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Municipal Government Investors Corp. Bond Proceeds Investments Fixed Rate Investment Agreements for Construction, Debt Service Reserve and Bond Funds February 2007 Victor Adams Managing Director 704-554-1160 Table of Contents Introduction Bond Proceeds Accounts

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Municipal Government

Investors Corp.

Bond Proceeds InvestmentsFixed Rate Investment Agreements forConstruction, Debt Service Reserve and Bond FundsFebruary 2007

Victor Adams

Managing Director

704-554-1160


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Table of Contents

  • Introduction

  • Bond Proceeds Accounts

  • Traditional Investments - Shortcomings

  • Fixed Rate Investment Agreements

  • Bidding Process for Investment Agreements


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Introduction

  • The traditional investment choices for bond proceeds of money market funds or laddered portfolios have shortcomings in terms of liquidity/price risk and yield.

  • This presentation introduces Fixed–Rate Investment Agreements as a third alternative. These agreements are offered by highly-rated banks and insurance companies.

  • Investment Agreements offer fixed rates consistent with longer investment terms, yet maintain the attractive liquidity of a money-market fund.

  • The Investment Agreements described in this presentation comply with NC GS 159-30, and are familiar to the LGC.



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Bond Proceeds Accounts

New bond issues can create several accounts requiring investment:

  • Construction / Capitalized Interest Account (or Project Fund) - Money requiring high liquidity to pay contractors’ ongoing payment requests throughout the term of the construction period.

  • Debt Service Reserve Fund (DSR) - In revenue bond issues, an amount of proceeds equal to one-year’s debt service is typically set aside to secure bondholders. The term of the DSR usually matches the maturity of the Bonds.

  • Debt Service Fund (DSF) – Interest and Principal Accounts Some Bond indentures (e.g., revenue bonds) require monthly “sinking fund” payments which accumulate in an account, and are then paid out to investors on the semiannual bond debt service payment dates.



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Traditional Investments - Shortcomings

  • The fundamental objectives for the investment of bond proceeds are:

    • Safety of Principal

    • Liquidity

    • Yield Maximization

  • Traditional choices for the investment of bond proceeds have been:

    • Money Market Funds

    • Laddered Portfolios of Securities

      These investments fail to maximize all three of the objectives.


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Money Market Funds – Low, Variable Yield

  • Money Market Funds have historically yielded much less than longer-term fixed-rate alternative investments. Since 1989 this difference has averaged about 1.44%. Money market funds variable yield makes budgeting investment returns on Funds impossible.


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Laddered Portfolios – Three Primary Risks

  • In an attempt to increase and lock-in yield for funds, some issuers employ a “laddered” portfolio approach.

  • A laddered portfolio is a series of successively longer-term, fixed-rate securities. Unfortunately, this approach exposes a fund account to three risks:

    • Principal Risk

    • Interest Rate Risk

    • Mark-to-Market Risk


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Laddered Portfolios – Principal Risk

Principal Risk - Example

  • Suppose an issuer creates a laddered portfolio of Treasury securities to invest a construction fund. The securities have a series of maturities matching estimated construction draws of $1 million/month.

  • Suppose after 6 months, the actual construction draws occur more quickly at a rate of $1.5 million/month, requiring larger fund withdrawals. The issuer must sell securities before their maturity in order to meet the new schedule.

  • If interest rates have risen since the Bonds were issued, the issuer will have to sell securities at a loss. The losses must be made up by additional fund contributions.


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Laddered Portfolios – Interest Rate Risk

Interest Rate Risk - Example

  • Using the previous scenario of a laddered portfolio for a construction fund, suppose the actual construction draws occur more slowly than the estimated draws of $1 million/month.

  • If draws on the account are smaller than planned, securities in the account will mature prior to the money being needed. These monies will have to be reinvested.

  • If the re-investment rate is low, or if interest rates have fallen since the bonds were issued, the account will earn less interest than budgeted. The loss in income must be made up by additional fund contributions.


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Laddered Portfolios – Mark-to-Market Risk

Mark-to-Market Risk - Example

  • Suppose an issuer invests DSR account funds (reserve funds) in a 5-year Treasury security, which is typical.

  • If interest rates rise, the securities’ mark-to-market value will decline.

  • At the end of the fiscal year, the Bond trustee will note the decline in mark-to-market value and declare the account “under-funded”. The loss in value must be made up by additional deposits to the account.



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Fixed Rate Investment Agreements

  • Investment Agreements are eligible investments under NC GS 159-30, and meet the highest standards of safety of principal, liquidity and yield.

  • The providers of Investment Agreements are typically highly-rated Bank and Bond Insurance companies.

  • Two Major Types

    • Repurchase Agreement (Repo)

    • Forward Purchase Agreement (FPA)


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Repurchase Agreements (“Repo”)

Repurchase Agreement or “Repo”

  • Repos are typically used for construction or project funds, which will be spent in the next several months or years.

  • In a Repo the issuer deposits funds with a Provider (bank) who then places collateral securities (US Treasury or Agencies) with a third party custodian. The Issuer can make withdrawals as needed for construction costs. The Provider must replenish any decline in value of the collateral.


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Forward Purchase Agreements (“FPA”)

  • Forward Purchase Agreement (“FPA”)

  • FPAs are typically used for Debt Service Reserve or Debt Service Funds (Bond Funds) which are outstanding for the life of the Bond issue.

  • In an FPA the Trustee purchases short-term securities on specific future dates from the Provider (typically Treasuries and Agencies). The securities yield a guaranteed long-term* fixed rate and mature at par on or before the bond payment dates.

  • In certain cases the borrower may choose to receive the interest as an up-front cash payment, maximizing cash by monetizing the future earnings of the Fund.

    * Even thought the securities delivered are short-term, they carry a long-term fixed rate.


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Investment Agreements – Features and Benefits

Safety–Funds are either invested in Treasuries and Agencies held by the Trustee, or collateralized (103%) by these securities. Agreements also typically carry additional provider “downgrade” provisions offering additional security.

Liquidity - Funds may be withdrawn at “par” at any time, for any purpose listed in the Bond documents.

Maturity - Agreement’s maturity is equal to the maturity of the account invested.

High Fixed-Rates - The yield of the agreement is fixed for its term. The interest rate level will be a function of the original maturity of the account that is invested.

Par-Value Accounting – Due to the ability to always withdraw funds at par, an Investment Agreement’s mark-to-market value is always par.


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Summary

  • Investment Agreement features overcome the problems of principal, interest rate, and mark-to-market risks inherent in money market funds and laddered portfolios.

  • Investment Agreements offer the benefits of typical short-term investments (safety of principal and liquidity) but carry fixed rates and higher yields and offer features not otherwise obtainable in traditional investments (up-front payment options).


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Investment Agreement Bidding Process

  • According to IRS regulations, tax-exempt bond issuers must purchase an Investment Agreement through a competitive bidding process (to obtain a safe-harbor ruling). A competitive bid also insures the issuer will receive the highest yield.

  • The timeline for the bidding process is as follows:

Week 1 Preparation of 1st draft of Bid Specifications

Preliminary list of eligible bidders prepared

Week 2 Bid Specifications finalized

Bid Specifications circulated to bidders along with expected cash flows and project financial information

Bids taken and winner awarded

Week 3 Investment Agreement documentation process

Close and fund


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