Debt Management

1
Debt Management

• Kevin Thompson
• Public Financial Management
• GFOAA
• June 20, 2007

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Intro
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Components of CIP Funding

• Dollar amount of projects
• Revenues available for debt service
• Term structure of debt (bond amortization)
• Cost of funds

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Cycle of CIP Funding
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Cycle of CIP Funding
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Cycle of CIP Funding
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Debt Capacity
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Term Structure of Debt
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Term Structure of Debt

• Level Debt Service
• Level Principal
• Deferred Principal

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Existing Debt
Today
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Term Structure of Debt

• Level Debt Service
• Level Principal
• Deferred Principal
• Projections
• 50 million of debt annually
• 5.0 interest rate

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Level Debt Service
2007
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Level Debt Service
2007
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Level Debt Service
2007
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Level Debt Service
2007
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Level Debt Service
2008
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Level Debt Service
2008
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Level Debt Service
2008
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Level Debt Service
2008
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Level Debt Service
2013
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Level Debt Service
2013
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Level Debt Service
2018
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Level Debt Service
2018
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Level Debt Service
2033
End of Existing Debt
Level Budgeting
Nice, Downward Slope
62 Principal
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Level Principal
2007
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Level Principal
2007
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Level Principal
2007
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Level Principal
2007
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Level Principal
2008
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Level Principal
2008
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Level Principal
2008
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Level Principal
2008
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Level Principal
2013
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Level Principal
2013
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Level Principal
2018
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Level Principal
2018
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Level Principal
2033
End of Existing Debt
Level Budgeting
Nice, Downward Slope
66 Principal
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Deferred Principal
2007
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Deferred Principal
2007
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Deferred Principal
2007
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Deferred Principal
2007
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Deferred Principal
2008
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Deferred Principal
2008
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Deferred Principal
2008
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Deferred Principal
2008
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Deferred Principal
2013
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Deferred Principal
2013
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Deferred Principal
2018
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Deferred Principal
2018
50
Deferred Principal
Level Budgeting
2033
Downward Slope
54 Principal
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Peak Debt Service
Level Debt Service Peaks at 80.5 million at
end of existing debt holding capital spending
and interest rates constant, this will be the
debt service budget Level Principal Peaks at
81.5 as new debt is stacked on existing level
debt service budget will be 75.1 at the end of
the existing debt Deferred Principal Peaks at
92 million at the end of existing debt
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Targeting a Cost of Funds
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Targeting a Cost of Funds
By issuing fixed-rate, level debt service 20-ish
year debt, issuers are setting a default targeted
borrowing rate in the 12-15 year range and
lowering their cost of funds through refundings.
Three Year Average of MMD AAA Rates
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Historical Trends of Interest Rates
Excel Demo
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Historical Trends of Interest Rates
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Ways to Lower Cost Of Funds

• Shorten amortization
• Front-loaded principal/level principal
  amortization
• Use combination of traditional and variable rate
  debt in the debt portfolio
• Use combination of traditional and synthetic debt
  in the debt portfolio

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Reducing the Default Target
Setting a 10 year target would produce the
following expected results.
Three Year Average of MMD AAA Rates
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Variable Rate Debt
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Variable Rate Debt
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Variable Rate Debt
Surplus
Deficit
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Variable Rate Benefit
Asset liability matched variable rate debt has
cost of funds of -2.
Assumes one standard deviation from the mean
Borrowing Cost of 4.30 unmatched and 20 cash
balance, translates to 3.04 combined cost of
funds when asset-liability matched.
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Interest Rate Swaps in General

• An interest rate swap is a contract, not a
  security between two parties (referred to as
  counterparties) to exchange interest rate
  payments at specified dates in the future.
• The interest rate payments for a given
  counterparty equal the product of an interest
  rate (swap rate) and a principal amount.
• Usually, the swap rate for one counterparty is a
  fixed rate, while the swap rate for the other
  counterparty is a variable rate.
• The principal amount by which the swap rates are
  multiplied is notional. That is, principal
  payments are not swapped, paid or exchanged the
  notional principal amount is only an arithmetic
  device to calculate swap payments.

Fixed Payments (Fixed interest rate X notional
principal amount)
Counterparty A
Counterparty B
Floating Payments (Variable interest rate X
notional principal amount)
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Why Use Swaps?

• Exploit Attractive Synthetic Financing
  Opportunities
• Swaps and other derivatives can allow issuers to
  opportunistically create cheap synthetic
  variable-rate or fixed-rate debt
• Issuers can arbitrage the prices paid for certain
  financial instruments in different markets, e.g.
• monetization of in-the money bond call options
  in swaptions market
• Synthetic variable-rate debt (fixed-rate bond
  swap) can allow issuers to conserve valuable
  credit/liquidity facilities
• Risk Management
• By hedging, issuers improve asset/liability
  management and reduce cashflow variability

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Floating-To-Fixed Swap (Synthetic Fixed)

• A floating-to-fixed interest rate swap allows an
  issuer to effectively convert all or a portion of
  its variable (floating) rate debt to a
  synthetic fixed rate
• The issuer becomes a fixed rate payor,
  receiving a floating rate payment from a
  counterparty and paying a predetermined fixed
  rate
• To the extent the variable rate received by the
  issuer offsets the variable rate paid by the
  issuer to bondholders, the issuers debt cost
  equals the fixed swap rate plus any ancillary fees

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Yield Curves in 2003
MMD
BMA Swap
68 LIBOR Swap
Includes 30 basis points assumed support cost for
underlying floaters
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Forward swap premiums decline as the yield curve
flattens

• Forward premiums (the cost of hedging forward)
  are the increase in rates for a forward-starting
  swap compared to a swap that starts today.

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Diversified Debt Portfolio

• Traditional Fixed assumes 12 year MMD rate
• Blended Portfolio assumes
• 50 Traditional Fixed
• 30 Synthetic Fixed (10 year BMA Swap)
• 20 Variable Rate (excludes asset-liability
  matched earnings)

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Tax Risk and Performance Expectations

• Long-term BMA/LIBOR swap ratios have narrowed
  significantly over the past several years
• The compensation for taking tax risk, i.e. the
  expected savings (reduction in nominal yield)
  versus a BMA swap or fixed-rate bonds, has
  decreased to near a 13-year low
• PFM would therefore recommend using a BMA swap
  for hedging purposes

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Diversified Debt Portfolio

• Traditional Fixed assumes 12 year MMD rate
• Blended Portfolio assumes
• 50 Traditional Fixed
• 30 Synthetic Fixed (10 year LIBOR Swap)
• 20 Variable Rate (excludes asset-liability
  matched earnings)

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Checklist Points to Remember

• Use a Swap Advisor with experience (not General
  FA or GIC broker)
• Use Swap Counsel with experience (not just Bond
  Counsel)
• Consider the benefits of swap insurance
• KISS (Keep It Simple)
• Have a plan What Next?
• What costs?
• What reporting?
• What contingencies?

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Debt Management Parameters

• Establish and Monitor Cost of Funds Target
• Set Target
• Set Parameters which Allow Flexibility Based on
  Current Market
• Monitor Overall Exposure of Portfolio
• Establish Limits for Debt Type Exposure
• Fixed Rate
• Variable Rate
• Synthetic Structures
• Establish Limits for Tax Risk Exposure
• Purchased Tax Risk
• Variable Rate

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