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HomeMy WebLinkAboutIR 7382 INFORMAL REPORT TO CITY COUNCIL MEMBERS No. 7382 p.1 rya*rsr s To the Mayor and Members of the City Council U� .�f; May 23, 1989 a�T:E•X•"A�y. Subject: ARBITRRA{EIREBATE STATUS REPORT +az3 SUIR as a Under the Tax Reform Act of 1986 (TRA), arbitraged (excess) earnings on bond proceeds must be rebated to the federal government . Arbitrage is defined by Treasury regulations as the ability to obtain tax exempt funds and invest those funds in higher yielding taxable securities resulting in a profit to the issuer. Arbitrage can only be earned during a 'temporary period" (three years) without jeopardizing the tax- exempt status of the bonds. After the 'temporary period" all Investments must be yield restricted. For the City's two bond Issues since the effective date of TRA (1987), first year arbitrage earnings total $ 595,966.13. (GO Bonds, =318, 485.78 and Revenue Bonds $27T,480.35) This amount is now Identified as a liability of the City. It is not likely (without a major market move in taxables) to decrease this positive arbitrage already earned, however, dependent on the options chosen, we can limit any further arbitrage. Each of the two options has costs associated with it . The City initially took and has retained the philosophy that it should secure ALL of its legitimate investment earnings. We have not attempted to earn arbitrage on these funds, however, the market 's increasing rates created this unavoidable situation In taxable securities. We have attempted not to leave any money on the table. This report Is to 1) explain the effects of arbitrage on the City's earnings and operations, 2) gain an historical perspective of how arbitrage is earned and why, 3) review the monitoring process used, and 4) identify options available under Tax Reform. It is important to remember that the final regulations on arbitrage/ rebate have not yet been published by Treasury. We are still working In unknown territory. HISTORICAL BACKGROUND AND PERSPECTIVE With the Introduction of Tax Reform (TRA), the US Congress attempted to remedy abuses in the tax-exempt issuances which were created solely for arbitrage purposes. Arbitrage bonds would, for example, be sold at 6% and invested in taxable securities yielding 9%. There Is a more popular school of thought which alleges that the TRA was structured to earn federal dollars to balance the budget by capturing legitimate and Illegitimate arbitrage and ultimately to ISSUED BY THE CITY MANAGER FORT WORTH, TEXAS—�- INFORMAL REPORT TO CITY COUNCIL. MEMBERS No. 72 R9 r �,4 EoRr To the Mayor and Members of the City Council 0 `v z xAy Subject: eliminate tax-exempt issuance for the additional Income from individual and institutional owners of the bonds. Regardless of the motive, cities and other entities were presented with three options: M earn normal., legitimate arbitrage and hope that the legislation would be changed within the five years reporting period (before it had to be rebated), or (2) attempt to avoid arbitrage by earning less than the issue yield (negative arbitrage) and lose money, or (3) utilize a vehicle which avoids arbitrage, such as SLUGS or tax exempt paper. Initial indications were that substantial action was being taken at all levels of government to protest the onerous aspects of the TRA. The state treasurers initiated a constitutional amendment process. The Governors presented their arguments and GFOA along with other professional organizations moved to change the law legislatively. Such action actually produced a change in the law raising the minimum Issuance under rebate from 85mmillion to 810 million. The Supreme Court case of "Baker versus South Carolina" however closed the door on Judicial appeal of the arbitrage rebate provisions. Currently, changes to the regulations remain uncertain. ` The City of Fort North made the decision in 1887, with the first bond proceeds falling under TRA, to Invest the proceeds, according to the projected draw-down schedules, in taxable securities. These bond Issues were set up as separate portfolios and monitored carefully as the expenditures were made. The portfolios were neither traded aggressively nor actively, as was the other consolidated portfolio. However, even the buy and hold strategy resulted in significant arbitrage earnings. For the City's two bond Issues of 1887, first year arbitrage earnings total 8 585,866.13. (GO Bonds, 8318,485.78 and Revenue Bonds 8277, 480.35) = &UITRAGE ZANIME RESULTED Utilizing the buy and hold method to assure allowable earnings even in a normal yield curve will generally earn excess Interest because of the low rate at which the bonds are issued and the higher rates out 2-3 years on the curve. In the last two years, we have experienced a significant yield rally in the bond market which has even further Increased our excess earnings. For example, a two-year treasury in 1887 was yielding a 7T►, and a two-year now yields close to 10%. We will follow the example of the two bond proceeds (from April 1887) to see how such earnings are created. The two issues and their issue yields base-line are: ISSUE ISSUE TIELD GO Bonds 1987 6.50277 Rater do Sewer Bonds 1987 6.4258896 ISSUED BY THE CITY MANAGER FORT WORTH, TEXAS -- INFORMAL REPORT TO CITY COUNCIL MEMBERS No. 7384 ID- 3 +&A 7 f AE tUr,�as To the Mayor and Members of the City Council s xah Subject: felf3 Therefore, any earnings over these yields are arbitrage. Figure 1 shows that although the funds are to be spent over a three year period and matched as closely as possible to the scheduled draw- downs during that period, any security with a maturity over one year already put the City into an arbitrage position. (The lines on Figure i represent the issue yield and the bars the earnings for the treasury securities across the yield curve.) Figure 2 shows the breakdown on the original purchases, based on draw- down schedules, by yield. If the issue yield in April 1987 was 6.458898%, arbitrage was earned beginning with the stay 1988 maturity yielding 7.06%. In addition, Figures 3 and 4 show the planned draw-down (construction) schedules for each issue. These work plans were subsequently changed to reflect the realities of the construction protects . The delays in spending however simply magnified our arbitrage situation because the rates were moving up continuously during this period. None of the funds in question have been traded or swapped to create non-market-generated arbitrage. If proceeds were not spent the funds were simply re-invested to new schedules. The yield curve now, which reflects the expected yields at various maturities, for the remaining "temporary period" is basically: 05/89 8.82 06/89 8.89 07/89 8.96 08/89 8.98 09/89 9.26 10/89 9.20 11/89 9.20 12/89 9.25 01/90 9.30 02/90 9.28 03/90 9.33 04/90 9.30 That means that everything (at this point) that has had to be re- invested and will have to be re-invested will be at a minims 200 points above the issue yield. This then is the situation which created for the City substantial arbitrage profits - without trying! We now have four bond portfolios under TRA restrictions. The effect on the overall earnings for all funds distributed to all funds is estimated at 91.5 - 2 million this year. This is a result of limiting the maturities and the trading possibilities in the TRA funds . ISSUED BY THE CITY MANAGER FORT WORTH. TEXAS-- INFORMAL REPORT TO CITY COUNCIL MEMBERS No. 72A2 p-4 +fP rig/o Soar To the Mayor and Members of the City Council c * a xA Subject: +f 3 WNI TORI NG All funds are monitored on a ongoing basis. The Treasurer and the departments Involved have worked together to address the expenditure levels in these funds. According to the regulations, 85% of the funds In each issue must be expended in the three year "temporary period" or the City is required to restrict earnings to the Issue yield. Failure to do so could result in loss of the tax exempt status of the issue. This will be done through tax exempts or SLUGS if necessary. Efforts are being made to assure that the funds will be expended on the planned projects and funds in these issues is being expended before older issues (not under TRA) proceeds . No options are available to the City after the three year "temporary period". Control of arbitrage options exist only before the yield restriction becomes mandatory. TURE OPTIONS All tax-exempt bond Issues will come under the TRA. At this point, there is no viably proposed change being considered by Congress or the Treasury to that rule. As a result, the City has options available to It In only two areas : Issuance and investment . Each of these options are being evaluated as to their advantages and their disadvantages . All options must be evaluated In terms of our overall goals . -provide funds for needed capital projects, -provide capital funds at the lowest cost to taxpayers, -secure all allowable earnings due the City, and -be in a position to maximize and retain earnings should the TRA regulations change. OPTIONS Sf. ISSUANCE The City of Fort Worth has traditionally sold general obligation or revenue bonds in the tax-exempt arena. There are other options available to the City which may avoid some or all arbitrage provisions . 2). Continue to issue tax-exempt debt . Advantages: The advantages of this option are low Interest rates and a set debt schedule. Disadvantages: The primary disadvantage is the necessity to rebate all earnings over Issue yield. ISSUED BY THE CITY MANAGER FORT WORTH, TEXAS INFORMAL REPORT TO CITY COUNCIL. MEMBERS No. 7382 p.5 — �pR itlF� To the Mayor and Members of the City Council ;r6X, Subject: 1#7 1 2). Issuance of taxable debt. Advantages: Taxable debt does not come under the tax reform provisions . It is not subject to arbitrage nor rebate. The strong credit rating of Fort Worth and generally high visibility could make it a viable player In the taxable market . Disadvantages: Taxables do not enjoy the lower borrowing rate of the tax-exempts and thus would raise our borrowing cost . This would have to be balanced by higher Investment earnings. If taxable rates decline significantly, the City would still be stuck with the higher rates unless the bonds are refunded and refundings are limited to one under TRA. The City's rating and reputation, though strong, does not guarantee it as strong position in the taxable market because of the significantly stronger corporate Issues against which it would be competing. (Parenthetically this assures some degree of success to one assumed federal objective: that of reducing or eliminating tax-exempts for the tax earnings available to the federal government . ) 3). Issuance of short-term debt . Advantages: Issuance of short term debt takes advantage of the TRA provisions for bond proceeds spent within six months . Under these regulations, sales of such short term vehicles as commercial paper would be timed to provide funds as construction schedules required. No arbitrage cost is involved. Disadvantages: The administrative costs are somewhat higher for short Issues and the borrowing rates can fluctuate widely dependent upon the markets. Definite debt planning becomes such more difficult and some larger construction projects can not be effectively timed to avoid higher rates demanded by the markets. 4). Utilization of a state fund. The State Revolving Loan Fund administered by the Water Development Board Is being used currently to finance $33 million in projects. Advantages: These draws are spent within the six months period. Under the fund, moneys can be drawn therefore as needed and thus avoid arbitrage. Disadvantages: Competition for these funds is growing and there is a limit to the funds available. ISSUED BY THE CITY MANAGER FORT WORTH, TEXAS-- INFORMAL REPORT TO CITY COUNCIL MEMBERS No. 7392 .p-A - Mp*Tied too? the Mayor and Members of the City Council xA Subject: OPTIONS Q,K INVESTMENTS There is only one safe haven for bond proceeds' investments and that Is purchase of tax exempt securities . Any arbitrage earned on tax exempts may be retained. Calculations of arbitrage treat purchase of tax exempts as cash outlays. However, the substantially lower rates on tax-exempt paper makes earning any arbitrage - even up to the allowable Issue yield - difficult . Combinations of taxables and tax exempts are therefore the options most normally investigated. 1). Purchase of tax exempt securities. Tax exempts can be bought for the entire bond proceeds or for a portion of the proceeds. Advantages: Under this method, the arbitrage calculations treat the purchases as if the cash has been spent and there are no earnings being received. This would relieve arbitrage and enable all earnings to be retained by the City. Disadvantages: The earnings made under this option are considerably less than that on taxable securities . (We would insist on AAA bonds for the portfolios . ) The purchase of these securities is not as flexible or operationally as efficient as taxables and the supply of short term municipals Is somewhat limited. The liquidity of the securities could be the largest problem. 2). Utilize WiF tax exempts Advantages: Legislation is currently pending which would allow municipalities to utilize tax-exempt funds. This would eliminate some of the more difficult operational problems of dealing with tax-exempts (liquidity and short durations) while increasing yields which would not have to be rebated. Disadvantages: The yields, although increased, would still be below normal taxable securities. 3). Investments bought to a specific drawdown schedule to earn allowable arbitrage. Allowing for rebate of excess funds. Advantages: This option allows the City to earn its maximum earnings under the law. Until the laws are finalized, it also provides for the opportunity to keep those earnings should the laws be changed. Disadvantages: All excess earnings are to be rebated to the Treasury. OPL SUISAR The options afforded issuers of tax-exempt debt are few and may be limited further in the future as the federal government searches for means to reduce its own debt . No one option will solve the problem. A combination of short term debt (especially for revenue) and some ISSUED BY THE CITY MANAGER FORT WORTH, TEXAS -- INFORMAL REPORT TO CITY COUNCIL MEMBERS No. 7382 p.7 +'p*t 4r0 `aFfokry To the Mayor and Members of the City Council � op rFxty. Subject: r*s taxable options may prove feasible on the issuance side. On the investment side, we will work within the TRA restraints, assure that no legitimate earnings are lost, and assure that the tax-exempt status of the bonds is in no way jeopardized. We are currently moving into tax exempt bonds (where feasible) in preparation for the end of the first two temporary periods for the 198T issues in 1990. ugrlas Harman City Manager OOOL ISSUED BY THE CITY MANAGER FORT WORTH, TEXAS-- ri s s i • i 111111 • i • MIA1101 i i •• • ce) 0 _ 0 CV ii I- 0 iGLm ca to V) 06 LQIWAVIA\ C*4 M 7@ 0 E 4) CL 0 co co C\j 0 Q >b MONSOON 0 N w ;0% 0 0 CD Liu kc) LQ Q� uj 0 co co llqt CY YGINA L P UR CHA SES vs YIELD CUR VE Date PAR Yield at Cast 10187 11230,000 5.85 11187 605,000 6.12 12187 11400,000 6.18 1188 193759000 6.14 2188 595,000 6.23 3188. 545,000 6.28 4188 6809000 6.25 110- 5188 940,000 7.06 6188 1 ,875,000 7.07 8188 935,040 7.09 9188 11900,000 6.93 11188 975,000 7.10 12188 1 ,940,000 7.09 2189 980,000 7.21 3189 985,000 7.27 WATER AND SEWER Fig. 2 FIGURE 3 PLANNED PROCEEDS M VERSUS ACTUAL liSB. HATER AND SEVER ISSUE 1987 (Shorting yield at scheduled maturities) ORIGINAL SCHEDULE ACTUAL PROCEEDS USE PLAN Yield SPENDING PATTERN 08/87 6 0 90, 000 09/87 0 0 10/87 0 0 11/87 1, 700, 000 6.20 0 12/87 680, 000 6.23 0 01/88 680, 000 6.34 0 02/88 680P000 6.40 0 03/88 680, 000 6.48 0 04/88 680, 000 6. 54 <<< arb. pt . 0 05/88 680, 000 6.54 0 06/88 1, 020, 000 6.59 0 0718E 1, 020, 000 6.61 0 08/88 1, 020, 000 6.66 571 09/88 1, 020, 000 6.70 0 10/88 1, 020, 000 6. 77 2, 009 11/88 1, 020, 000 6.80 0 12/88 1, 020, 000 6.82 3, 491, 494 01/89 1, 020, 000 6.87 0 02/89 1, 020, 000 6.92 2, 016, 735 03/89 1, 020, 000 6.97 701, 313 04/89 1, 020, 000 7.03 n/a 9 17, 000, 000 $ 6, 302, 122 37% FIGURE 4 PLAN P20CEEDS M VERB ACTUAL M G.O. BOND ISSUE 1887 (Showing yield at scheduled maturities ) ORIGINAL SCHEDULE ACTUAL PROCEEDS USE PLAN * Yield SPENDING PATTERN 04/87 5 571,000 6 175, 590 05/87 506,000 84, 893 06/87 577, 000 20, 798 07/8" 549, 000 27, 086 08/87 338, 000 109, 475 09/87 640, 000 71, 503 10/8" 368, 000 51, 03-2 11/87 376, 000 6.20 445, 903 12/87 633, 000 6.23 172, 191 01/88 513, 000 6.34 18, 600 02/88 862, 000 6.40 20, 090 03/88 998, 000 6.48 626, 832 04/88 937, 000 6.54 M arb. pt . 630, 001 05/88 818,000 6.54 968, 215 06/88 1, 019, 000 6.59 7981742 07/88 868, 000 6.61 434, 097 08/88 958, 000 6.66 341, 455 09/88 703,000 6.70 1, 001, 000 10/88 661, 000 6.77 1, 987, 434 11/88 889, 000 6.80 1, 745, 450 12/88 987, 000 6.82 3, 159, 247 01/89 587, 000 6.87 750, 400 02/89 799, 000 6.92 809, 040 03/89 575, 000 6.97 n/a 04/89 652, 000 7.03 n/a 83% of plan 05/89 779, 000 7.13 06/89 685, 000 7.16 07/89 601, 000 7.20 08/89 283, 000 7.22 09/89 422, 000 7.23 10/89 382, 000 7.25 11/89 $55, 000 7.27 12/89 355, 000 7.30 01/90 148, 000 7.30 02/90 341, 000 7.37 03/90 493, 000 7.44 04/90 556, 000 7 .49 * Schedule was calculated using last four frond issues spending patterns .