With the termination of tax-exempt advance refunding bonds squarely in the crosshairs of the tax reform measures making their way through both houses of Congress,1 the municipal market needs to consider the impact of the loss of this refinancing tool on the ability of state and local governments to manage their capital costs for infrastructure and other public projects.2 Issuers would be faced with two sets of considerations:
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for their existing outstanding bonds, what options will they have if they seek to refinance prior to the bonds’ first call date?
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for their new issues in the future, what structural changes should they consider to address the inability to advance refund such issues on a tax-exempt basis?
In both cases, municipal derivatives – which have faded to the deep background in the years since the financial crisis but left some issuers to contend with their aftermath even today – are likely to figure prominently among the potential solutions.
Refinancing Alternatives for Outstanding Bonds
If outstanding bonds can no longer be refinanced on a tax-exempt basis with advance refunding bonds on or after January 1, 2018, issuers could instead issue taxable refunding debt, assuming that sufficient savings exist in spite of the higher taxable rates on the refunding debt. Alternatively, issuers could wait until 90 days prior to the first redemption date of the outstanding bonds to issue tax-exempt current refunding bonds, which would still be permitted under the tax reform changes and could provide savings from the point of such current refunding; however, the issuer would not realize the potential savings that could have otherwise accrued before the current refunding date. Issuers also could consider executing a forward refunding, where the issuer contracts with the underwriter in advance to issue current refunding bonds at pre-determined tax-exempt rates within the 90 days prior to the outstanding bonds’ first call date, assuming the risk premium (e.g. higher interest rate) on such locked-in rates would allow sufficient savings to the issuer.
Synthetic Advance Refundings and Municipal Derivatives
Issuers should expect to see the reemergence in the municipal market of synthetic refundings as a potential replacement for advance refundings, particularly for bonds issued prior January 1, 2018. While structures can vary, in a synthetic refunding, an issuer might enter into an interest rate swap (such as a floating-to-fixed rate swap) that would become effective at a future date (coinciding with when the issuer would be able to undertake a current refunding of the bonds) at a locked-in fixed rate, or might enter into a so-called swaption, that would provide the counterparty with the option to execute an interest rate swap in the future.3 Typically, the synthetic advance refunding would be completed with the issuance in the future of variable rate current refunding bonds, which together with the swap would create for the issuer a synthetic fixed rate. These and other similar structures can allow the issuer to achieve some of the refinancing value normally available through an advance refunding, although entailing increased complexity and risks as well as reintroducing the need for liquidity facilities that have become scarce in the current market.
The federal financial regulators expressed considerable concerns regarding the use of derivatives in the municipal securities market prior to and during the financial crisis. As a result, in 2010 the Dodd-Frank Act established a comprehensive structure for regulation of derivatives activities by the Commodity Futures Trading Commission (CFTC), creating a significantly different regulatory environment today as compared to before the financial crisis, including new business conduct rules that swap counterparties must comply with when engaging in swaps with public entities. In addition, these concerns regarding municipal derivatives in part drove the creation of the municipal advisor regulatory regime to address questions regarding the quality and impartiality of advice issuers had received on their new issue and derivatives activities. The derivatives regulatory structure under the CFTC and the municipal advisor regulatory structure under the Securities and Exchange Commission (SEC) and Municipal Securities Rulemaking Board (MSRB) overlap in some respects and engender uncertainties as to how the two regulatory regimes will interact with each other and impact transaction participants in the municipal securities market. The reemergence of municipal derivatives will test the effectiveness of the safeguards that Congress intended to create in the Dodd-Frank Act.
Structural Alternatives for Future Bonds
As state and local governments begin to prepare for the issuance of new bond offerings in 2018, they will need to consider whether and how to preserve the ability to achieve the types of interest cost savings previously made available by advance refundings. For example, the traditional 10-year no-call period used by much of the non-bank qualified municipal securities market – which effectively drives the current use of advance refundings – could be significantly shortened or dispensed with altogether to allow an earlier current refunding, although this may result in higher interest costs. Other issuers may opt to use variable rate debt that, under most structures, allow the issuer to borrow at short-term rates and provides the issuer with an opportunity to redeem the debt much more easily, but also normally provides bondholders with the option to require the issuer to repurchase bonds put back to the issuer. Issuers seeking to lock-in a fixed rate while achieving the flexibility provided by variable rate debt, or otherwise looking to hedge their interest rate exposure, might consider returning to the practice of entering into interest rate swaps in connection with their variable rate debt issuances. As with synthetic refundings, the reemergence of swaps in this context would reintroduce increased complexity and risk and would occur in a dramatically changed regulatory environment.
Broader Implications of Tax Reform on the Municipal Bond Market
While advance refundings face the darkest prospects under the Congressional tax reform bills because they are targeted by both chambers, the House bill also would terminate the issuance of private activity bonds, tax credit bonds, and bonds for professional stadiums.4 Twenty-one Republican members of the Congressional Municipal Finance Caucus have mounted a last-ditch effort to convince their colleagues to remove the elimination of advance refundings and private activity bonds from the final tax reform legislation, with the effectiveness of this effort to be played out in the coming hours.5 Because the Senate and House bills differ on the three additional categories of bonds, these categories have a greater potential for surviving tax reform since differences between the two versions would need to be negotiated in conference between the House and Senate conferees. Further, given the narrow Republican margin in the Senate and the difficulty that the Majority Leader has had in marshalling 50 votes on major initiatives, it is conceivable that the House would simply pass the Senate version to avoid the necessity of a second vote in the Senate on a conference bill, resulting in the preservation of these three additional categories of bonds while eliminating advance refundings.
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State and local governmental issuers and other obligors should be ready to incorporate into their capital and budget planning the impact of the significant changes that tax reform may be on the verge of introducing into government debt management programs.
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1 As of the date of this alert, the House has passed its version of tax reform while Senate approval of its version remains pending. See Clark Hill PLC Client Alert, "House and Senate Tax Reform Bills Agree on Ending Municipal Bond Advance Refundings," November 10, 2017.
2 Advance refunding bonds consist of new bonds issued by an issuer more than 90 days before its existing bonds may be redeemed or mature, with the new bond proceeds held in escrow to repay the existing bonds. While refinancing higher interest outstanding debt with lower interest new debt to achieve savings is the primary driver of most advance refundings, advance refundings also are sometimes undertaken to facilitate contractual changes in the underlying bond documents or in connection with mergers or reorganization of the issuer or other obligor.
3 In the past, some issuers used up-front payments in these structures as a means of dealing with short-term budgetary shortfalls but found themselves facing potentially large termination payments or retaining unhedged exposures many years later.
4 See Clark Hill PLC Client Alert, "Tax Reform Takes Aim at the Municipal Securities Market," November 6, 2017.
5 See the November 28, 2017 Letter.
