Bonds 101. Michigan Association of School Boards. November 10, PFM Financial Advisors LLC. 555 Briarwood Circle Suite 333

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1 Bonds 101 Michigan Association of School Boards November 10, 2017 PFM Financial Advisors LLC 555 Briarwood Circle Suite 333 P: F: Ann Arbor, MI PFM 1

2 Overview of Municipal Bonds PFM 2

3 How does a school borrow money? A school can borrow money in two ways: Issuance of municipal bonds or notes Installment Purchase Agreements The Revised Municipal Finance Act, Public Act 34 of 2001 governs most debt issuance in Michigan. The Act provides: A municipality can not just go to the bank and borrow money or take out a loan A local bank can buy the municipality s bonds or installment purchase agreements. PFM 3

4 What is a Municipal Bond A promise by state or local governmental units to repay an amount of money borrowed along with interest Bond is repaid over a period of time 1 to 30 years for Michigan schools Municipal bonds are usually tax-exempt to investors which allows municipalities to borrow at lower interest rates because the bonds are not subject to federal, state or local taxation PFM 4

5 Participants and Their Roles PFM 5

6 The Finance Team Participants School CFO s Bond Finance Team Municipal Advisor Municipal Advisor Works closely with School Advises School on all facets of bond financings including competitive versus negotiated sale Serves in a fiduciary capacity to always look out for the best interest of the School Does not underwrite/buy the bonds May assist with continuing disclosure requirements Bond Counsel Bond Counsel Works closely with School Ensures School complies with state and federal laws Prepares legal documents on behalf of School Provides opinion that bonds are exempt from state and federal taxation, where applicable Underwriter Bond Underwriter/ Purchaser Has arm s length relationship with School Deals directly with the investors (lenders of money) Underwrites/purchases the bonds Represents both the School and the Investors Provides proceeds of sale to the School PFM 6

7 The Key Participants and Their Roles Bond Counsel Represents the legal issues of the bondholders. Their opinion addresses the main legal issues: that the bonds constitute legal, valid, and binding obligations of the issuer, and that interest on the bonds is exempt from federal income taxation under applicable tax laws. Municipal Advisor A consultant to an issuer of municipal securities who provides the issuer with advice with respect to the structure, timing, terms or other similar matters concerning a new issue of securities. Underwriter The securities dealer who purchases a bond or note issue from an issuer and resells it to investors. If a syndicate or selling group is formed, the underwriter who coordinates the financing and runs the group is called the senior or lead manager. Paying Agent The place where principal and interest are payable. The bank designated by the issuer as the custodian of funds and official representative of bondholders. PFM 7

8 The Players and their Roles-Continued Credit Enhancers The use of the credit of a stronger entity to strengthen the credit of a weaker entity in bond or note financing. This term is used in the context of bond insurance, bank facilities and government programs. Escrow Agent The third party (called an escrow agent) to be held in trust pending a contingency or the fulfillment of a condition or conditions in a contract such as payment of a purchase price. Upon that event occurring, the escrow agent will deliver funds to the proper recipient, otherwise the escrow agent is bound by his or her fiduciary duty to maintain funds in the escrow account. Verification Agent Verifies that the funds in the escrow account and securities purchased are sufficient to cover the bonds refunded. PFM 8

9 School Capital Financing Options PFM 9

10 School Capital Financing Options Limited Tax General Obligation Debt Limited tax debt may only be issued if the total of all outstanding debt does not exceed 5% of State Equalized Value (SEV) Energy conservation is exempt from limitation Voted Unlimited Tax General Obligation Debt Non-School Loan Revolving Fund qualified Limited to 15% of SEV School Loan Revolving Fund Qualified Exempt from debt limit, though State Treasurer has ability to not qualify bonds if the outstanding bonds and loans exceed 25% of a district s Taxable Value Installment Purchase Contracts Limited to 1.25% of taxable value PFM 10

11 Limited Tax General Obligation Bonds Pledge the limited tax general obligation full faith and credit of the school district for the repayment of the debt Generally paid from one or more of the following sources: General Fund Sinking Fund / Millage revenue Most common projects financed with limited tax general obligation bonds are energy conservation bonds Repaid from energy cost savings The amount of voted unlimited tax debt the school district has outstanding could limit it s ability to issue limited tax bonds. Not a common way for Michigan schools to finance large capital projects. PFM 11

12 Voted School Bond Issues Voter Approval Required Voters must authorize the School District to issue a not-to-exceed dollar amount of bonds to pay for improvements identified in the ballot proposal. Unlimited Debt Millage The School District levies the number of mills on taxable property necessary to pay the annual principal and interest payments. Debt service is paid by the debt levy, not the General Fund. Items Required on Ballot Maximum amount of bonds Bond purpose First year s estimated millage rate for new bonds Simple average annual millage rate for new bonds Maximum term of the bonds Additional requirements for SLRF qualified bonds Estimated amount to be borrowed from SLRF Estimated interest cost of SLRF loan Estimated term of the loan PFM 12

13 Considerations When Voting Bonds Needs of the school district Cost of projects Cost to taxpayers Can you do it without a millage increase? What are taxpayers willing and able to pay? Timing Anticipated drop in millage due to: o Declining existing bond payments o Increased taxable values o Build-up of fund balance o Savings achieved from refunding Can the bonds be sold in series to reduce the millage impact? Preferred election timing Lead time to adequately prepare for successful election PFM 13

14 Sample Payment Schedule PFM 14

15 School Loan Revolving Program ( SLRF ) Program Overview State guarantee for payment of debt service Allows use of State s ratings Currently AA- by S&P, Aa1 by Moody s and AA by Fitch Borrowing From and Repaying the SLRF Districts must levy between 7 and 13 mills of SLRF qualified debt millage Interest rate on the loans is based on the rate of the State s financing currently % A District must repay any loans from the SLRF by the Mandatory Loan Repayment Date (MLRD), which is 72 months after the final maturity on the bonds. Maximum Taxable Value growth rates used to project loan repayment and millage; 5 year historical average Taxable Value growth rate for first five years 20 year average growth rate thereafter, but not less than 0% or more than 3%. District pays SLRF Qualification Fees at closing Fee is based on the size of the bond issue with a $5,000 minimum Projects financed with SLRF Qualified Bonds are subject to regional prevailing wages PFM 15

16 School Loan Revolving Fund Participation How it Works Taxable Value Existing UT Debt SLRF Activity at 5.00% Total Fiscal Projected Existing Mills UT 1-Jul Amount 30-Jun Levy Yr. End Taxable UT Debt without Mills SLRF Borrowed SLRF Year 30-Jun Value [1] Growth Payments SLRF Levied Balance (Repaid) Balance $420,371,427 $2,656, $10,258,566 ($286,300) $10,490, ,513, % 2,974, ,490,681 94,204 11,118, ,841, % 2,885, ,118,254 66,009 11,749, ,352, % 2,816, ,749,258 56,231 12,402, ,042, % 2,742, ,402,436 40,200 13,072, ,907, % 2,651, ,072,610 5,894 13,742, ,245, % 2,580, ,742,215 (144,466) 14,294, ,922, % 2,483, ,294,201 (322,958) 14,694, ,950, % 2,387, ,694,231 (503,402) 14,932, ,338, % 2,291, ,932,622 (685,871) 14,999, ,098, % 2,196, ,999,125 (870,442) 14,882, ,241, % 2,101, ,882,895 (1,057,193) 14,572, ,779, % 2,002, ,572,457 (1,251,204) 14,050, ,722, % 1,918, ,050,632 (1,432,307) 13,319, ,084, % 1,825, ,319,702 (1,626,339) 12,356, ,876, % 1,727, ,356,017 (1,827,887) 11,140, ,112, % ,140,180 (3,661,791) 8,013, ,806, % ,013,431 (3,771,645) 4,617, ,970, % ,617,177 (3,884,794) 934, ,619, % ,412 (973,735) ,768, % PFM 16

17 State Qualified or Non-Qualified Bonds? The tables below show the advantages and disadvantages of issuing State Qualified bonds. State SLRF (School Loan Revolving Fund) Qualified Bonds: Advantages Receipt of State ratings (Aa1/AA-/AA) Generally lower cost of borrowing Ability to borrow from SLRF for amounts needed over 7 mills State guarantee to make bond payments Disadvantages State review and oversight More time consuming process longer time period required to prepare for bond election State regional prevailing wage scale requirement for construction Fee applies for State qualification Non-State Qualified Bonds: Advantages No State review and oversight Less time consuming process ability to hold an election faster than with Qualified bonds Do not have to pay regional prevailing wage scale for construction No State qualification fee Disadvantages Must sell on own rating or purchase insurance Typically a higher cost of borrowing than Statequalified bonds Mills needed for debt are not eligible to be counted in 7 mills qualified levy could have implications on future debt millage. No State back up guarantee for bonds PFM 17

18 State Qualification Considerations Does District have additional large capital needs over the next 20 to 30 years which would require millage in excess of 7 mill? no If millage required for Qualified bonds is higher, will the higher millage rate required on the ballot be problematic for passage of Bonds? yes no Does the District have ample time to finalize project scope and cost for State Qualified process? no Is the District able or willing to consider a later election date? yes yes yes Is District able to obtain an investment grade rating or bond insurance without State qualification? no yes Proceed with Non- State Qualified Bonds Proceed with State Qualified Bonds PFM 18

19 Other Considerations Related to State Qualification Decision Elimination of Treasury approval process provides more time to finalize project scope and costs Qualified bonds do not apply to the debt limit Limitation on use of bond proceeds: If qualified, excess bond proceeds and investment earnings may only be used to pay debt service on the qualified bonds, or Repay the State PFM 19

20 2018 Elections and Lead Time Election Dates State Qualified Preliminary Qual. Meeting Filing Deadline May 8, 2018 Dec. / Early Jan. Feb 13, 2018 Aug 7, 2018 April May 15, 2018 Nov 6, 2018 July Aug 14, 2018 September Special May June / July Lead Time: 5 Months to 1 year before election, depending on project Ballot prepared at Preliminary Qualification meeting or by filing deadline if Non-Qualified Project scope determined no later than the Preliminary Qualification meeting for Qualified bonds and a week before ballot is to be finalized for Non-Qualified bonds PFM 20

21 Recent Election Statistics PFM 21

22 Sample Tools to Assist in Educating Public Educating your public on what the bond issue will cost them, and how it compares to other schools in your area can be helpful tools in passing a bond issue. PFM 22

23 Bond Process Details PFM 23

24 Process of a Municipal Bond Issuance Plan of Finance Legal Framework Marketing/Sale Administration Determine capital needs / source of repayment Determine affordability of project(s) Select the Financing Team Legal / Voter approval, if required Determine sale type Structure issue Prepare/publish Prelim. Official Statement Obtain bond rating(s) Marketing Bonds Bond sale / award Publish Final Official Statement Closing / money transfer Invest Bond Proceeds Begin project Track performance / Administer payments Ongoing disclosure and other requirements PFM 24

25 Bond Sale Methods There are 3 methods of sale for school bonds, as shown below. 1. Competitive Sale Sold at a specific date and time Any firm may bid on the bond offering most received via internet Bonds awarded to the lowest conforming bid 2. Negotiated Sale Underwriter pre-selected (may be through an RFP process) Underwriter offers bonds for sale to investors (includes local citizens) Pricing date, bond size and maturities flexible Commonly used for complex financings, story bonds, distressed credits and/or in volatile market conditions 3. Direct or Private Placement Bonds are sold directly to private investor or bank (may be through an RFP process) Typically shorter bond terms and small bond amounts PFM 25

26 Municipal Bond Ratings What is a rating? A rating is an alphabetic and/or numeric symbol used to give relative indications of credit quality. Unless a school cannot achieve an investment grade rating, a rating is required for the sale of any public sale of major issue. Public bonds sales over $1 million are typically rated. Who are the ratings providers? The three major ratings agencies are Moody s Investors Service, Inc. ( Moody s ), Standard and Poor s ( S&P ), and Fitch Ratings ( Fitch ). Additionally, recently Kroll Bond Rating Agency ( KBRA ) has begun providing municipal bond ratings. Long-Term Municipal Ratings Moody s Aaa Aa A Baa Ba B Caa Ca C S&P AAA AA A BBB BB B CCC CC C Fitch AAA AA A BBB BB B CCC CC C Short-Term Municipal Ratings Moody s MIG1 MIG2 MIG3 MIG4 S&P SP-1+ SP-1 SP-2 SP-3 Fitch F1 F2 F3 S&P, Fitch and Kroll may append + or (Moody s 1, 2, or 3) modifiers to assigned ratings. PFM 26

27 The Value of a Strong Credit Rating Strong credit ratings should result in lower cost of borrowing. The table below shows the spreads between interest rates on various credit rating categories. 3.00% Long-Term (20 Year) Municipal Credit Spreads January 2000 to October % 2.00% 1.50% 1.00% AAA to Aa Spread AAA to A Spread AAA to BAA Spread 0.50% 0.00% PFM 27

28 Credit Rating Process What do rating agencies look for? History of Strong Management Track record of making tough decisions during challenging fiscal times Documented Good Management Policies and Practices Diverse Economy A broad economic base that can withstand economic downturns Demonstrated tax base stability Sound financial position with reserves and stable enrollment Financial flexibility to address unforeseen circumstances Stable enrollment Manageable Debt Burden Debt service as percent of operating expenditures Rapid amortization of debt PFM 28

29 Bond Sale / Pricing Terminology Maturity Date Principal payment Date upon which principal is repaid to investor Typically years of maturity dates Coupon Rate by which interest is repaid to investor; on a semi-annual basis Yield Market return on investment Varies; based upon length of maturity and price of the bonds (Premium or Discount Bonds) Bond Price Determined by the relationship between the Coupon & Yield Price moves inversely to yield Call Features Allows bonds to be retired before final maturity date Typically 10 Year Call PFM 29

30 Post-Issuance Compliance PFM 30

31 Continuing Disclosure Overview Securities Exchange Act of 1934 prohibits fraudulent, inaccurate or misleading information in disclosure documents. Securities and Exchange Commission ( SEC ) Rule 15c2-12 is a requirement on underwriters, as issuers are currently not regulated. It requires underwriters to do the following prior to purchasing or selling bonds: Review the offering document (Official Statement) Obtain Continuing Disclosure Agreements from issuers for ongoing disclosure Exemptions: Continuing disclosure is generally not required if: The bond issue is less than $1 million The bonds are sold to investors in units of not less than $100,000 and are sold to 35 or less sophisticated investors The bonds are sold in $100,0000 minimum denominations and mature in nine (9) months or less from issuance For more information, see: PFM 31

32 Continuing Disclosure Summary What to File? Financial and Operating Data in Official Statement (as required by the Continuing Disclosure Agreement) Audited Financial Statements Material Events Notices ( 15 Deadly Sins ) most common: rating changes, bond calls and defeasances When to File? Deadline as shown in the Continuing Disclosure Agreement Where to File? Electronic Municipal Market Access System ( EMMA ) Why File? Legally required by the agreements entered into with investors at the time bonds are sold Provide information for liquidity for investors (ie for the resale of the district s bonds in the secondary market) PFM 32

33 Federal Tax Concerns Arbitrage concerns Earning more interest in the bank from your bond proceeds than the interest you are paying on the bonds Requirement to pay rebate every five years after date of issuance Rebate Exceptions Under certain circumstances you may be able to keep the extra interest earned Small Issuer ($5 million for non-school construction projects) Six month exception (100% in 6 months) 18 month exception (15% in 6 months, 60% in 12 months, 100% in 18 months) 24 month exception (10%, 45%, 75% & 100% in 6, 12, 18 & 12 months) Private Use/ Change in Use The tax exemption on your bonds depends upon the use of the assets that you bond finance No private business use arrangement with private entity beyond permitted de minimis amount Private business use means use in a trade or business carried on by any person other than an exempt entity for its exempt purpose An exempt entity is any state or local governmental entity (501(c)(3) entities are not exempt entities) De minimus amount means no more than 10% of the proceeds of a bond issue may be used for any private business use PFM 33

34 Questions? Kari L. Blanchett, Managing Director Paul R. Stauder, Managing Director 555 Briarwood Circle, Suite 333 Ann Arbor, MI (734) PFM 34