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Investing Bond Proceeds

April 20, 2004

Lester T. WoodManaging DirectorBond Logistix, LLC

Lauren BrantSenior Managing ConsultantPFM Asset Management LLC

California Municipal Treasurer’s Association

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Noticing the Obvious

FINISHED FILES ARE THE RE-SULT OF YEARS OF SCIENTIF-IC STUDY COMBINED WITH THE EXPERIENCE OF MANY YEARS

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Investing Bond Proceeds •Financial Requirement

•P & I Payments

•Earning Assets

•Debt Service

•Reduce Borrowing Costs

•BondProceeds

•Use ofEarnings

•Objective

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Overview•Who’s Involved in the Decision Making Process?

•Arbitrage Considerations.

•Fun with Funds!

•Mixing and Matching Investments.

•Case Study.

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Who’s Involved?

Public Agency Consultants

Finance Director Trustee

Treasurer Underwriter

Mayor Financial Advisor

City Manager Investment Advisor

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Arbitrage Considerations• What is arbitrage?

• Exceptions, Exemptions, Elections

• How does arbitrage factor into the investment strategy for my bonds?

• How will I keep track of the arbitrage of my bond issue?

• Planning Ahead

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What is Arbitrage?

Bond Yield(tax-exempt)

Investment Yield (taxable)

4.0

5.0

6.0

7.0

8.0

9.0

1993 1994 1995 1996 1997 1998

Positive Arbitrage

Negative Arbitrage

Yie

ld

• 100% tax on earnings in excess of bond yield

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Loopholes

• Exceptions

─ Project fund spending

• Exemptions

─ Small issuer

• Elections

─ Penalty in lieu of rebate

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Investment Strategy• Factors to consider prior to issuance:

─ IRS regulations─ Marketplace vs. arbitrage yield─ Interest rate trends

• Ongoing strategy considerations:─ Arbitrage is cumulative from day one,

across all funds

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Netting Effect

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How do I Keep Track?Transaction Transaction Transaction Future Value Future Value

Date Days Type Amount Factor Cash Flow--------------- -------------------------- --------------------- ------------------ -----------------------

5/12/98 1800 Deposit 236,491,000.00 1.29199835 305,545,981.15 5/12/98 1800 Withdrawal (39,947,000.00) 1.29199835 (51,611,457.98)6/30/98 1752 Withdrawal (25,949,000.00) 1.28320184 (33,297,804.46)9/30/98 1662 Withdrawal (14,175,000.00) 1.26686948 (17,957,874.92)

12/31/98 1572 Withdrawal (20,475,000.00) 1.25074500 (25,609,003.95)3/31/99 1482 Withdrawal (20,100,000.00) 1.23482575 (24,819,997.66)6/30/99 1392 Withdrawal (19,050,000.00) 1.21910912 (23,224,028.78)9/30/99 1302 Withdrawal (19,050,000.00) 1.20359253 (22,928,437.66)

12/31/99 1212 Withdrawal (19,600,000.00) 1.18827343 (23,290,159.16)3/31/00 1122 Withdrawal (20,650,000.00) 1.17314930 (24,225,533.12)6/30/00 1032 Withdrawal (19,600,000.00) 1.15821768 (22,701,066.49)9/30/00 942 Withdrawal (12,200,000.00) 1.14347610 (13,950,408.41)

12/31/00 852 Withdrawal (5,150,000.00) 1.12892215 (5,813,949.06)3/31/01 762 Withdrawal (1,000,000.00) 1.11455344 (1,114,553.44)

--------------- -------------------------- --------------------- ------------------ -----------------------15,001,706.05

Calculation Date 5/12/03Days Since Inception 1800

Arbitrage Yield 5.190000%Future Value at Earnings of 5.19% $15,001,706.05Future Value at Earnings of 5.60% $16,486,923.58

Arbitrage Rebate Liability 5/12/03 $1,485,217.53

Earnings Yield 5.600000%

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Planning Ahead At Issuance• Calendar of Important Dates

– Expenditure benchmarks– Yield restriction– 5-year payment date– Filing

• Data Collection– Segregated funds

• Refunding issues– Transferred proceeds

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Fun with Funds!

• Project (Acquisition/Construction)–Match to Draw Schedule

• Debt Service Reserve– Covenant to Maintain Fixed Amount– Semi-Annual Availability

• Capitalized Interest

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Fun with Funds!

• Debt Service Principal & Interest

–Capitalized Interest–Cash Flow Thereafter

• Escrows

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Surety Bonds or L.O.C.

• Insurance with Recourse

• Replace Cash Funded DSR

– Debt Cap Problem at Time of Issuance

– Over Budget on Project Costs After Issuance

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Cost of Surety or L.O.C.

• Premium Cost

• Lost Ability to Earn Positive

• Current/expected arbitrage position

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Mixing & Matching Investments• Typical bond proceeds investments:

─ Liquidity Pools

─ Structured Portfolios

─ Investment Agreements

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Considerations• Liquidity requirements

• Yield objectives (arbitrage yield vs. market)

• Purpose of funds

• Agency’s tolerance for risk

• Bond document investment language (boilerplate)

• Net/Gross funding for construction fund

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Liquidity Pools

• Money market funds• County pool• Local Agency Investment Fund (LAIF)• Joint powers authority

Features

• Liquidity within restrictions of investments

• Ease in administration

Issues to consider

• Variable investment rate

• No customization to draws

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Structured Portfolios Features

• Customized investment strategy

– Portfolio initially structured to match expected draw schedule

• Active trading can improve yield

• Portfolio restructured as draw schedule changes and to adjust for market changes

• Ability to lock in higher yield on longer-term funds

Issues to consider

• Can be time consuming to monitor and manage

• Slightly higher transaction costs may be incurred

• Mark-to-market risk for Reserve Fund

• Reduced liquidity

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Investment Agreements

• Guaranteed Rate

• Withdrawals at Par

• Shift Reinvestment and Market Rate Risks to Provider

• Issuer Assumes Credit Risk on IAs

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Investment Agreement Providers

• Banks

• Primary Dealers

• Private Placements • Insurance Companies

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Investment Agreements

• Standard With Collateral Downgrade

• Collateralized

• Puts

• Forward Delivery

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Uses of Investment Agreements

• Construction / AcquisitionFull flex draws

• Debt Service ReservesSemi-annual draw

• Debt Service Float Monthly window

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Conclusion1. Consider the risks/rewards of all options.

2. Develop an investment strategy for all proceeds prior to issuance.

3. Revisit each fund’s strategy on a frequent basis.

By doing these things, you increase your chances of reducing your borrowing costs.