FGFOA Debt Management

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Best Practices in Debt Management
November 14, 2006
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Stephens Municipal Bond Specialists
Scott Johnston Senior Vice President
scott.johnston_at_stephens.com 727-
502-3500 Scott Johnston has served as senior
managing underwriter on transactions ranging in
size from 50,000 in notes to over 1 billion in
bonds. Mr. Johnston managed William R Houghs
variable rate desk which underwrote over 160
variable rate transactions ranging in size from
3 million to 500 million. Because of his daily
contact with all sectors of the bond market, he
is thoroughly knowledgeable about market
conditions and the demand for specific kinds of
securities. As one of the most the senior
underwriters in the State, other firms frequently
seek his opinion on pricing levels of Florida
bonds at their initial marketing. Mr. Johnston
holds a B.A. degree in Economics from Tulane
University. He has been actively involved in the
underwriting, trading and selling of municipal
bonds for over 20 years. He is also a NASD
Registered General Securities Representative, a
Registered General Securities Principal,
Registered Municipal Securities Principal and a
Registered Municipal Securities
Representative. Andy Mathes Vice
President amathes_at_stephens.com
901-681-1373 Andy Mathes specializes in the use
of innovative financing techniques for
structuring bonds and investments. He has
advised clients on the issuance of more than 580
new money and refunding bond transactions. His
is a municipal securities principal and
additionally holds Series 7, 9, 10, 53, 63 and 65
registrations. Mr. Mathes worked as a
verification agent for Ernst Young and has
structured innovative investments since
1998. www.stephens.com
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What Happens When We Dont Plan Properly?
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Best Practices in Debt Management

• Establish realistic goals and develop a plan to
  accomplish the objectives
• Maintain Credit ratings
• Manage relationship of debt growth with the tax
  base
• Tie the term of borrowings with the life of
  assets, considering repair and replacement costs
  that will be incurred in future years
• Minimize interest expenses

• Who can assist you with this process?
• Your underwriter
• Hire a financial advisor/swap advisor
• Seek advice from experienced counsel
• Review guidelines of the GFOA
• Review guidelines of Fitch, SP and Moodys

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GFOA RECOMMENDED PRACTICE Debt Management Policy
(1995 and 2003) Background. Debt management
policies are written guidelines and restrictions
that affect the amount and type of debt issued by
a state or local government, the issuance
process, and the management of a debt portfolio.
A debt management policy improves the quality of
decisions, provides justification for the
structure of debt issuance, identifies policy
goals, and demonstrates a commitment to long-term
financial planning, including a multi-year
capital plan. Adherence to a debt management
policy signals to rating agencies and the capital
markets that a government is well managed and
should meet its obligations in a timely
manner. Debt levels and their related annual
costs are important long-term obligations that
must be managed within available resources. An
effective debt management policy provides
guidelines for a government to manage its debt
program in line with those resources.
Best management practices for government debt
issuers Fund balance reserve policy/working
capital reserves Multiyear financial
forecasting Monthly or quarterly financial
reporting and monitoring Contingency planning
policies Policies regarding nonrecurring
revenue Debt affordability reviews and
policies Superior debt disclosure practices
Pay-as-you-go capital funding policies Rapid
debt retirement policies (greater than 65 percent
in 10 years) Five-year capital improvement plan
integrating operating costs of new facilities
Financial reporting awards Budgeting
awards Courtesy of Fitch Ratings, 2002
A debt policy Clarifies and documents your
financings and the management of all your debt.
Ensures the many considerations of borrowing are
reviewed in decision-making. Offers guidance
for ongoing obligations (such as disclosure and
arbitrage compliance). Helps to coordinate
long-range planning for capital projects and debt
issuance. Shows citizens and rating agencies
your commitment to responsible debt issuance and
management.
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• What should you prioritize within the planning
  process?
• Very Significant
• Fund balance policy.
• Debt affordability policy.
• Significant
• Pay-as-you-go capital financing.
• Multi-year forecasting.
• Quarterly reporting.
• Quick debt retirement.
• Influential
• Contingency plans.
• Non-recurring revenue policy.
• Depreciation of fixed assets (GASB 34
  implementation).
• 5 Year CIP integrating operating cost impacts.
• GFOA financial reporting award.
• GFOA budgeting award.

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Elements Appearing in Debt Policy Statements
1. Purposes and uses of debt 19. Sale
process 2. Types of debt 20. Assessed
value 3. Capital expenditures 21. Analysis
requirements 4. Refunding bonds 22. Reserve
capacity 5. Disclosure 23. Per capita
limitations 6. Statutory limitations 24.
Size of issuance 7. Project life 25.
Intergovernmental coordination 8. Rating
agency relations 26. When not to issue debt 9.
Operating budget 27. Operating revenue 10.
Revenue and TIF bonds 28. Lease debt 11. Bond
rating goals 29. Capitalized interest
guidelines 12. Misc. limitations 30. Market
value limitations 13. Repayment provisions 31.
Credit enhancement 14. Maturity guidelines 32.
Limited tax GO bonds1 15. General fund revenue
33. Inter-fund borrowing 16. Expenditure
limitations 34. Variable rate debt 17.
Professional services 35. Debt service
funds 18. Short-term debt 36. Derivatives
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Capital Planning Process

• Strategic Planning Five to ten year capital
  planning process which establishes goals,
  identifies needs and produces a list of potential
  capital projects.
• Revenue Identification Sources are identified
  to fund potential capital projects.
• Project Prioritization Merging of strategic
  plan needs and revenue sources utilizing a formal
  or informal prioritization system to develop a
  capital plan.
• Approval Public and Legislative input to review
  proposed capital plan and formal adoption.
• Capital Budget Based upon an approved CIP and
  emergency developments not in CIP, a capital
  budget is prepared and submitted to the
  legislature for approval and passage.
• Monitoring/Review Monitoring project
  performance.

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Evaluate your policy for permitted investments

• Make sure that your investment policy is up to
  date.
• Matching your permitted securities with the
  securities allowed by your bond insurers is a
  prudent policy.
• Employ established market benchmarks to evaluate
  performance.
• Example
• Your investment policy may allow you to purchase
  CDs (which can be unrated and will only have a
  FDIC guarantee of 100,000) while disallowing AAA
  government backed paper (FHLB Notes) or AA rated
  investment agreements

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• Capital projects funded by municipalities may
  include
• Streets and roads
• Schools
• Government buildings
• Higher education buildings (including research
  laboratories and dormitories)
• Transportation facilities (including bridges,
  highways, roads, airports, ports and surface
  transit)
• Electric power generating and transmission
  facilities
• Water tunnels and sewerage treatment facilities
• Hospitals, healthcare and assisted-living
  facilities, and nursing homes
• Housing for low-income and moderate income
  families
• Other buildings or infrastructure deemed for the
  good of the general populous.
• In General, Municipal Bonds may not be used to
  fund operational needs.

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The steps from planning through implementation
and monitoring
Plan of Finance

• Determine capital needs / Source of repayment
• Select the Financing Team

Legal Framework

• Legal / Voter approval, if required
• Determine sale type
• Structure issue
• Prepare disclosure/financing documents
• Public Notification, if required

Marketing

• Marketing
• Sell the Bonds

Administration

• Closing / Money transfer
• Invest Bond Proceeds
• Begin project
• Track performance / Administer payments

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• General Obligation Bonds
• Backed by the full-faith and credit taxing power
  of municipality
• Typically must be approved by voters
• Provides cheapest rate of financing
• Vulnerable to property tax revolts
• Conservative structure
• Revenue Bonds
• Backed by identified revenues, usually user fees
• Need not be approved by voters
• Rates usually 25 to 55 basis points higher than
  GO rates
• Relies solely on ability to pay
• Invulnerable to property tax rates
• Flexible structure

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Capital Planning

• Policies
• Comprehensive Financial Policy
• Debt Policy
• Fund Balance Policy
• Derivatives Policy
• Capital Improvements Programming
• Debt Capacity Analysis
• Targeting Cost of Funds

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Ways to Lower Cost Of Funds

• Shorten amortization
• Annual payment of 9.6 million per 100 million
• (vs. 7.5 million for 21 year level debt
  service)
• Front-loaded principal/level principal
  amortization
• Annual payments starting at 9.3 million and
• declining to 4.8 million per 100 million
• Use combination of traditional and synthetic debt
• Use of swaps
• Back-end variable rate exposure (tax risk)
• Use combination of traditional and variable rate
  debt

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Ways to Lower Cost Of Funds
We are seeing more and more municipalities issue
both new money and refunding bonds with interest
rate swaps (they issue variable notes and then
pay a fixed rate to a swap counterparty while
receiving a variable rate payment that offsets
the cost of the new obligations). The next
three pages detail a summary of 1) why swaps are
in vogue 2) pricing benefits and 3) potential
dangers We would like to explain both the good
and potential bad of these transactions for
tax-exempt issuers.
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Ways to Lower Cost Of Funds

• Why are historically conservative issuers using
  LIBOR based swaps?
• Lower projected debt service than comparable
  fixed rate alternatives. In 2004, a bond with an
  average life of 15 yrs had an average insured
  yield of approximately 4.10. Conversely, an
  issue that was synthetic fixed with a 67 of
  LIBOR swap with the same amortization schedule
  cost the issuer 3.77. For a refunding, this
  dramatically reduced negative arbitrage as well
  as debt service. Add a counterparty fee and
  credit charge into the swap rate and perhaps the
  net rate to the issuer becomes 3.90.
• Education issuers have been reviewing
  derivative based financing alternatives for years
  now. They are up the learning curve and
  assessing the risks and rewards from a different
  perspective than we saw in the late 90s.
• They need the savings. Budgets are (as always)
  strapped and the savings in debt service are
  real. Refundings that cant even be considered
  with traditional fixed rate bonds work (hit their
  savings targets) when swaps are employed.
• Their contemporaries are using swaps.
• Benefits to the counterparty
• Deals that dont work otherwise can happen.
• Lower debt service sells better than anything
  else.
• The Swap Counterparty typically will make a
  larger spread on a transaction involving a swap
• Swaps create the opportunity to do follow up
  business. They are easily restructured, extended
  or canceled. Its vital to note that for an
  issuer who is paying fixed on a swap that if
  rates decline, it will cost money to get out.
  Restructuring a swap does not require an OS,
  underwriters counsel or an election.

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Example Traditional Fixed Rate Bond Scenario
Scale from on 10/30/2007 (Insured MMD
0.20) Resulting TIC 4.43 Resulting AIC
4.52
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Example 70 of LIBOR Swap Structure with Fixed
Rate Bonds
Scale from 10/30/2007 (Insured MMD 0.20)
Swap rates from the morning of 10/30/2007. Swap
Rate includes 0.10 in additional spread to the
ask swap rate. Sell Fixed Rate Bonds when they
result in lower debt service and swap later
maturities to fixed to gain efficiency Resulting
TIC 4.18 Resulting AIC 4.27 Debt Service
Reduction 5,844,687.50 actual debt service
reduction will be affected by the reset
percentage of BMA and LIBOR. See the following
page for additional analysis.
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70 of LIBOR Swap Structure with Fixed Rate Bonds
Basis Risk Analysis The table illustrates the
impact of a change in the relationship of BMA and
70 of LIBOR on the annual debt service of the
bond issue.
This matrix assumes a constant LIBOR rate of
5.00 over the life of the bond issue.
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Assisting with Interest Rate Swaps

• Putting your first interest rate swap can be a
  significant undertaking. Stephens provides the
  expertise to streamline this procedure

• Understand Issuers strategic and financial
  objectives.

• Receive management and board approval.

• Execute telephonically, with signed confirmation
  to follow.

1. Client Focus
2. Educate
3. Approve
4. Document (one time)
5. Execute

• Negotiate and sign the Master Agreement that will
  governs all future derivative transactions.

• Educate Issuer about proposed strategies.

• The Financial Products Group is currently
  assisting mutual funds, corporate clients, banks
  and municipalities with the use of interest rate
  swaps.

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Ways to Lower Cost Of Funds Basic Refunding
Concepts

• A refunding is an issue, the proceeds of which
  are used to pay all or a portion of the
  principal, interest and/or redemption price of a
  prior issue.
• Usually, the proceeds of the refunding issue are
  deposited to an escrow and used to buy securities
  to pay the defeasance requirements of the prior
  bonds
• Refund (escrow) to maturity
• Refund (escrow) to call first call, if
  refunding generates savings
• Economic and/or Legal Defeasance
• Partial versus Full Refunding

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Ways to Lower Cost Of Funds Basic Refunding
Concepts

• The three types of refundings are
• Current Refunding the old bonds are called or
  mature within 90 days of the issuance of the new
  refunding bonds.
• Advance Refunding the old bonds are callable
  or mature more than 90 days after the issuance of
  the new bonds.
• No limit on number of current refundings
• May advance refund bonds issued after 1/1/86 once
• May advance refund bonds issued before 1/1/86
  twice
• Bonds refunded prior to 3/14/86 may be advance
  refunded once more
• Forward Refunding the new bonds are to be
  issued at a later date, generally, 90 days before
  the first call date and less than one year in the
  future

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Ways to Lower Cost Of Funds Basic Refunding
Concepts

• Refunding to Maturity may be used to defease
  bonds that cannot be refunded for savings. The
  loss will equal the cost of issuance
• Refunding to First Call is required if
  refunding produces PV savings
• Premium Callable Bonds must be priced (for arb
  yield purposes) to the first call date, which
  reduces savings on refundings
• Non-Refundable Bonds private activity (AMT)
  bonds are generally not advance refundable or may
  be limited to
• Par to Par Refunding may be required for AMT
  and other refundings, requiring the issuer to
  contribute the cost of issuance

I
P
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Construction Fund and Capitalized Interest

• Construction Fund - Bonds should finance no more
  than two years of expected Construction/Project
  costs
• Gross Funding vs. Net Funding
• Two Year Spend-down Rules
• Three Year Temporary Period
• Capitalized Interest Fund Proceeds of a bond
  issue may be deposited into a Capitalized
  Interest Fund to finance the interest payment on
  the Bonds during the construction period.

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Debt Service Reserve Fund

• Provides Short-Term Liquidity and Credit
  enhancement
• Limited to depositing 10 of Bond Proceeds into a
  Debt Service Reserve Fund
• Generally sized to the Reasonably Required
  Reserve and Replacement Level which is the
  lesser of a three-prong test
• 10 par
• 125 average annual debt service on the Bonds
• maximum annual debt service

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Present Value Concepts

• The opportunity cost of delayed receipts is
  called the Time Value of Money and is a
  reflection of our impatience (earnings potential,
  foregone utility, etc)
• The opportunity cost of receiving the 1 in the
  future is the foregone interest that could be
  earned were 1 received today
• The Present Value (PV) of an amount received in
  the future is the amount that would have to be
  invested today at the prevailing investment rate
  to generate the given future value
• The use of Present Values takes the Time Value of
  Money into account and allows you to compare cash
  flows received and/or paid in different periods

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Types of Bonds

• Variable Rate Bonds (VRDBs) bonds whose
  interest rates change at specified intervals over
• the life of the issue. These bonds may have an
  interest rate floor and/or a cap that provide
  some
• limits for interest.

0
Fixed Rate Bonds - bonds whose interest rates
remain constant over the life of the issue.
These rates are determined on the date the bonds
are priced.
Principal
10mm
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
494K
0
Principal 10 million Interest 4.94 (20yr
rate (or 494k/yr) Price 100.00 Yield 4.94
Maturity
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Optional Redemption Provisions

• An optional redemption (or call) allows the
  issuer to redeem bonds usually on a certain,
  earliest possible date after the date of issue.
  A series of call dates are specified for a period
  after this first call date. If the bonds are to
  be called on the first call date at a premium to
  par, bonds called on subsequent call dates will
  generally be redeemed at descending prices. For
  example

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Principal Amortization Types
Level Debt Service
Level Principal
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Principal Amortization Types
Deferred Debt Service
Accelerated Debt Service
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Principal Amortization Types
Uniform Debt Service fixed dollar margin
Proportional Debt Service fixed percentage
margin
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Asset Evaluation

• For each of an issuers funds, determine the
  purpose, the term, and what the fund is invested
  in.
• Isolate funds that would apply to Asset-Liability
  Management
• Funds that are unrestricted and invested for
  short terms
• Assets that should be evaluated in an
  Asset-Liability context
• The short, unrestricted assets cannot be shifted
  to long term investments, therefore we seek to
  eliminate budget uncertainty by creating an
  Asset-Liability Match by adjusting the
  liabilities.

Unrestricted, Short Term Assets
Core Balance
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Relative Pricing Issuers Goals
An issuer must recognize the markets opposing
forces

• Issuers Goals
• Sell Bonds at Lowest Interest Rate
• Given Current Market Conditions
• Compared to Bonds from Similar Issuers of Like
  Maturity
• Retain Maximum Flexibility For Future
• Call Features - Short
• Additional Bonds Test - Easy
• Permitted Investments - Anything
• Revenue Coverage - Minimal
• Pledged Security - Minimum
• Pay Minimum Fees

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Relative Pricing Investors Goals
An issuer must recognize the markets opposing
forces

• Investor's Goals
• Buy Bonds at Highest Interest Rate/Lowest Price
• Given Current Market Conditions
• Compared to Bonds from Similar Issuers of Like
  Maturity
• Restrict the Issuers Ability to Change the Terms
  of the Borrowing in the Future
• Call Features - Long
• Additional Bonds Test - Difficult
• Permitted Investments - Limited
• Revenue Coverage - Maximum
• Pledged Security - Maximum
• Pay Minimum Fees

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Municipal Bond Buyers
State, Regional, National Retail
Institutions and Retail Buyers Purchase Bonds
from Underwriter
Bank Trust Departments
Money Managers
Property Casualty Insurers
Bond Funds UITs
0
5
10
15
20
25
30
Maturities in Years
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Bond Market Transparency

• The MSRB now requires all Municipal Bond trades
  to be reported as they occur to The Bond Market
  Association for inclusion in their Real-time
  Transaction Reporting System

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Current Market Conditions
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How do Institutional Investors Evaluate the Muni
Market? Relative Value
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How do Institutional Investors Evaluate the Muni
Market? Relative Value
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How do Institutional Investors Evaluate the Muni
Market? Relative Value
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Forward Premiums are LOW