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Investing Bond Proceeds and Capital Funds

Investing Bond Proceeds and Capital Funds. Presented by Julio F. Morales April 24, 2006. The Last Step in Financing Process. Do not ignore the reinvestment of bond proceeds. Increase DSR earnings by 1.0% for 30 years: ($1 million DSR x 1.0% x 30) = $300,000. Refunding with 3%

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Investing Bond Proceeds and Capital Funds

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  1. Investing Bond Proceedsand Capital Funds Presented by Julio F. Morales April 24, 2006

  2. The Last Step in Financing Process Do not ignore the reinvestment of bond proceeds Increase DSR earnings by 1.0% for 30 years: ($1 million DSR x 1.0% x 30) = $300,000 Refunding with 3% savings on $10 million = $300,000 In comparison to If you ignore the reinvestment of bond proceeds, you can effectively undo all your efforts April 24, 2006

  3. Arbitrage Yield IRS calculation of effective interest rate paid on a tax-exempt bond IRR Calculation of Par Value vs. Adj. Debt Service Principal & Interest +/- Premium / (Discount) - Bond Insurance Arbitrage Yield 4.85% April 24, 2006

  4. IRS Arbitrage Regulations Arbitrage Yield – the effective interest rate paid on a tax-exempt bond issue. • Yield Restriction • Issuers are restricted from investing bond proceeds at a rate materially higher than the arbitrage yield, except in the following case: • Issuer “reasonably expects” to spent 85% of project fund or construction fund monies) within a temporary period of 3 years. • Bond proceeds held in a reasonably required reserve (i.e., DSR fund) • De minimis amount = lesser of $100,000 or 5% of the bond issue. • Arbitrage Rebate • The IRS requires an issuer to rebate excess interest earnings above the arbitrage yield (i.e., rebate payments), generally every five (5) years. There are three primary exemptions from rebate • Proceeds spent within prescribed 6-month, 18-month, or 2-year schedule. • Small issuer –expects to issue less than $5 million in a calendar year. • Bond proceeds are invested in tax-exempt municipal securities. April 24, 2006

  5. Goals: Maximize Earnings • You must perform rebate calculations • You get to keep all earnings up to the arbitrage yield • Goal is to invest at or above the arbitrage yield • “Opportunity Cost” if invested below the arbitrage yield 6.00% Subject to rebate Investment=5.00% 5.00% Arbitrage Yield=4.85% Opportunity Costs Money Market=4.00% 4.00% 3.00% April 24, 2006

  6. Investment Principles Safety minimize chances of issuer default Chance of decline in market value Liquidity Time constraint Function of cash flow needs Yield Risk/reward ratio Portfolio Goals Preservation of principal Flexibility Investment Return Investment Objectives Balance: Best return for lowest risk April 24, 2006

  7. Permitted Investments • Most investment policies address investment options for operating funds. • Typically, investment options for bond proceeds are defined under “permitted investments” in the Trust Indenture / Fiscal Agent Agreement. • Rating Agencies/Bond Insurers impose standard investment guidelines. April 24, 2006

  8. Investment Alternatives • Money Market Instrument or LAIF • Laddered Portfolio – Treasury /Agency Securities, Corporate Bonds, CDs • Investment Agreements – GICs, Repos, Forward Purchase Agreements • Combination of Above April 24, 2006

  9. The Lottery • State of California offers payments of $5 million over 20 years or a single up front payment. ? Total over 20 years=$100 million One-time Payout or April 24, 2006

  10. The Lottery • Which would you choose? • Depends on discount rate $62.3 million Total over 20 years Discount rate = 5.0% April 24, 2006

  11. Advantages of Investment Agreements Market Risk –Investment Agreements are par instruments that eliminate the potential market risk associated with most fixed income securities. Elimination of market risk is especially important for a long-term investment (e.g., DSR) or in a rising interest rate environment. Asset / Liability Management – Investment Agreements can be structured to match cash flows, maturity dates, call provisions, etc. – allows issuer to match assets with liabilities. Reinvestment Risk – Issuer can lock-in the reinvestment rate (on DSR) for the life of the investment. Construction Risk – Full-flex GICs / Repos allow issuers to make withdrawals in any amount on any date. Investment Agreements providers assume construction risk – cash flow variances of withdrawal from project fund accounts. Default Risk – Investment Agreements providers assume default risk on the bonds. Flexibility – Investment Agreements are negotiated contracts. Issuers can structure options or contour cash flows to meet their needs. April 24, 2006

  12. Limitations of Investment Agreements Limited Market Trading – Since most Investment Agreements are structured to meet the specifications of an individual issuer (bond deal), there is no secondary market for investment agreements. • Contracts can be structured with a market breakage fee (fixed income pricing) • Option to Terminate (at par). Documentation – Investment Agreements require more than just a trade confirmation. Investment agreements are structured with unique provisions; and therefore require a negotiated contract (typically 7-10 days after bidding). Broker / Bidding Agent - Investment agreements (like most securities) are often sold via GIC brokers or bidding agents. IRS excludes bidding fees from arbitrage calculations. April 24, 2006

  13. Break-Even Analysis April 24, 2006

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