Amtec Newsletter

Reclaiming Negative Arbitrage
The Tax Reform Act of 1986 dramatically changed the financing habits of municipalities throughout the nation. Under these new rules, losses of income and increased expenses connected with the issuance of bonds have managed to create a void which has not been effectively filled by many municipalities.

The strict definition of arbitrage is borrowing in one market and investing in another. Municipalities have the ability to borrow in the tax exempt market and invest the bond proceeds in the taxable market. When this occurs and the taxable investment yield on the proceeds exceeds the yield of the tax exempt bond issue, a rebate or repayment of arbitrage profits is due to the United States through the Internal Revenue Service.

There are some exceptions to rebate and they are generally connected with spending bond proceeds quickly. When this occurs, the rules allow the issuer to retain all arbitrage profits. This is easier said than done in the harsh New England climate.

Another exception to rebate is the small issuer exemption which allows the issuance of $5 million or less in a calendar year by a single issuer. While this is an effective tool in controlling exposure to rebate, it may not be the most cost effective means to issue bonds.

During 1985, municipalities throughout the nation issued general obligation bonds aggregating $55.3 billion. In 1987, this volume plummeted to $30 billion according to the Bond Buyer.

Throughout the nation, the safe harbor of a $5 million issuance seemed the most effective means to avoid the feared and much misunderstood rebate computation. A closer examination of the issuance process indicates that issuing bonds annually to avoid rebate computations may waste valuable cash resources. The cost to issue bonds and pay the professionals associated with a bond issuance is far greater than the cost to compute a rebate.

The origin of this expensive solution may lie with the earliest rules surrounding the rebate computation. They were not issued for three years following reform and not finalized until 1993. Therefore, rebate avoidance may have been an alternative strategy in the early years.

The actual cash losses may run even deeper. Municipalities have not focused on their ability to earn arbitrage profits, establish reserves for rebate, and retain up to the legal maximum income allowed by law. Failure to accomplish this objective creates arbitrage losses. In many cases, these losses can be minimized or eliminated, generating a new source of income into many communities.

Here is how it works. If City A borrows $10 million to complete a project, the proceeds can be invested on a taxable basis until the project is completed. During the construction period, investments above the tax exempt bond yield are generally available. As an example, a 180 day Treasury Bill may yield 5.5% and the bond yield may be 5.4%. While this creates a small arbitrage profit of .1%, it is far from what occurs in many of our communities.

More often, City A floats a bond issue for $10 million and invests in lower yielding money markets in an effort to avoid a rebate or a computation. The law does not require a rebate computation, it only requires that all rebates be paid. Therefore, if a community invests its proceeds well below the bond yield in one of many money funds available, it can be assured of negative arbitrage or never having to pay a rebate and avoiding the issue of the computation.

This trend is not new and is used throughout the nation. However, there are an increasing number of finance directors who now understand that through the elimination of negative arbitrage on investments, significant additional dollars become available to the community. The differential of 2% annually on a $10 million bond issue can generate an additional $200,000! The math gets even better when you review the traditional "spreads" between the money market funds offered to municipalities and the 1 year Treasury Bill. It would not be uncommon if this amount were closer to 2.5%.

Many municipalities are not equipped to deal with rebate management. Issuing bonds in small increments may not be cost effective when used as the sole means of rebate computation avoidance.

Rebate computation fees are generally less than $1,000 per year and annual reporting is a key in determining how much income has been earned and how much more can be earned prior to establishing a rebate reserve.

Investing bond proceeds in an actively managed portfolio to achieve a proper matching of investments to liabilities will yield much higher returns. A proven strategy is the investing in direct U.S. Government Bills and Notes and limiting investments in money markets or pooled accounts.

Reducing Negative Arbitrage
• Determine an allowable investments schedule.
• Develop a draw schedule which becomes the basis of the investment portfolio. Match the maturities of qualified investments to the need date. Income optimization is achieved.
• Develop investment portfolios reflecting risk factors associated with the various qualified investments.
• Conduct the bidding process for the selected portfolio of investments.
• Utilize rebate computations as a source for determining investment yield and rebate status at least annually.
• Analyze portfolio as rates or spending patterns change.

Every Finance Director Needs To Know...
Reliance on bond counsel for guidance on the aspects of rebate management will result in compliance with the Tax Code but it may be very costly. Issuer A sold $10 million in bonds and defensively invested bond proceeds for three years to avoid having to compute and pay a rebate. At the end of five years bond counsel instructed A to gather the investment and disbursement records and forward the information for the computation of rebate. A’s staff spent in excess of 25 hours gathering investment and disbursement records that were up to five years old. Some of the records were missing.

Bond counsel performed the calculation after much consultation with the Finance Director and associated staff. Counsel spent 14 hours completing the assignment. The cost.... well, you get the picture. There was no rebate liability and A’s Finance Director was pleased.

Many rebate calculation services do not disclose the amount of accumulated negative arbitrage. Negative arbitrage is the amount of allowable income which could have been earned and retained by issuers. This additional income is substantial and can increase the available bond proceeds to further the purposes of capital projects.

A’s bond yield was 6.00%. The average return on investments in A’s chosen money market fund was 4.60%. The results yielded a negative return of 1.4% on an average balance of $3 million for three years. This translates to negative arbitrage of $126,000!

Issuer B opted to compute rebate annually. The goal was to achieve a qualification for a rebate exception and to ensure that the B’s chosen portfolio of Government Securities was providing income equal to or above the bond yield. Upon receiving each annual report, B was able to measure its cumulative return and rebate. When positive arbitrage was earned, it was set aside for a future rebate. This process was repeated five times. On the fifth bond anniversary, B paid a rebate of $23,500 to the IRS.

B used an arbitrage rebate specialty firm to compute its rebate liability annually. The total cost for five years of service was guaranteed not to exceed $2,400, an average of $480 per year.

In addition to the savings over the direct cost of the rebate computation, B earned an additional $149,500 of income, of which $23,500 was a rebate. The remaining $126,000 was used to purchase 85 computers for B’s middle school. B achieved a fiscal budget surplus which was used to stabilize its mill rate.

Rebate is not only a legal issue, its a business problem with multiple business solutions. Amtec can provide the necessary tools which allow you to become a successful rebate manager.