Permitted Investments

Introduction

Tax-exempt bond proceeds are often available for investment prior to being disbursed.  Since investment earnings are a direct offset to financing costs, designing and implementing an investment strategy that maximizes earnings within appropriate safety, liquidity, and federal tax law constraints is an important component of minimizing overall borrowing costs.

Permitted Investments Language

Drafting the permitted investments section of a bond resolution or indenture presents an opportunity to focus on appropriate investments for the tax-exempt bond proceeds.  It is not uncommon for bond counsel to provide a first draft of permitted investments language that was used in a prior financing and that may not be well suited to the current financing.  Since bond counsel will have no role in investing funds, one or more appropriately skilled financing team members should assume responsibility for refining the permitted investments provisions.

Investing Tax-Exempt Bond Proceeds

Options to invest bond proceeds generally include (but are not limited to) the following:

A. Individual Securities or Structured Portfolios;

B. Investment Agreements (a.k.a. Guaranteed Investment Contracts);

C. Forward Purchase or Delivery Agreements; and

D. Pooled and Money Market Funds.
 

A. Individual Securities or Structured Portfolios

Generally, these securities are limited to direct obligations of the United States Treasury, obligations of federal agencies that are directly or indirectly guaranteed by the United States, obligations of other federal agencies, and debt obligations of other entities, including corporate, for-profit entities, that are of exceedingly high credit quality and relatively short duration.

 
B. Investment Agreements (a.k.a. Guaranteed Investment Contracts)

As its name suggests, an investment agreement (“IA”) or guaranteed investment contract (“GIC”) is a contract providing for the lending of tax-exempt bond proceeds to a financial institution which agrees to repay the funds with interest under predetermined specifications.  However, this description is often as much as two IAs will have in common as security, liquidity, yield, and administrative provisions can vary significantly among members of this broad category.  It is this flexibility in creating IA terms that often allows a properly structured IA to be an attractive vehicle for investing bond proceeds.  Under favorable market conditions, IAs can offer:

• a fixed interest rate in excess of otherwise appropriate individual securities;
• appropriate liquidity terms for the funds invested thereunder;
• virtual elimination of market price risk and reinvestment risk as well as administrative and brokerage costs and fees; and
• credit quality as defined by the bond documents.

An IA “type” is largely determined by its security provisions, especially those related to collateralization, withdrawal and payment provisions, and by the type of financial institution providing the IA.  Examining each determinant provides useful insight into the advantages and disadvantages of IAs.

An IA is essentially a promise by a financial institution to pay a specific rate of interest on the funds invested and to repay those funds at specified times.  The single most important consideration with respect to purchasing an IA, is the provider’s ability to make good on these promises.  Most IA providers, especially those qualifying under the Permitted Investments section of a bond indenture, are insurance companies, financial institutions, banks, or primary U.S. government securities dealers with repayment ability for both short-term and long-term obligations that are rated by firms such as Moody’s, Standard & Poor’s or Fitch.

While a financial institution’s credit rating is the best place to start evaluating the safety of a particular IA, it is important to note that repayment ability may change subsequent to executing the agreement.  Safeguards against downgrades and default include requiring specific downgrade language, selecting highly rated providers, and possibly limiting contract length (to make an unforeseen deterioration in financial condition less likely).  Recent history suggests that drastic changes in institutions and national economies can take place over the course of days.  Downgrade triggers and language surrounding the actions of the IA provider should be incorporated into the IA and should include the ability to terminate the IA if the provider fails to secure a replacement provider, a replacement guarantee, or collateral on the IA.  While shorter-term IAs for long-term funds can expose an issuer to reinvestment risk upon maturity, providers and issuers alike often turn to collateralization to provide the requisite security on longer term IAs.  Another option is to include optional termination provisions which allow an issuer to liquidate the IA at any time subject to a market-price termination fee.

Collateralization can vary according to the amount and type of collateral, the frequency of its valuation (i.e., how often it is marked to market), and the holder of the collateral.  The safest and most common type of collateral arrangement involves a third-party collateral agent who holds securities for the benefit of the issuer.  The collateral requirement can be equal to or somewhat in excess of the IA balance and determined weekly (or more or less frequently) by the collateral agent.  Most collateral agreements require the provider to cure collateral deficiencies within a specific number of days (i.e., often 7 days).  In the event of default under an IA that has been collateralized, the collateral agent will liquidate the collateral and remit amounts equal to the then outstanding IA balance to the issuer.  If properly structured, the collateral agreement will create a perfected third-party interest in the collateral, thereby avoiding the possibility that a bankruptcy court could attach the collateral as an asset of the IA provider.  This structure is less prone to market risk than the purchasing of treasuries and/or agencies with comparable maturities.

Collateralization is a cost passed on to the issuer in the form of a lower yield.  However, if a collateralized IA still yields in excess of the bond yield, the issuer should be indifferent to such cost (given arbitrage rebate restrictions).  To the extent the collateralized yield is below the bond yield, the issuer must weigh in the potential risk versus the available yield.

Among an IA’s greatest strengths is the ability to tailor withdrawal and interest payment provisions to exactly meet bond proceeds expenditure requirements, while eliminating market price risk, reinvestment risk, and the costs associated with monitoring investments (i.e., paying brokerage and management fees).  Of course, greater flexibility for the issuer will always come at the expense of yield.  The issuer hopes that a full flexibility IA will still bear an interest rate in excess of the bond yield.  If not, a tradeoff of liquidity for yield must be evaluated.  This tradeoff can be mitigated if a reasonably accurate construction schedule is available.

The range of available withdrawal and interest payment provisions in decreasing order of flexibility (and increasing order of yield) can be characterized as follows:

Full-Flex:  Provides for frequent withdrawals up to the full amount of the IA (for project purposes, not alternative investments), any desired interest payment dates or frequency, and reinvestment (if preferable) of interest earnings at a specified yield.  Any of these terms, including notice requirements for withdrawals, can be relaxed in an effort to create additional yield.  Full-flex is most useful for construction funds.

No Sooner, No Greater:  Provides that the issuer may make withdrawals only after a specified date in a not-to-exceed amount.  The increased average life and predictability of repayment requirements usually results in higher yields but can expose an issuer to the possibility of cash flow shortages.  No sooner, no greater is often used in conjunction with small deposits to money market funds or similarly liquid investment vehicles to address this concern.  This type of provision is best suited to construction funds for phased projects or where highly accurate draw schedules are available.

Bullet Draws:  Provides for pre-determined withdrawal and interest payment amounts and dates.  Exceptions are limited to indenture requirements such as default, mandatory redemption of bonds, and a reserve fund draw.  Bullet draws provide the highest yield available but have little flexibility.  They are almost always used in conjunction with more liquid investments, or when there exists a high degree of confidence in cash flow requirements such as in capitalized interest and reserve fund applications.

Who Provides Investment Agreements?

Insurance Companies:  These were among the first institutions to make IAs available for bond proceeds.  Often referred to as guaranteed insurance contracts, these securities are typically “guaranteed” only by the repayment ability of the insurance company.

Banks:  Often referred to as bank investment contracts, these securities can be thought of as a flexible series of CDs.  They may or may not be collateralized and are typically issued only by the nation’s largest and most creditworthy banking institutions.

Primary U.S. Government Securities Dealers:  These institutions issue repurchase agreements (“Repos”) which, by their nature, are collateralized.  Here, we are referring to long-dated Repos, typically with a maturity in excess of one year.  A Repo involves an issuer’s purchase of a security allowed under the bond documents and the provider’s agreement to buy the security back from the issuer at a specified date and price, with the interest rate of the agreement being a function of the repurchase price and other payment terms.  While the securities subject to the Repo (or flex-repo) belong to the issuer during the term of the Repo, collateral valuation and holding is subject to negotiation.

How can an Issuer Procure an Investment Agreement?

An IA intermediary works with the issuer to develop a structure that best meets the requirements of the bond issue in terms of security, liquidity and yield.  If all the investment objectives cannot be met in the current interest rate environment, the issuer may decide to make tradeoffs in terms of the structural criteria or to wait until the IA market improves.  It should be noted that normally the IA intermediary’s fee is paid by the IA provider upon successful completion of a transaction.  Therefore, an issuer will not incur any costs if the process is delayed or never completed.

If the issuer is satisfied with the structure of the IA, the IA intermediary will draw up a request for IA bids or “bid form” which carefully states all the requirements of the desired IA structure and explains the bidding procedure.  The bid form should also state any other conditions which the winning provider must meet to complete the transaction.  These requirements will include circulating a draft of the actual IA contract within a specified time, providing a legal opinion as to enforceability of the contract, paying all of its own legal fees, supplying the issuer with monthly status reports, and any other requirements the issuer deems necessary.

Steps to eliminate any risk of future regulations causing an issuer to incur additional arbitrage rebate include:

Bidding Yield:  Since the Treasury has indicated that the terms of an investment should be based on the reasonable and realistic needs of an investor without regard to the arbitrage rules, the criteria for selecting the winning IA provider should be based on the highest yield rather than fixing the yield and bidding some form of liquidity or security features.  A permissible variation on this concept is to set the interest rate on the IA to the arbitrage rate on the bonds and to bid for an up-front “premium” payment (assuming that IA yield is higher than the bond yield).  This premium represents an approximation of the present value of the issuer’s rebate liability on that particular investment.

No-Fee Bidding:  The IA should be bid in a manner that eliminates the possibility that the IA intermediary’s fee (paid by the provider) could be considered additional yield to the issuer, and therefore increase its arbitrage rebate liability.  The Treasury Regulations provide explicit guidance as to what may be paid as a brokerage commission and still not be treated as additional yield to the issuer.

 
C. Forward Purchase or Delivery Agreements

A forward purchase agreement (“FPA”) or forward delivery agreement (“FDA”) differs from the conventional purchasing of securities principally because the settlement date(s) of a trade or trades agreed to today may be months or even years in the future.  Consequently, the purchased securities, and therefore the credit component of risk, remain unchanged relative to conventional practice.  Yields on securities purchased pursuant to an FPA can be substantially higher than the current market yield for securities of similar remaining duration.  These agreements are used for proceeds that are highly expected to be available for investment in the future.

A written agreement is needed for FPAs because their unique calendaring and provisions are not yet standard procedure among securities dealers.  Moreover, it is often advantageous to both parties to allow some flexibility.  Documenting the trade’s basic terms as well as the definition of eligible securities tends to be relatively simple and inexpensive.  In marked contrast to guaranteed investment contracts or other types of investment agreements, an issuer need not be overly concerned with the provider’s performance under the FPA because the issuer does not deliver its cash or securities until it obtains performance by the provider.  If the provider does fail to deliver a security, the issuer simply purchases the same or similar security on the open market – exactly as it would have done had it never entered into the FPA.

Bond counsel or another qualified counsel should ensure that the agreement provides for the issuer to own securities delivered under the FPA for bankruptcy purposes.  This is necessary to ensure that the provider’s bankruptcy does not result in the securities held by the issuer (or its trustee) to be deemed a part of the bankruptcy estate.

 
D. Pooled and Money Market Funds

Pooled Funds available for bond proceeds investment attempt to leverage economies of scale in professional management, purchasing power, transaction costs, credit risk diversification, and liquidity requirements to improve upon what a smaller or less experienced investor could accomplish through individual securities purchases.  While they often offer an administratively simple option for smaller local agencies, it is important to understand the credit, liquidity and yield characteristics of each fund.  Because these funds are not highly regulated, their managers may have different philosophies which impact net asset value, liquidity, and, ultimately, safety.  Before investing in such pools, issuers should study the type and average life of underlying investments and fully understand deposit, withdrawal, interest payment, and interest allocation provisions.

Money Market Funds are, by federal law, designed to maintain a share price of $1.00.  Money market funds generally buy only U.S. treasury and agency securities, repurchase agreements for those securities, and the highest credit quality corporate commercial paper and other short-term indebtedness.  The average life of investments in a money market may not exceed ninety (90) days.  Money market fund mechanical liquidity ranges from zero to three days.  Not all money market funds are permitted investments under local and state laws, local investment policies, or traditional permitted investments language.

Mutual funds that are not money market funds are seldom permitted investments for bond proceeds. They may contain highly volatile securities and, consequently, pose significant credit and market risk concerns.