Authored by Tom Kaleko and Anton Voinov

Municipal borrowing rates have declined significantly over the past several weeks as all debt markets have traded higher, driven by increased uncertainty about future domestic and global economic growth. Domestically, many market observers are starting to wonder if the longest expansion in U.S. history is losing steam and what will be the long-term economic effects of certain policy measures, such as the ongoing trade conflict with China. Internationally, uncertainty surrounding Brexit negotiations, as well as stagnating growth in European and Asian markets, is adding to economic worries. 

Accordingly, the Federal Reserve Board (Fed) lowered its target benchmark rate another 25 basis points recently, further marking the end of a multiyear tightening cycle and reversing previous predictions for multiple rate increases in 2019.

Ongoing economic concerns have been reflected by significant declines in long-term borrowing rates, as investors scale back their outlook for long-term growth. We see this in the U.S. Treasury yield curve, which is now partially inverted. Additionally,

• As of Sept. 16, 2019, the five year Treasury rate is the lowest point on the curve at 1.69 percent.
• The one year and 30 year Treasury rates are only separated by 45 basis points. 
• Municipal yields, while not inverted, have declined significantly since the beginning of the year. 
• As of Sept 16, the 30 year AAA MMD rate stands at 2.16 percent, only 86 basis points above the one year rate. 
• Looking at the MMD/Treasury ratio, the current ratio range of approximately 60-90 percent is closer to historical averages and generally lower than has been the case over much of the past several years.

The charts below present the recent movement of tax-exempt and taxable rates at different parts of the curve, as well as the evolution of the MMD/Treasury ratio over the same time period.

If the 2017 Tax Cuts and Jobs Act had not eliminated advanced refundings, today’s rate environment would stimulate a significant boost in advance refunding transaction volume, with issuers taking action to refinance outstanding debt at lower rates. However, since advance refundings are no longer available, underwriters are aggressively pursuing alternative refunding structures, including:

• Taxable advance refundings
• Forward delivery refundings
• “Cinderella bonds” which begin as taxable debt and convert to tax-exempt
• Cash defeasance with subsequent replacement of spent monies with new debt

As you evaluate refunding proposals, we urge careful consideration of the pros and cons of each refunding approach. By definition, the first three approaches are more costly than traditional tax-exempt debt. It is helpful to keep the following questions in mind:

• How much is the negative arbitrage? In an advance refunding, bond proceeds will be placed in an escrow and invested to the call date at a rate lower than the bond yield. You can think of negative arbitrage as an additional cost of the transaction. Of course, this cost can be avoided by waiting to refund at the optional call date. A good way to evaluate the negative arbitrage cost is to calculate how much interest rates would have to increase prior to the optional call date to erode savings equal to the negative arbitrage cost.
• What is the interest cost savings as both a net present value of the refunded debt service and in absolute dollars? The Government Finance Officers Association’s best practice recommends a minimum 3 percent of refunded debt service savings for advance refundings. A comparison of the absolute dollar savings to the cost of the transaction can often be instructive. 
• It is also important to consider the true purpose of undertaking the refunding, how the anticipated debt service savings will be used and the level of interest rate risk and the associated time horizon you are willing to accept. 

As mentioned earlier, all alternative refunding structures, with the exception of cash defeasance, are more costly than tax-exempt borrowing. So the key rationale for undertaking one of these refunding approaches should be either the need to secure debt service savings prior to the call date of the bonds, or a strong belief that the current rate environment will soon deteriorate. 

We recognize many local governments are working through tough budgets and welcome cost saving measures. That said, given the current economic outlook and reasonable likelihood of further Fed loosening action, we urge abundant caution and forward thinking when evaluating the breakeven analytics between undertaking an alternative refunding today versus waiting to refinance debt through a current refunding.

Baker Tilly Municipal Advisors welcomes the opportunity to discuss your refunding alternatives to determine the true viability of a refunding for interest cost savings or other related objectives from debt restructuring.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.