active management of the debt portfolio - 2013 nacubo conference
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Active Management of the Debt Portfolio
Remy Hathaway, Prager & Co., LLC Sherry Mondou, University of Puget Sound Thomas Richards, University of Missouri System
Prager & Co. LLC, Financial Advisor to two Very Different Institutions
University of Missouri
University of Puget Sound
Policy, Strategy and Implementation
Comprehensive policy covering debt, derivatives and liquidity Short—so people will read it Establishes risk framework, then optimizes cost Ongoing communication strategy at enterprise level
Financing strategy driven by (in order) 1. Mission 2. Existing portfolio and institutional risk 3. Transactional economics
Evaluation of outcomes—including extreme ones
Strategy – Risk-First Framework
Most debt policies use phrase “risk-adjusted cost of capital” or “risk tolerance” but do not quantify it
Starting with risk—especially tail events—allows the institution to elect where and how much risk is acceptable Taking into account other institutional risks (e.g. market
rate risk and tax risk)
Compensation for risk must be considered. Is it worth it, and where else might we be better compensated for risk?
“Essentially, all models are wrong, but some are useful.” -George E.P. Box
Risk Assessment - Categorization
Debt Service Risk: “How much different could debt service be from what’s in the budget?” Market Rate Risk Credit Risk Tax Risk (and Basis Risk)
Liquidity Repricing Risk Counterparty
Performance Risk
Liquidity Risk: “How much of the balance sheet is exposed to the debt portfolio? Reissuance/Remarketing Risk Liquidity Facility Renewal/Failure Risk Swap Collateralization Risk Swap Termination Risk
One More Risk – Brain Damage Risk
How much management and staff time is dedicated to managing the debt portfolio? Issuance/refundings Renegotiation of liquidity facilities Managing puts/liquidity events
How much board/regent/trustee time is spent?
Is there an appropriate return on invested time? On future
expected demands on time?
Debt Service Risk – From Complex to Basic Max
Rate Ratio Change Impact % of O.E. Market Rate Risk
195 Tax-Exempt Variable-Rate 0.11% 2.9% 5.6 75 Taxable Variable-Rate 0.40% 4.6% 3.4
-165 LIBOR Fixed Payer Receipt 0.15% 67% 3.1% -5.1 LIBOR Fixed Receiver Payment SIFMA Fixed Payer Receipt SIFMA Fixed Receiver Payment Basis Swap Payment Basis Swap Receipt
4.0 0.6% Tax Risk
195 Tax-Exempt Variable-Rate 1.7% 3.3 SIFMA Fixed Payer Receipt SIFMA Fixed Receiver Payment Basis Swap Payment Basis Swap Receipt BABs Subsidy
3.3 0.5% Credit Risk
195 Tax-Exempt Variable Rate 0.11% 4.0% 7.8 75 Taxable Variable Rate 0.40% 7.0% 5.3
13.1 2.1% $ Millions % of O.E. Liquidity Repricing Risk Maximum One-Year Risk: 15.1 2.4%
100 Liquidity Facility 2.0% 2.0 0.3% 50% of Maximum 11.2 1.8% 25% of Maximum 5.6 0.9%
Counterparty Performance Risk -165 Swap Notional 0.0 0.0%
0%
1%
2%
3%
Market RateRisk
Tax Risk
Credit RiskLiquidityRepricing Risk
CounterpartyPerformance
Risk
Max Debt Service Risk Components (as percentage of 1 Year Operating Expenses)
Measuring Risk in Context
$ Millions % of O.E.Maximum One-Year Risk: 4.6 4.6%50% of Maximum 2.3 2.3%25% of Maximum 1.2 1.1%
0%
1%
2%
3%
4%Market Rate Risk
Tax Risk
Credit RiskLiquidityRepricing Risk
CounterpartyPerformance
Risk
Max Interest Rate Risk Components(as percentage of 1 Year Operating Expenses)
$ Millions % of E.R.75.2 49.5%50.1 33.0%37.5 24.7%25% of Maximum
Maximum Three-Year Risk:50% of Maximum
0%
10%
20%
30%
40%Reissuance Risk
Facility RenewalRisk
CollateralizationRisk
Swap TerminationRisk
Max Liquidity Risk Components(as percentage of Expendable Resources)
Example: Collateralization/Termination Exposure
How useful are historical results?
(70%)
(60%)
(50%)
(40%)
(30%)
(20%)
(10%)
0%
10%
1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013
Backward-Looking Maximum Percentage Declines in 10-Year Treasury
From One-Year Prior
From Three Years Prior
5/30/84-8/21/86: 51% decline within
three years
4/17/85-4/16/86: 38% decline within one year
Source: Federal Reserve
Projecting Short-Term Rates using Fed Funds (Fed Funds History + Projections = Potential Outcomes)
30Y Low:4.51% Average: 5.21%
30Y High: 7.53%
0%
5%
10%
15%
20%
1954
1959
1964
1969
1974
1979
1984
1989
1994
1999
2004
2009
Source: Federal Reserve
0%
1%
2%
3%
4%
5%
6%
7%
12/3
1/20
1212
/31/
2013
12/3
1/20
1412
/31/
2015
12/3
1/20
1612
/31/
2017
12/3
1/20
1812
/31/
2019
12/3
1/20
2012
/31/
2021
12/3
1/20
2212
/31/
2023
12/3
1/20
2412
/31/
2025
12/3
1/20
2612
/31/
2027
Fed Funds Expected Rate Range (6/19/2013 Release)
Most hawkish governor up to highest 30-year average
Median governor up to 60-year average
Most dovish governor up to lowest long-term target rate.
“It is better to be vaguely right than exactly wrong.” -Carveth Read
The Experience of Two Very Different Institutions, one large…
University of Missouri System Public research university with 4
campuses + health system Enrollment 75,000 Endowment $1 billion $2.7 billion operating expenses $1.3 billion debt outstanding Aa1 / AA+ Treasurer and Interim VP
Finance
Policy / Governance – University of Missouri
Recently adopted comprehensive policy for debt and derivatives management Outlines authority, responsibilities and reporting
Board approves any issuance of debt Board receives quarterly comprehensive reporting on portfolio Board receives annual evaluation of debt capacity, given anticipated
debt-financed projects within a five year timeframe
Establishes framework for evaluating risks in debt portfolio as well as any new issuance of debt Board receives annual debt portfolio risk assessment
Policy does not define specific limits, giving maximum flexibility to management team and Board.
Strategic Restructuring – University of Missouri
Recently launched $350 million commercial paper program capable of issuing either taxable or tax exempt paper.
CP provides particular flexibility during construction phase of capital projects, allowing for low cost “just-in-time” financing with ability to convert to permanent financing at any time.
CP program was structured in a manner that minimizes our need to provide daily self-liquidity by establishing a $100 million cap on CP maturing within any seven day time period. Even with $350 million in CP outstanding, daily liquidity
requirement remains $100 million due to the cap.
Strategic Restructuring – University of Missouri
Prior to CP Program $100 million weekly reset VRDBs $120 million daily reset VRDBs $220 million daily self-liquidity requirement
Post CP Program Launch $100 million weekly reset VRDBs remain outstanding $120 million daily reset VRDBs converted to CP $60 million new CP issued $200 million daily self-liquidity requirement
Total variable rate debt increased from $220 million to $280 million, yet daily self-liquidity requirement decreased from $220 million to $200 million
Strategic Restructuring – University of Missouri
By reducing our daily self-liquidity requirement and essentially capping it at $200 million, we can better optimize the investment of our working capital to generate additional return.
Opportunity cost of holding daily self-liquidity could easily be 100-300bps when compared to other alternatives.
Our General Pool (essentially working capital) averages $1.7 billion throughout the year. Optimization of risk-adjusted returns is a top priority as investment income helps fund operations.
The Experience of Two Very Different Institutions, one small…
University of Puget Sound, Tacoma, WA National residential liberal
arts college Enrollment 2650 Operating budget $120
million Endowment $275 million $75 million debt outstanding A1/A+ rating VP Finance & Administration
with broad portfolio
Policy / Governance – University of Puget Sound
First adopted debt policy in 2005; now refined annually Provides general framework
Based in mission and strategic goals, with the long term in mind Debt is a valuable and scarce resource Consider affordability, risks, financial structure Monitor capital markets, refunding and other opportunities No specific limits, allows flexibility
Clarifies responsibilities Board approves issuance of debt, committee approves terms Management, with expert counsel, monitors market and risk, makes
recommendations, negotiates terms, interfaces with external parties Board receives annual review of debt portfolio risk
Goals of 2012 Transaction – University of Puget Sound
Improve student success through strong residential programming Policy change, programs,
bed capacity Manage debt portfolio risks Within context of broad
institutional risks Decrease debt portfolio
risk Retain debt capacity at
A1/A+ rating
Risk Assessment and Strategic Restructuring – University of Puget Sound
Comprehensive assessment of risk profile A year in advance of anticipated debt financing Changing market conditions Changes in board’s risk tolerance or risk allocation? Strategic residential objective, upcoming debt financing
Prager & Co. as financial advisor served as an extension of university staff Assessment of financial condition, risks, credit and debt capacity, peer
analysis, structures, etc Quantitative analysis of options
Risk Assessment and Strategic Restructuring – University of Puget Sound
The portfolio before the transaction: $60 million VRDNs, all synthetically fixed, structured in
different rate environment, still low cost of capital, performed well to date $10 mil, 3.6% all-in, self-liquidity, Soc-Gen long-term swap $50 mil ($20 + $30), 4.3% all-in, bank LOC, BoNY long-term swap
Board not as comfortable with debt risks as they once were Swap counterparty performance Mismatch between 67% LIBOR and SIFMA Failed remarketing, deterioration of LOC provider credit Liquidity (LOC) renewal/repricing risk in 2012
Risk Assessment and Strategic Restructuring – University of Puget Sound
Should we issue traditional fixed rate on new money for residence hall?
Should we convert all or some of VRDNs to fixed rate? How would we handle outstanding swaps? What would be the budget impact?
Should we consider a direct bank purchase vs. new LOC
provider for all or some of our variable rate debt?
Comparison of Financing Scenarios
Scenario 1: 4.58%
Scenario 2a: 4.79% Scenario 2b: 5.15%
Scenario 3a: 5.14% Scenario 3b: 6.32%
Scenario 4: 6.82%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
0% 10% 20% 30% 40% 50% 60%
Inte
rest
Rat
e Ri
sk
(as %
of F
Y201
0 O
p. E
xp.)
Liquidity Risk (as % of FY2010 Expendable Resources)
Debt Portfolio Risk Assessment (with Projected WACC)
Scenario 1: 4.58% WACC Scenario 2a: 4.79%
Scenario 2b: 5.15% Scenario 3a: 5.14%
Scenario 3b: 6.32%
Scenario 4: 6.82%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
0 5 10 15 20 25Wei
ghte
d Av
erag
e Co
st o
f Cap
ital
(WAC
C - i
n %
)
Principal Duration (in Yrs)
Expected WACC vs. Principal Duration
Risk Assessment and Strategic Restructuring – University of Puget Sound
The Transaction Issued new debt at fixed rate for residence hall Refunded 30% of VRDNs and converted to fixed rate, retained
orphan swap with intent to terminate when conditions are favorable
Refunded 50% of VRDNs through a 7-year direct purchase transaction, retained swap
Retained 20% of VRDNs with self-liquidity, retained swap, may terminate swap in future
Risk Assessment and Strategic Restructuring – University of Puget Sound
End result 47% traditional fixed 40% variable rate direct bank purchase, synthetically fixed 13% VRDN with self liquidity, synthetically fixed
Reduced interest rate risk and liquidity risk Expected WACC of 4.79% and within Board’s risk comfort Level debt service affordable in budget, with new money
structured to accommodate temporary orphaned swap
Ongoing Monitoring and Reporting
Puget Sound assesses debt portfolio review annually, including risk trend
Additional Considerations (at Issuance and Beyond)
Taxable vs Tax-Exempt Cost differential Reporting requirements Value/cost of par call for tax-exempt debt
Term Direct purchase: renewal risk at put date Matched to project life Longer to allow recycling/internal bank structures
Issuance Timing Interest rate outlook Negative arbitrage in refundings Hedging efficacy/outcomes
Conclusions
Clear policy should drive debt portfolio decisions
Portfolio risks and outcomes must be monitored on an ongoing basis
Quantitative frameworks should be established for budget and balance sheet outcomes Current and pro forma debt portfolio
Resources
University of Missouri System Debt Policy http://www.umsystem.edu/ums/fa/treasurer/debt_policy
University of Missouri System Quarterly Debt Report
http://www.umsystem.edu/ums/fa/treasurer/debt_snapshot_reports
Federal Reserve Historical Data http://www.federalreserve.gov/releases/h15/data.htm
Federal Reserve Interest Rate Projections
http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm (Click on “PDF” under Projections Materials)
Appendix – Why Fed Funds? Quarterly average SIFMA rates (and LIBOR rates) correlate
very well with Fed Funds, but with more history.
y = 63.23%x + 0.37% R² = 94.82%
0%
1%
2%
3%
4%
5%
6%
7%
8%
0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
SIFM
A
Fed Funds (Effective, 3-Day Lag)
Least Squares Regression (Quarterly Average, n=88)
Source: Federal Reserve, SIFMA
Appendix – Why the 10-Year Treasury? Good correlation with LIBOR Swap Rates…not so much MMD,
but even MMD is generally reasonable, and there’s more history.
y = 1.0505x + 0.0073 R² = 0.9632
y = 0.4935x + 0.0254 R² = 0.6619
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
8.0%
1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0%10-Year Treasury Rate
Interest Rate Correlations with 10-Year Treasury (1998-Present)
100% of 30 Yr LIBOR Swap Curve30 Yr Tax-Exempt Fixed RateLinear (100% of 30 Yr LIBOR Swap Curve)Linear (30 Yr Tax-Exempt Fixed Rate)
Source: Federal Reserve, Thompson, Bloomberg
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