When governments issue bonds, additional considerations are likely to apply to bond proceeds. Investment policies, legal requirements such as the arbitrage yield permitted under federal tax rules, requirements from bond covenants and/or credit enhancement providers, and the anticipated timing of drawdown of bond proceeds should be taken into account when determining what investments to purchase. Multiple accounts with varied investment horizons are often involved.
Cash flow analyses are critical components of the process and are useful in reducing the possibility of “negative arbitrage” that may occur when the rate of interest paid on the bonds that are issued exceeds the interest received from reinvestment opportunities. The manner in which bond proceeds are invested may have a material impact on the size and cost of a bond issue, and on the cash flow available to make debt service payments, and needs to be understood and analyzed by governmental issuers in that context.
The Government Finance Officers Association (GFOA) recommends the following:
- Issuers should have an Investment Policy that addresses a bond indenture’s permitted investments and other investment requirements related to bond proceeds with that policy.
- Issuers should be aware of unique considerations related to investing bond proceeds such as multiple accounts that may be required for a bond issue, the Municipal Advisor Rule as it relates to investment advice on bond proceeds, and tax compliance issues related to tax-exempt bond proceeds.
- Issuers should coordinate the management of bond proceeds with the necessary staff in their government to ensure funds are spent properly and cash flows are matched with investment maturities.
Coordination of Bond Requirements with Investment Policy
GFOA recommends that governments have an Investment Policy which takes into consideration all inherent risks and which also includes specific policies for the investment of bond proceeds to ensure that legal and regulatory requirements are met, fair market value bids are received, and issuer objectives for various uses of proceeds are attained. Governments should be aware that different types of bond proceeds may have different investment goals.
Often the bond indenture will contain a list of permitted investments as well as any other investment requirements related to credit enhancement providers. Different types of debt issuances may have unique investment requirements related to various Federal, State and other programs. These requirements need to be coordinated with the Investment Policy. In addition, governments should discuss with bond counsel any required disclosures related to investments.
Establishment of Multiple Funds and Accounts
Governments typically must establish various funds and accounts as required in the bond indentures and must be knowledgeable of different types of investment that each fund may require. Some common funds and accounts and associated investment horizons include the following:
- Construction Fund (investment horizon is short-term, typically ranges from 12-36 months)
- Capitalized Interest Fund (investment horizon is short-term, typically ranges from 6-18 months)
- Interest Account (investment horizon is usually 6 months)
- Sinking Fund/ Principal Account (investment horizon is usually 12 months)
- Escrow Fund/ Redemption Account (investment horizon depends on a redemption date)
- Debt Service Reserve Fund (investment horizon is long-term, maximum duration investment allowed under governments’ Investment Policy may be used)
While these are typical investment horizons for each of the funds/accounts described above, expectations and requirements can vary across governments and each issuer should consult with their advisory team and Investment Policy to determine optional timeframes and security options.
The MA Rule and Broker-Dealers Advice
Due to the Securities and Exchange Commission’s (SEC) Municipal Advisor (MA) Rule, brokers may be considered municipal advisors if they provide advice on investments of bond proceeds to governments, which limits the ability to directly solicit information from broker-dealers on reinvestment choices.
Governments should understand their interactions with broker-dealers under the existing regulatory environment at the time of a bond sale and how they will engage specific professionals to formulate an ultimate decision on the efficiency of reinvestment options that will be selected.
Governments may obtain advice from a broker-dealer through a Request for Proposals (RFP) process or when they have retained an independent registered municipal advisor (IRMA) whose duties include advice on investments. The GFOA Alert on the MA Rule can serve as a resource for issuers on understating the MA roles, their fiduciary duties, and the RFP or IRMA exemption. Issuers may also choose to retain a registered investment adviser if they want more than de minimis investment advice.
Municipal issuers should be knowledgeable and consult with tax and legal counsel on various Federal tax rules and post-issuance tax compliance requirements for tax-exempt bond proceeds in order to maintain their tax-exempt status. In the broadest terms, the tax requirements can be grouped into two categories: (1) arbitrage and rebate; and (2) use of bond proceeds and of bond-financed facilities. Each of these categories involve rules that make it advisable for an issuer to adopt practices that track how bond proceeds are invested and how and when bond proceeds are spent. Further, issuers should maintain proper records for the required time period, which is typically the life of the bonds plus three years.
Management of Bond Proceeds Spending
When an issuer sells new money bonds and expects to take a considerable period of time to spend bond proceeds on capital projects, this may result in an interest cost that exceeds interest earnings during that time period (“negative arbitrage”). It is critical to develop consistent and reliable spend-down estimates for the associated capital projects and periodically update those estimates to compare against investment income projections based upon prevailing and expected market conditions.
Issuers will need to identify and ensure coordination between the persons responsible for monitoring and managing spending, cash flow projections, and investment performance and compliance. This is especially true if these areas involve different offices and staff and can typically include debt management staff, treasury staff, public works or engineering staff, etc. This coordination is critical and GFOA recommends that governments do the following:
- Monitor how and when bond proceeds will be invested and spent with respect to federal tax law requirements, especially when there are changes in timing or spending plans from what was planned at the time of bond issuance.
- Make certain that the drawdown of proceeds is planned and recorded and that the investment duration is shorter than the expected drawdown schedule. Since the draw schedule may change over time, it should be periodically revisited.
- Borrow only as much as needed to fund capital projects or expected expenses, after consideration of cash funding, grants, or other funding sources.
- Explore options to stage bond issues over the capital construction period to minimize potential arbitrage liability and/or negative arbitrage.
Consider not issuing bonds significantly earlier than proceeds are expected to begin being spent on capital expenditures.
- GFOA Investment Policy BP and Sample Investment Policy;
- GFOA Investment Program for Public Fund BP;
- GFOA Primary Market Disclosure BP;
- GFOA Alert: The MA Rule and Issuers;
- GFOA Selection and Review of Investment Advisors BP;
- GFOA Government Relationships with Securities Dealers BP;
- GFOA Post-Issuance Compliance BP;
- GFOA Developing and Implementing Procedures for Post-Issuance Tax Compliance for Issuers of Governmental Bonds Alert;
- NABL Considerations for Developing Post-Issuance Tax Compliance Procedures.