After Tax Reform: Municipal Market Update & Considerations

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1 After Tax Reform: Municipal Market Update & Considerations Fundamentals of Public Finance Seminar Presented by: Geoffrey Stewart February 26, 2019 PFM 1735 Market Street 43 rd Floor Philadelphia, PA pfm.com PFM 1

2 Timeline of 2017 Tax Reform HR1 Introduced into House Nov 9 Nov 16 Senate Finance Committee begins markup process Reconciliation process begins to resolve differences between House and Senate versions of the bills. Dec 15 Dec 19 President Trump signs the Tax Reform and Jobs Act into law. House Ways and Means Committee concludes mark up process, reports Amended Bill out of committee. Senate release its version Nov 2 Nov 13 Full House passes HR 1 by a margin of Senate Finance Committee concludes mark up process, reports amended bill out of committee. Dec 4 Reconciliation Committee releases final bill. House passes bill ; Senate passes bill Dec 22 PFM 2

3 Municipal Bond Market Impacts of Tax Cuts & Jobs Act of 2017 Tax Reform legislation impacting municipal bonds became effective starting January 1, As initially proposed, the tax reforms proposed elimination of: Tax-exempt private activity bonds Tax-exempt advance refundings New tax credit bonds Tax-exempt stadium bonds SPARED from tax reform: Private activity bonds Stadium bonds ELIMINATED through tax reform: Tax-exempt advance refundings New tax credit bonds Additionally, lower tax rates for corporations (21% from 35%) and individuals could lead to a drop in demand for municipal bonds or higher return requirements (i.e., higher rates) from investors PFM 3

4 PAYGO Act of 2010 Waived BAB Subsidies Preserved at Current Levels The PAYGO Act of 2010 enacts mandated spending cuts to federal programs to offset any legislation that increases the federal deficit, such as the tax reform legislation. Included in these spending cuts are subsidies for ARRA bonds, which include Build America Bonds. The cuts for 2018 would total $136 billion, and would be similar in size over the ensuing 10 years. Due to the high cost of the tax reform legislation ($1.5 trillion), should the full PAYGO spending cuts have occurred, ARRA bond subsidies would have been eliminated in their entirety. As part of the Continuing Resolution that was passed on December 21, 2017 to fund the federal government, the mandatory PAYGO Act cuts that would result from the tax reform legislation were waived, removing BAB and other ARRA subsidies from the threat of complete elimination. THIS ALLOWS BABs AND OTHER ARRA SUBISDY BONDS TO CONTINUE TO RECEIVE FEDERAL SUBSIDIES AT THEIR CURRENT LEVELS. It is important to note, however, that it is expected that Congress will continue to seek ways to pay for the cost of the final tax reform package and ARRA (including BAB) subsidies could continue to be threatened beyond their current levels of sequestration. The current federal fiscal year (10/1/2018 9/30/2019) sequestration amount for ARRA subsidies is 6.20% and had ranged from this level to 8.7% since PFM 4

5 Continuing Risks to Tax-exempt Programs Congressional leaders have suggested that they will continue to target tax-exempt private activity bonds (PABs) and uses that are outside of core public infrastructure projects as well as stadium financings. How this fits in with the President s infrastructure initiatives remains to be seen. Ongoing efforts to offset the cost of tax reform could put PABs and other municipal bond programs, and subsidies (i.e., ARRA and BAB subsidies) at risk of future offsets and reductions through sequestration options or other legislative actions and mechanisms in order to reduce spending and curtail the federal deficit. Summary: municipal bonds appear to be low-hanging fruit for Congress / Federal Government to find cost savings in budget deliberations. PFM 5

6 A Record December With the threat of the elimination of both taxexempt PABs and Advance Refundings, the municipal market saw a rush of volume in December as issuers sought to issue PABs and complete Advance Refundings while still permitted. $80.0 $60.0 $40.0 $20.0 Total Municipal Bond Issuance ($billions) While PABs were left unchanged, tax-exempt Advance Refundings were eliminated. $0.0 SOURCE: Bond Buyer / Thomson Reuters The Stats: Jan Feb March April May June July Aug Sept Oct Nov Dec Total 2017 issuance: $434.8 billion ($17 billion short of 2016 record) $144.6 billion in Q4 (33% of full year amount) $62.5 billion in December (1,168 transactions) a new record 3x higher dollar volume than December, 2016 Previous monthly issuance record: $54.7 billion (December, 1985) PFM 6

7 Advance Refundings in the Municipal Market Total refunding volume since the Great Recession has ranged from 30% 50% of the total municipal market. Total advance refunding volume in in this time period ranged from 13% - 22% of the market. This figure is likely elevated for 2017 with the surge in December. Many predict reduction in the tax-exempt market of 10% - 15% in the coming years due to the loss of tax-exempt advance refundings, as many bonds that would have become currently callable in the next few years have been pulled forward into Non-traditional strategies for advance refundings could offset these losses. MUNICIPAL MARKET ISSUANCE SOURCE: THOMSON-REUTERS & PNC PFM 7

8 2019 Municipal Market Update MMD Rates Over Time (10 years) The municipal market in 2019 continues trends seen in 2018: A flatter yield curve as short-term rates have increased while long-term rates have remained largely unchanged. 6% 5% 4% MMD Range (over past 10 years) Current MMD Average MMD (over past 10 Years) Stable and attractive long-term rates. Yield 3% 2018 tax-exempt issuance volume was 24% lower than 2017 volume much of this is attributed to exceptionally high volume in December 2017, driven by the end of the year tax reform and the loss of advance refundings. 2% 1% 0% Maturity Year 2018 Tax-exempt Cumulative Issuance Bond fund flows (investors) remain genrally positive, indicating an ongoing demand for municipal bonds. Billions $450 $400 $350 $300 $250 $200 Tax-Exempt 2018 Total 2017 $150 $100 $50 $0 Date PFM SOURCE: THOMSON-REUTERS 8

9 Post-Tax Reform Issuance Strategies and Structures There are numerous tools and strategies available to take advantage of low interest rates levels prior to the current refunding date. These include: Taxable advance refundings Forward delivery bonds Tenders Cinderella structures (taxable bonds beyond current period, tax-exempt bonds at current call date) Synthetic advance refundings (e.g., forward delivery, cash settle swaps) New Money bonds may also be issued with a variety of different features to allow for more flexible redemption features in the absence of the ability to advance refund newly issued bonds on a tax-exempt basis: Variable rate bonds and other short-term instruments with continuous call features Short calls Make-whole calls Hybrid calls PFM takes an active role in partnering with our issuer clients in order to independently evaluate strategies and tools that are available in the market, and will assist clients in determining how well these tools achieve their short- and long-term objectives and risk profile. PFM 9

10 Short Call Date Provisions Shorter call dates do not always equate to greater optionality Staying shorter on the yield curve can have cost savings benefits Decision should be based on current relative value (i.e., relationship between short-, medium- and long-term rates) and dependent on future rate movement Option Value = Time value + Intrinsic value To date, the increase in time value is more than offset by the loss in intrinsic value With the yield curve at record levels of flatness and rates stills relatively low, issuers must consider the opportunity cost to not locking in longer term rates versus the added flexibility of shorter calls. Analysis to determine proper valuation and direction on timing of call date provision should be completed on a case-bycase basis PFM 10

11 Forward Starting Swap (Synthetic Advance Refunding) A forward starting swap (Synthetic Advance Refunding) allows an issuer to take advantage of current low interest rates and achieve debt service savings based on the current rates, while allowing for a future current refunding of outstanding bonds (when an advance refunding is not permitted) this strategy, however, is not risk free. A forward or delayed-start interest rate swap is executed based on current rates and terms determined and agreed upon today, that becomes effective on a pre-determined future date (e.g., in 6 months, in 1 year, etc.). The fixed payer rate (to be paid by the issuer), variable swap index (to be paid by the counterparty) and fees are negotiated at the time that the forward swap is agreed to (Commitment Date). On the Effective Date (date on which the swap would begin), the issuer terminates the swap and sells fixed-rate bonds. The swap termination receipt or payment (to or from the issuer) offsets higher or lower bond yields at issuance, providing the issuer with an all-in cost that is similar to the rate levels that existed at the Commitment Date of the forward starting swap. Forward Period Swap Commitment Date: Execute Forward Swap Agreement setting terms of future swap no payments exchanged Swap Effective Date: Terminate swap and issue fixed-rate current refunding bonds Gain / (loss) in swap value offsets higher / (lower) debt service cost on bonds, in theory, achieving a similar amount of savings PFM 11

12 Forward Starting Swap Basic Economics If, at Effective Date, swap rates are higher than the executed swap rate at Commitment Date: Issuer receives a termination payment from the swap counterparty. At-Market Swap Rate > Executed Swap Rate Issuer Receives Termination Payment That receipt of funds is used by the issuer to reduce the amount of bonds issued in order to fund the current refunding escrow, lowering refunding debt service to impact savings, which helps to offset the higher bond rates at issuance. Issuer 1.602% 82%*LIBOR Swap Dealer If, at Effective Date, swap rates are lower than the executed swap rate at Commitment Date: Issuer makes a termination payment to the swap counterparty. At-Market Swap Rate < Executed Swap Rate Issuer Makes Termination Payment That payment is made by the issuer as cash or is bond-funded (dependent on local issuer and tax law) -- issuer would then issue fixed rate bonds at lower bond rates but would issue more bonds or make a cash payment, which would offset the lower bond rates at issuance. Issuer In both instances (lower or higher rates at Effective Date), the issuer is able to achieve similar all-in borrowing costs and debt service savings that were available at the time of the Commitment date of the swap. There is no assurance that swap rates will move in lock-step with the issuer s actual borrowing costs (Basis Risk) or that the LIBOR or SIFMA / MMD relationship will remain the same (e.g., Tax Risk). Historically, LIBOR Swap Rates and the MMD Index have been well-correlated but there are times when markets move independently. PFM Swap Advisors LLC stands ready to assist PFM clients in the evaluation and where applicable, execution of swap transactions, providing advice and guidance to ensure that the issuer receives the proper pricing and terms on the transaction % 82%*LIBOR Swap Dealer PFM 12

13 Thank you. PFM 13