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© PFM 1
Bond Proceeds Investment Strategies & Arbitrage Considerations2017 CDFA Advanced Bond Finance WebCourse
PFM Asset Management LLC
One Keystone PlazaSuite 300Harrisburg, PA 17101
717.232.2723pfm.com
Michael Steinbrook and Gray LepleyPresented By:
September 2017
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Treasury Yield Curve – Identifying Value and Managing Risk
Source: Bloomberg. Rates as of September 14, 2017.
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Investment of Various Accounts in Normal Yield Curve Environment
Source: Bloomberg. Rates as of September 14, 2017. See important disclosures at the end of this presentation.
Debt Service Reserve Account
Advance Refunding Escrow
Current Refunding Escrow & Debt Service Fund
Construction Fund & Capitalized Interest Fund
Subject to Arb Rebate
Subject To Yield Restriction
No Rebate Restrictions
Potentially No Rebate Restrictions
Equity Funds
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
September 14, 2017March 14, 2017September 14, 2016
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Developing an Appropriate Investment Strategy
Monitoring and Reporting
State Law and Regulations
Bond Covenants
Objectives and Liquidity Needs
Current Market Conditions
Arbitrage Rebate
Compliance
Investment Strategy
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Active Management vs. Passive Strategies
Active Management
Ideal for funds with expansive permitted investments and/or uncertain liquidity needs
• Advisor goal: generate incremental earnings via swapping amongst individual CUSIPs, sectors, and duration buckets to attempt to offset advisory fees
• Enhanced ability to take advantage of benefit from near-constant duration exposure
Passive Strategies
Ideal for funds with conservative, straightforward permitted investments and predictable liquidity needs
• One-time engagements with subsequent opportunities to restructure in the future
• May require significant change to market conditions and/or cash flow requirements for restructurings to add value
A C T I V E M A N A G E M E N T
P A S S I V E S T R AT E G I E S
Real-time monitoring of holdings through time Periodic/ad-hoc monitoring
More frequent trades to manage duration and/or
liquidity
Wholesale restructurings to rebalance to target
Greater ability to take advantage of short-term securities mispricings
No ability to take advantage of short-term opportunities
Enhanced ability to add incremental net value
May require substantial changes in market conditions
to add value
Advisor has fiduciary responsibility
No fiduciary responsibility once portfolio is structured
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Sample Permitted Investments
Money market/short-term investments
• Local Government Investment Pools (LGIPs)
• Overnight repurchase agreements
Open-market securities
• U.S. Treasuries and direct obligations (examples: Treasury Bills, Treasury Notes)
• Federal Agency securities (examples: Fannie Mae, Freddie Mac)
• Commercial paper (examples: General Electric Capital Corp., Toyota)
Structured investments
• Guaranteed investment contracts (GICs)
• Flexible repurchase agreements (Flex Repos)
• Forward delivery agreements (FDAs)
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Sample Project Fund Analysis
Observations
Active management provides flexibility to react to changes in market conditions and deviations from draw schedule
Strives to add incremental value through sector swaps and duration management
For illustrative purposes only.
-
10,000,000
20,000,000
30,000,000
40,000,000
50,000,000
May-17 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18
S T R A T E G Y *initial weightedG R O S S Y I E L D
*estimated grossE A R N I N G S
Actively managed portfolioTreasuries and Federal Agencies 0.99% $1,848,000
Actively managed portfolioTreasuries, Federal Agencies, CP 1.02% $1,917,000
Preliminary Draw Schedule
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Project Fund Sample Portfolio
Portfolio Statistics
Please see important disclosures at the end of this presentation. For illustrative purposes only.
Sector Allocation Snapshot
Strategy Overview• Seek to structure portfolio and strategy in line with scheduled
project draws with additional liquidity built-in to portfolio to account for unanticipated draws or project accelerations
• Commercial paper and Federal Agencies selectively targeted to steeper portions of the yield curve
• Treasuries/Agencies can be swapped into commercial paper as longer-dated securities roll down the curve
• Does not take into account benefit from future rolling commercial paper purchases, which may be significant
Portfolio Cash Flows vs. Draws
Invested Amount $322MM
Portfolio Duration 0.55 years
Average Gross Yield* 1.02%
Average Credit Quality AA-/Aa3
Gross Earnings (Proj.) $1.92MM
0
25,000,000
50,000,000
75,000,000
100,000,000
125,000,000
150,000,000
175,000,000
Under 6m 6m to 1Y 1Y to 1.5Y 1.5Y to 2Y
Portfolio Cash FlowsPortfolio Draws
Federal Agencies27%
CP24%
Treasuries36%
Money Market13%
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Sample Reinvestment Vehicles
*For illustrative purposes only. See important disclosures at the end of this presentation.
V E H I C L E *initial weightedG R O S S Y I E L D R I S K S other
C O N S I D E R A T I O N S
Money market fund 0.80% Reinvestment Flexibility to extend duration
Portfolio:Treasuries, Federal Agencies 0.99%
CreditInterest rateReinvestment
Portfolio:Treasuries, Federal Agencies, commercial paper
1.06%CreditInterest rateReinvestment
Structured investment(to maturity) 1.31% Credit
Bankruptcy Safe Harbor issues
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Comparison of Operating and Reserve Funds
Operating Funds Reserve Funds
Security for BondholdersCash-on-Hand
Absolute(Avoid negative returns)
Market, Credit, andReplenishment
Dynamic(Unconstrained)
Investment PolicyLiquidity NeedsValuation Methodology
Relative(Beat the benchmark)
Market, Credit, andTracking Error
Relatively Static(Percentage of benchmark)
Investment PolicyLiquidity Needs
return target
measures of risk
duration target
constraints
purpose
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Sample Breakeven Analysis
Rates as of September 1, 2017.
5 years
2 years 3 years
1.72%
1.32% 1.99%
5 - Y E A R I N I T I A L I N V E S T M E N T V S . 2 - Y E A R I N T E R I M W I T H 3 - Y E A R B R E A K E V E N
-
500,000
1,000,000
1,500,000
2,000,000
2,500,000
0 1 2 3 4 5
Net
Inte
rest
Ear
ning
s
Investment Horizon, Years
5-year Investment2-year Interim3-year Breakeven
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Sensitivity Analysis
Important to evaluate the impact of interest rate changes and attempt to mitigate interest rate risk
• The target duration is developed to protect the portfolio against the impact of rising rates while seeking higher yields available from longer maturities
Short time to valuation date warrants conservative duration positioning with extension trades once the valuation occurs
*As of September 1, 2017, and subject to change.
2 - Y E A R T R E A S U R YY I E L D O F 1 . 3 1 6 % / D U R A T I O N O F 1 . 9 6 *
change inI N T E R E S T R A T E S
M A R K E TV A L U E
change inM A R K E T V A L U E
-1.00% $10,198,484 $198,484
-0.50% $10,098,627 $98,627
0.00% $10,000,000 $0.00
0.50% $9,902,584 -$97,416
1.00% $9,806,360 -$193,640
1 0 - Y E A R T R E A S U R YY I E L D O F 2 . 1 1 9 % / D U R A T I O N O F 8 . 9 6 *
change inI N T E R E S T R A T E S
M A R K E TV A L U E
change inM A R K E T V A L U E
-1.00% $10,933,668 $933,668
-0.50% $10,455,148 $445,148
0.00% $10,000,000 $0.00
0.50% $9,567,011 -$432,989
1.00% $9,155,034 -$844,966
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Tax Considerations Timeline Arbitrage rebate requirements apply to every tax-exempt borrowing and certain taxable subsidy
obligations
Compliance begins with pre-issuance planning and continues with post-issuance policies and procedures (does it ever end…)
Pre-Issuance• Timing• Project Draw Schedule• Evaluate available exceptions and elections• Identify investment options
Issuance• Invest bond proceeds• Purchase securities, establish FMV• Revise draw schedule• Make elections in Tax Certificate
Post-Issuance
• Arbitrage reporting• Record retention• Private business use• Continuing disclosure
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What is Arbitrage?
IRS limits earnings on the investment of tax-exempt bond proceeds• Earnings limited to the bond yield unless exceptions apply. Excess earnings rebated to the IRS.
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Arbitrage Liability Example
Arbitrage is measured issue-by-issue in aggregate and over time
For each bond issue, all funds subject to arbitrage are blended together
Negative arbitrage in a fund can be used to offset positive arbitrage in other funds
($100)
($50)
($5)
($50)
$150
($55)
($150)
($100)
($50)
$0
$50
$100
$150
$200
Project Fund
Cap Int. Fund
Costs ofIssuance
Fund
Escrow Fund
Debt ServiceReserve
Fund
ArbitrageRebate Liability
Posi
tive
(Neg
ativ
e) A
rbitr
age
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What is Yield Restriction?
Like rebate, restriction against investing above the arbitrage yield
Only applies to proceeds that are subject to yield restriction
Arbitrage rebate liability and yield restriction liability are computed separately, cannot blend
Exceptions apply
Temporary periods
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Impact – Waiving 3-year Temporary Period
No waiver of temporary period =
• No rebate liability at year 5
• Yield Restriction Liability at year 5
• Pay IRS excess interest earned in years 4 and 5
Waiver of temporary period =
• No rebate liability at year 5
• No yield restriction liability at year 5
• Keep excess interest earned in years 4 and 5
Applies toYield Restriction
Only
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Valuation of Investments
Value of investments determined one of three ways:
1. Plain Par
• Investment originally purchased at a price between 98 and 102
• Valued at par (100) plus accrued interest
2. Present Value (fixed rate investment)
• Accreted value based on original YTM, plus accrued interest
3. Fair Market Value (any investment)
• Utilize a pricing source (Bloomberg, IDC, bank/trustee, etc.)
• FMV price plus accrued interest
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Investment Valuation – Example
Debt Service Reserve Fund• Bonds issued on 8/31/2012
• Arbitrage yield – 3.50%
• DSRF deposit of $1,020,000
• DSRF invested in $1M of 3.50% coupon U.S. T-Notes due 8/15/2022
• Purchase price @ 101-24 (101.75) / 3.29% Yield on 8/31/2012
• 1st 5th-Year Rebate Calculation Date – 8/31/2017
• Fair Market Value Yield of U.S. T-Notes on 8/31/2017 – 1.80%
Note – issuers may also have an annual fair market value requirement for financial reporting purposes and/or for DSRF sizing
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Investment Valuation – Example – Results
Different approaches may yield significantly different results
Select the approach that minimizes liabilities and that is reasonable and consistently applied
May use different methods for different investments
May use a different method for the same investment on different dates
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Allocation of Proceeds to Expenditures
Question:With borrowing rates still low, should you sell more bonds today for longer dated projects, or sell multiple tranches that better line up with expected project draw schedules?
Permitted to use any reasonable, consistently applied accounting method to account for gross proceeds, investments, and expenditures of an issue.
Commingled Funds - allowable methods include:
• Specific tracing method
• Gross proceeds spent first method
• First-in, first-out method (FIFO)
• Ratable allocation method
IRS is focused on issuers
spending bond proceeds
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Refunding Impacts
May accelerate final maturity of the issue and final rebate calculation
Possible loss of temporary period on the bonds being refunded
Escrow yield cannot exceed the bond yield by more than 1/1000th of 1%
May create Transferred Proceeds – when remaining proceeds of the prior issue become proceeds of the new Refunding Bonds
Series 2007(Refunded Bonds)
Bond Yield = 4.00%
Series 2017(Refunding Bonds)
Bond Yield = 2.00%Unspent Proceeds
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IRS and Compliance Considerations
IRS• Education Outreach• Audits and Examinations• VCAP – Voluntary Compliance Agreement Program• Treasury Regulations (new Issue Price Rules)
Post-Issuance Compliance• Effective policies and procedures• Arbitrage rebate monitoring and reporting• Private business use monitoring• Record retention• Continuing disclosure
Transparency
EffectivenessEfficiency
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Disclaimers
Investment Advisory Services
PFM is the marketing name for a group of affiliated companies providing a range of services. All services are provided through separate agreements with each company. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation.
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