yield 3.500% Materially Higher Yield 3.625% Current Investment Yield (and rising) 2.600% 1. How confident is the Authority in the draw schedule? 2. Does the Authority expect to meet a spending exception? Should the spending exception be applied? 3. Does the Authority expect to earn positive arbitrage? 4. Is waiving the 3-year temporary period an option? PFM 39

40 Debt Service Funds Often Overlooked PFM 40

41 Bona Fide Debt Service Fund Exception Depleted at least annually except for greater of: Previous year s earnings in the fund, or 1/12th of previous year s principal and interest payments Private Activity Bonds Fund has annual earnings of less than $100,000, or Average annual debt service does not exceed $2.5 million Excess portion subject to arbitrage I&S Fund - Residual or Interest Reserve PFM 41

42 Debt Service Funds 1/6 th of semi-annual interest payment and 1/12 th of principal payment is deposited monthly to meet debt service payments Monthly deposits can be invested in Treasuries with maturities that align with the upcoming interest and principal payment dates Rolling purchase of securities extends duration beyond that which is available from money market fund investments 9 month Treasury Note 3 month Treasury Bill July August September October November December January February March April May June Principal Deposit Interest Deposit Running Balance PFM 42

43 Short-Term U.S. Treasuries vs. Money Market Fund Index 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jan-18 Apr-18 Jul-18 Oct-18 Jan-19 MMF UST Source: Bloomberg, as of 2/8/2019. Money market fund yield is based on the S&P Rated GIP Index. Treasury Yield is based on the U.S. Generic Government 6 Month Index PFM 43

44 Debt Service Fund Investments Investment alternatives include: Ultra-short duration bias: money market fund Short duration bias: managed portfolio of securities Long duration bias: structured investments such as FDAs STRATEGY NET YIELD* KEY BENEFITS KEY LIMITATIONS Money market fund 2.19% Can take advantage of increases in interest rates; administrative simplicity Ultra- short duration Managed portfolio 2.56% Extends duration while retaining flexibility to reinvest at higher rates Duration cannot be extended beyond upcoming principal and interest payment dates FDA 5-year term 2.07% Synthetically extends duration beyond upcoming liquidity needs Locks in earnings for life of the agreement and therefore cannot take into account increases in interest rates *Yields as of February 11, 2019 and subject to change based on underlying market conditions. Money market fund yield based on the JPMorgan Federal MMKT- Agency PFM 44

45 FDA Mechanics for Debt Service Funds Securities purchased mature prior to the next Debt Service Payment Date Par and purchase price are structured to produce guaranteed interest earnings FDAs are the only vehicle that provides a guaranteed rate of return if held to maturity September 1 Debt Service Payment Date March 1 Debt Service Payment Date September 1 Debt Service Payment Date 9/15 10/15 11/15 12/15 1/15 2/15 3/15 4/15 5/15 6/15 7/15 8/15 Proceeds flow out to pay Debt Service Proceeds flow out to pay Debt Service *For illustrative purposes only. See important disclaimers at the end of this presentation. PFM 45

46 2 Year Treasury Note vs. 10 Year Treasury Note The spread between the 2 year Treasury Note and 10 year Treasury Note has narrowed considerably over the last few years Source: Bloomberg. As of February 8, PFM 46

47 Sample Analysis Debt Service Fund FDAs Fixed yield of FDA requires sensitivity and scenario analyses to determine attractiveness and appropriateness versus alternatives including managed portfolios and money market funds *For illustrative purposes only. See important disclaimers at the end of this presentation. PFM 47

48 Sinking Fund Investment Strategies PFM 48

49 Sinking Funds Background Tax legislation enacted under the American Recovery and Reinvestment Act of 2009 created several new types of tax credit bonds: Qualified School Construction Bonds (QSCBs) Qualified Zone Academy Bonds (QZABs) Qualified Energy Conservation Bonds (QECBs) Clean Renewable Energy Bonds (CREBs) Issuers are often required to make annual deposits into a Sinking Fund on a defined schedule Accumulated balance is used to pay down principal upon maturity of the bonds Deposits are often eligible for investment and associated earnings may be used to reduce future deposits Investment of Sinking Funds is limited to a maximum Permitted Sinking Fund Yield (PSFY) PFM 49

50 Investment Strategies Money market funds are inefficient and a poor asset-liability match Structured investments provide a fixed rate of return if held to maturity Lock in the rate today on all future deposits to the sinking fund Structured to match future deposit dates and final withdrawal to pay principal to bondholders Recurring one time purchase of securities provides upfront yield benefit Efficient because the maturity date of the investment closely matches the maturity date of the Bonds Zero coupon securities have a longer duration and higher yield relative to comparable couponbearing securities The amortization of the discount is used to reduce future sinking fund deposits PFM 50

51 Sample Sinking Fund FDA Cash Flows Rolling balance of deposits and interest earnings builds up through time FDAs are the only vehicle that provides a fixed rate of return if held to maturity Lock in a yield at or near the PSFY 7,000,000 6,000,000 Deposit Interest Rolling Balance 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 0 May-17 August-17 August-18 August-19 August-20 August-21 August-22 August-23 August-24 August-25 August-26 August-27 *For illustrative purposes only. See important disclaimers at the end of this presentation. PFM 51

52 Recurring Purchases - Sinking Fund Schedules Securities are purchased on an annual basis shortly after the sinking fund payment is deposited Revised deposit schedules are calculated to reflect the amortized interest from each security *For illustrative purposes only. See important disclaimers at the end of this presentation. PFM 52

53 Reserve Fund Investment Strategies PFM 53

54 Comparison of Operating and Reserve Funds Operating Funds Reserve Funds Cash-on-Hand purpose Security for Bondholders 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 Valuation Methodology Arbitrage Yield PFM 54

55 PURPOSE AND OBJECTIVE Our Approach: Debt Service Reserve Fund Committee Management of debt service reserve funds Attempt to minimize downside risk (avoid negative returns) PROCESS Proprietary models apply interest rate shocks to different portfolio structures Duration targets are chosen based on committee views of which portfolios outperform on a total return basis in the most likely interest rate scenarios valuation at cost annual valuation at market Portfolio s Ability to Take Interest Risk monthly valuation at market valuation at market with a buffer just past valuation semi-annual valuation at market upcoming valuation PFM 55

56 Sensitivity Analysis Thoroughly evaluate the impact of interest rate changes and design strategies to mitigate interest rate risk Target duration is developed to protect the portfolio against the impact of rising rates while seeking higher yields available from longer maturities Short time to valuation date warrants conservative duration positioning with extension after valuation date 2 - YEAR TREASURY YIELD OF 2.474%/DURATION OF 1.97* change in INTEREST RATES -1.00% MARKET VALUE $10,196,1 33 change in MARKET VALUE $196, YEAR TREASURY YIELD OF 2.654%/DURATION OF 10.00* change in INTEREST RATES -1.00% MARKET VALUE $10,925,8 24 change in MARKET VALUE $835, % $10,097,4 59 $97, % $10,498,1 50 $407, % $10,000,0 00 $ % $10,000,0 00 $ % $9,903,73 7 -$96, % $9,702,26 4 -$388, % $9,808,65 4 -$191, % $9,332,05 2 -$758,587 *Yields as of February 8, 2019, and subject to change. PFM 56

57 Sensitivity Analysis: Duration vs. Yield Price volatility of longer-duration securities must be appropriately managed In an increasing rate environment, investing in long-term securities can increase the probability that the reserve fund will earn a negative total return INITIAL STRUCTURE TOTAL RETURN assuming hypothetical change in interest rates DURATION INITIAL YIELD 0.00% +0.25% +0.50% +0.75% +1.00% % 2.52% 2.52% 2.52% 2.52% 2.52% % 2.46% 2.35% 2.23% 2.12% 2.00% % 2.43% 2.19% 1.95% 1.72% 1.48% % 2.28% 1.80% 1.32% 0.84% 0.37% % 2.20% 1.48% 0.76% 0.06% -0.65% *As of February 8, 2019, and subject to change. Assumes valuation in one year, i.e. March 1, Rates annualized. PFM 57

58 Sample Output Annual Mark-to-Market $10,000,000 cash balance with a March 1, 2020 mark-to-market date SENSITIVITY ANALYSIS 12 months forward Initial Duration 1.50 Initial Yield 2.50% Total Return, Rates +50 bps 2.23% Total Return, Rates +25 bps 2.35% Total Return, Rates Unchanged 2.46% Total Return, Rates -25 bps 2.58% Total Return, Rates -50 bps 2.70% SENSITIVITY ANALYSIS 12 months forward Initial Duration 2.00 Initial Yield 2.48% Total Return, Rates +50 bps 1.95% Total Return, Rates +25 bps 2.19% Total Return, Rates Unchanged 2.43% Total Return, Rates -25 bps 2.67% Total Return, Rates -50 bps 2.91% 60% 45% 30% 15% 60% 45% 30% 15% 0% Yields as of February 8, % PFM 58

59 Breakeven Analysis Assumptions and Methodology Methodology PFMAM s proprietary models allow us to perform tests on the hypothetical performance of portfolios under different interest rate scenarios. Actual portfolio holdings and modeled portfolio holdings are utilized to compare and contrast the performance of different portfolio combinations through time. It is important to note that the results shown are theoretical and are not based on the performance of actual portfolios. The Methodology and Assumptions Include: Model portfolios utilize the illustrated maturity concentrations as specified by PFMAM to achieve a target modified duration as of the date of the analysis. The portfolios are constructed using coupon-bearing US Treasury securities available on the secondary market at yields as of the date of the analysis. The model evaluates the impact on the total return of each stress-tested portfolio under different scenarios. Annualized total return is based on the initial value of the portfolio and the portfolio value resulting from the different scenarios as calculated below. A baseline Treasury yield curve is constructed using Federal Funds futures as a proxy for an overnight rate, and 6-month, 12-month, 2-year, 3- year, and 5-year Treasury yields as of the date of the analysis. Parallel interest rate shifts are applied to the baseline Treasury curve on the specified valuation date to create a shifted Treasury yield curve (e.g., a 0.50% increase in the overnight rate, 6-month, 12-month, 2-year, 3-year, and 5-year Treasury yields occurring in 6 or 12 months). Yields for individual dates are interpolated based on the shifted Treasury yield curve using the overnight rate, and 6-month, 12-month, 2-year, 3-year, and 5-year Treasury maturity dates as inputs. Portfolio values as of the end of the horizon are calculated as the sum of (a) the market value of the securities, plus (b) coupon payments received through time, plus (c) cash balances. Any maturing securities are assumed to remain invested in cash at an assumed overnight investment rate based upon current market conditions. All coupon payments and cash balances are assumed to remain in the account at all times. All of the securities used in the model were available during the time period presented. The performance depicted assumes each security was held at a static allocation through the entire period with no impact from cash flow. Coupon payments and maturities are assumed to be retained in the fund. The data shown has not taken into account advisory fees, trading costs, or other fees or charges which may apply. As with all investments, there is the possibility of loss. PFM 59

60 Escrow Structuring and Procurement PFM 60

61 Basics Definition of Escrow A portfolio of securities that is purchased at the lowest allowable or achievable cost, and that provides cash flows sufficient to defease a set of liabilities Why are escrows important? Escrow yield is one of the two major drivers of savings on a refunding transaction Appropriate strategy might save millions of taxpayer dollars What are SLGS? United States Treasury Securities, State and Local Government Series (SLGS) Designed for the investment of tax-exempt bond proceeds Purchased directly from U.S. Treasury Department via SLGSafe System Time Deposit (fixed rate) Demand Deposit (variable rate and tax-exempt) Open-market securities are purchased from secondary market broker dealers PFM 61

62 SLGS Program Suspension Availability of SLGS Program is based on the government s borrowing capability debt ceiling debate The most recent suspension concluded on February 12, 2018 Previous SLGS Suspensions May 15, 2002 July 8, 2002 February 19, 2003 May 27, 2003 October 19, 2004 November 22, 2004 February 16, 2006 March 17, 2006 September 27, 2007 September 28, 2007 May 6, 2011 August 2, 2011 December 28, 2012 February 5, 2013 May 17, 2013 October 17, 2013 February 7, 2014 February 14, 2014 March 13, 2015 November 3, 2015 March 15, 2017 September 11, 2017 December 8, 2017 February 12, days 97 days 34 days 29 days 24 hours 88 days 40 days 152 days 7 days 235 days 180 days 66 days PFM 62

63 Impact of SLGS Suspensions SLGS subscriptions placed prior to window closure will be honored Demand deposit SLGS rolled into special 90-day certificates New refundings and cash defeasances must be structured with cash or open-market securities Sample SAMPLE GROSS Gross Savings SAVINGS Open-market Securities SLGS 0% SLGS rollovers scheduled to occur in actively yield restricted defeasance accounts will need to instead be invested in open-market Treasuries pursuant to the terms of the IRS Revenue Procedure (or elect into new regulations) Cash Interest Earnings PFM 63

64 Capturing Value with Open-market Securities RELATIVE VALUE SLGS rates are fixed each morning, while open-market securities yields fluctuate over the course of the trading day Conduct real-time market monitoring Cost differential can substantially lower overall escrow cost depending on market conditions Open-Market Yield (floating) SLGS Rate (fixed) 2.70% 2.60% 2.50% 2.40% Spread OMTS 2.30% SLGS As of February 8, % 0.04% 0.02% 0.00% -0.02% RATE INTERPOLATION SLGS rates are designed to be set 1 basis point below open-market Treasuries of equivalent maturities every morning Interpolation of SLGS rates is imperfect SYNTHETIC DURATION Due to the far-forward settlement of escrow security purchases, open-market securities provide an additional benefit in yield compared to SLGS securities with similar maturities Additional duration pricing date settlement date Open-Market Security SLGS maturity date PFM 64

65 Capturing Value with Open-market Securities OTHER OPEN- MARKET SECURITIES Purchase less liquid but higher-yielding securities Includes REFCORP Interest STRIPS, US AIDs, and Federal Agencies Federal Agency market supply remains low; sizeable requirements must be procured via a reverse inquiry method Sample Security-by-Security Results Securities Solicited 13 Offers Received 56 Participating Providers 7 Winning Providers 6 High/Low Cost Differential $749, Average/Low Cost Differential $281, Best Dealer/Actual Cost Differential $157, PROCUREMENT CONSIDERATIONS Securities are awarded on a security-by-security basis to often multiple providers Achieve lower escrow cost via security-bysecurity bidding relative to all-or-none Establish pricing transparency and fair-market value PFM 65

66 Sample Security-by-Security Procurement Process Results Security Maturity Broker #1 Broker #2 Broker #3 Broker #4 Broker #5 Broker #6 Broker #7 TNote 9/30/2017 $22,102, N/A $22,110, $22,100, N/A $22,102, N/A TNote 3/31/2018 $22,162, N/A $22,197, $22,155, N/A $22,163, N/A TNote 9/30/2018 $22,366, N/A $22,366, $22,363, N/A $22,367, N/A TNote 3/31/2019 $22,458, N/A $22,459, $22,437, N/A $22,459, N/A TNote 9/30/2019 $22,850, N/A $22,855, $22,844, N/A $22,850, N/A TNote 3/31/2020 $22,802, N/A $22,802, $22,801, N/A $22,802, N/A TNote 9/30/2020 $431,786, $431,754, $431,963, $431,795, $431,795, N/A $431,713, TNote 3/31/2021 $15,509, N/A $15,513, $15,509, N/A $15,510, N/A TNote 9/30/2021 $15,443, N/A $15,445, $15,442, N/A $15,443, N/A TNote 3/31/2022 $16,008, N/A $16,017, $16,012, N/A $16,009, N/A TNote 9/30/2022 $16,017, N/A $16,019, $16,016, N/A $16,013, N/A TNote 3/31/2023 $458,618, $458,686, $458,606, $458,797, N/A N/A $458,739, TNote 3/31/2023 $442,976, $442,949, N/A $442,971, $443,146, N/A $442,998, Total Cost: $1,531,104, $1,333,390, $1,088,357, $1,531,248, $874,942, $197,723, $1,333,451, Difference: ($157,375.55) N/A N/A ($301,305.80) N/A N/A N/A High/Low Cost Differential Average/Low Cost Differential Best Dealer/Actual Cost Differential $749, $281, $157, For illustrative purposes only. PFM 66

67 Gross vs. Net Funding An escrow can be gross funded with securities purchased on the settlement date of the bonds May be suitable for shorter and smaller structures such as current refunding escrows but reinvestment risk should be considered Procurement can be done electronically and without a term sheet to enhance competition and cut costs Case Study: PFM solicited offers for a Treasury Note maturing January 31, 2018 on a forward settlement basis The best offer received for the security was approximately 60 basis points below market PFM recommended gross funding and purchasing the security on the settlement date of the bonds We conducted a competitive procurement for the security via the Bloomberg FIT platform and purchased the security at a yield of 1.404%, approximately 78 basis points better than the original offer Please refer to important disclosures at the end of this presentation. PFM 67

68 Current Refundings & Transferred Proceeds Current Refundings Even for very short terms, make sure escrows are INVESTED Short Term Investment Yields Cash does not count no negative arbitrage accrues Security Type Yield Consider alternative permitted defeasance investments: Demand Deposit SLGS Qualified, Treasury-only MMK fund Consider waiving the 90-day temporary period to bank negative arbitrage Make sure COI is fully spent in < 6 months Demand Deposit SLGS 1.86% 1-3 Month Time Deposit SLGS 2.40% 2.41% 1-3 Month Treasury Note 2.27% % Transferred Proceeds Double-whammy effect: 1. Lower Ceiling High-to-low refunding means new restricted arbitrage yield is lower 2. Higher Earnings Potential Proceeds that had been earning significant negative arbitrage now invested in higher yielding investments Source SLGS daily rate table and Bloomberg as of February 8, Subject to change based on underlying market conditions. PFM 68

69 Strategies to Optimize Earnings and Minimize Liabilities Spending exceptions APPLY when positive arbitrage, DO NOT APPLY when negative arbitrage Expenditure allocations Different permitted ALLOCATION methods may produce significantly different rebate outcomes Yield restriction monitoring Pay attention to expiring temporary periods and consider WAIVERS Investing bond proceeds Explore options beyond MMF, explore investment options appropriate for FUND TYPES Investment valuations Analyze valuation methods beyond PV to reduce rebate liabilities Refunding Impacts Review possible transferred proceeds, make sure current refunding escrows are INVESTED Computation Dates Don t have to wait for 5 th year dates; EARLIER computation dates could produce better results PFM 69

70 Disclaimers Investment Advisory Services PFM is the marketing name for a group of affiliated companies providing a range of services. All services are provided through separate agreements with each company. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. Investment advisory services are provided by PFM Asset Management LLC which is registered with the Securities and Exchange Commission under the Investment Advisers Act of The information contained is not an offer to purchase or sell any securities. Applicable regulatory information is available upon request. For more information regarding PFM s services or entities, please visit This material is only intended for institutional and/or sophisticated professional investors. It is for informational purposes only and should not be relied upon to make an investment decision, as it was prepared without regard to any specific objectives or financial circumstances. It should not be construed as an offer to purchase/sell any investment. Any investment or strategy referenced may involve significant risks, including but not limited to risk of loss, illiquidity, unavailability within all jurisdictions, and may not be suitable for all investors. To the extent permitted by applicable law, no member of the PFM Group, or any officer, employee or associate accepts any liability whatsoever for any direct or consequential loss arising from any use of this material, including for negligence. This material is not intended for distribution to or use by, any person in a jurisdiction where delivery would be contrary to applicable law or regulation, or it is subject to any contractual restriction. No further distribution is permissible without prior consent. Case study details were provided at your request. You should note the details provided are based on factual information from actual projects that PFMAM completed. It has been provided for general information purposes only and is not intended to provide specific advice or a specific recommendation. The results of individual projects will vary significantly depending upon the size and structure of each fund, permitted investments, prevailing market conditions at the time of the structuring and procurement process, and other events or circumstances beyond the control of PFMAM. 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. The views expressed within this material constitute the perspective and judgment of PFM Asset Management LLC at the time of distribution and are subject to change. Any forecast, projection, or prediction of the market, the economy, economic trends, and equity or fixed-income markets are based upon current options as of the date of issue, and are also subject to change. Opinions and data presented are not necessarily indicative of future event or expected performance. Information contained herein is based on data obtained from recognized statistical services issuer reports or communications, or other sources believed to be reliable. No representation is made as to its accuracy or completeness. To ensure compliance with U.S. Treasury Regulations governing tax practice, we inform you that any U.S. federal tax advice contained in this communication, including any attachments, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under U.S federal tax law, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. PFM Asset Management LLC cannot provide legal advice, and appropriate professionals should be consulted if such issues are involved. PFM Asset Management LLC is registered with the SEC under the Investment Advisers Act of A copy of our Form ADV, Parts 2A & 2B is available upon request. PFM 70

71 Thank you PFM 71