Authored by Tom Kaleko and Anton Voinov

Municipal borrowing rates have remained relatively constant over the past several weeks. There has been a bit of a divergence in the tax-exempt and taxable markets, as short-term tax-exempt rates have remained relatively constant, hovering just above the 1% mark, while longer-term rates have increased by approximately 20 basis points since early September.  In the same time period, Taxable rates have pivoted around the 5-year mark, as two subsequent Fed rate cuts forced the shortest part of the curve down, while longer-term rates (10 years and beyond have increased by around 30 basis points.  Aside from Fed action, recent indications of a potential US-China trade deal, as well as a very favorable jobs report, have signaled that imminent recession fears from earlier this year may have been somewhat premature. At the same time, continued uncertainty surrounding Brexit negotiations, the upheaval in Hong Kong, as well as stagnating growth in European and Asian markets, continue to damper the positive market tone. 

While the Fed lowered its target benchmark rate by a total of 75 basis points this year through three separate actions, current market predictions contemplate only one additional rate cut in late 2020, signifying a relatively stable view of current economic conditions.

Recent favorable economic news have reversed the trends seen in late summer/early fall 2019. That, combined was recent Fed action has resulted in a U.S. Treasury yield curve is no longer inverted and both the Treasury and the AAA MMD curves are steeper, with long-term rates somewhat higher. Specifically,

• As of Dec. 6, 2019, the one month Treasury rate is the lowest point on the curve at 1.52 percent, with all other points on the curve higher.
• The one year and 30 year Treasury rates are separated by 77 basis points – more than double the spread from three months ago. 
• The 10 year Treasury rate is currently 1.84 percent, up from the 2019 low of 1.47 percent that it hit most recently in early September.
• As of Dec. 6, the 30 year AAA MMD rate stands at 2.07 percent, 101 basis points above the one year rate (up 16 basis points from two months ago). 
• 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 stable economic outlook, 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 in the near future.

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.