qscbs sinking fund investment strategies - region one esc iii. pfm... · psfy is based upon the...
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One Keystone Plaza, Suite 300
QSCBs Sinking Fund Investment Strategies
April 2012
PFM Asset Management LLC
Harrisburg, PA 17101
Region 1 Finance Council Meeting
North Front & Market Streets
www.pfm.com
PFM Asset Management LLC
Contact
Matthew Eisel, CFA Senior Managing Consultant
[email protected] (717) 232-2723
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PFM Asset Management LLC
Contents
I Background
II Investment Options
All data as of 12/31/2011 unless otherwise indicated.
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PFM Asset Management LLC
Qualified School Construction Bonds
Designed to allow qualifying schools to borrow at or near 0% to rehabilitate, repair, and equip schools
A type of tax credit bond – others include BABs, QECBs, and CREBs
Section 148 of Internal Revenue Code applies (arbitrage regulations)
Commonly referred to as:
“Q-scabs”
“Q-scibs”
“Q-scoobies”
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I Background
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American Recovery and Investment Act
I Background
PART III – TAX CREDIT BONDS FOR SCHOOLS
SEC. 1521. QUALIFIED SCHOOL CONSTRUCTION BONDS.
“(a) QUALIFIED SCHOOL CONSTRUCTION BOND.
“(1) 100 percent of the available project proceeds of such issue are to be used for the construction, rehabilitation, or repair of a public school facility or for the acquisition of land on which such a facility is to be constructed with part of the proceeds of such issue.
“(c) NATIONAL LIMITATION ON AMOUNT OF BONDS DESIGNATED. – There is a national qualified school construction bond limitation for each calendar year. Such limitation is –
“(1) $11,000,000,000 for 2009,
“(2) $11,000,000,000 for 2010, and
“(3) except as provided in subsection (e), zero after 2010.
“(d) ALLOCATION OF LIMITATION. –
“(1) ALLOCATION AMONG STATES. – Except as provided in paragraph (2)(C), the limitation applicable under subsection (c) for any calendar year shall be allocated by the Secretary among the States in proportion to the respective amounts of each Elementary and Secondary Education Act of 1965 (20 U.S.C. 6333) for the most recent fiscal year ending before such calendar year. The limitation amount allocated to a State under the preceding sentence shall be allocated by the State to issuers within such State.
Source American Recovery and Investment Act (recovery.gov/About/Pages/The_Act.aspx).
“(e) CARRYOVER OF UNUSED LIMITATION. – If for any calendar year –
“(1) the amount allocated under subsection (d) to any State, exceeds
“(2) the amount of bonds issued during such year which are designated under subsection (a) pursuant to such allocation, the limitation amount under such subsection for such State for the following calendar year shall be increased by the amount of such excess. A similar rule shall apply to the amounts allocated under subsection (d)(4).”.
“SEC. 54F. QUALIFIED SCHOOL CONSTRUCTION BONDS.
PFM Asset Management LLC
2010 Texas QSCBs Allocation
Amount reserved for charter schools
$100,000,000
Amount reserved and used by LEAs* $131,873,000
Carryover balance from 2009
$22,402,337
Available allocation for districts
$338,203,337
Total = $547,674,000
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I Background
Source Texas Educational Agency (tea.state.tx.us). * LEAs include Dallas ISD, Pasadena ISD, Pharr-San Juan-Alamo ISD, and San Antonio ISD.
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Unique Characteristic of QSCBs – Sinking Fund
Sinking fund used as budgetary tool to build principal balance through time
Annual deposits accumulate in an amount equal to the par amount of the bond issue
No interim cash flows owed to bondholders before the maturity date of the bonds (similar to CABs)
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(mill
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Deposit Rolling balance Interest
II Investment Options
PFM Asset Management LLC
Permitted Sinking Fund Yield
Investment of sinking fund limited to Applicable Permitted Sinking Fund Yield (PSFY)
Since March 2009, monthly resets have ranged from 3.25% to 5.02%
PSFY is based upon the pricing date of the bonds
Current PSFY is 3.32% (as of April 1, 2012)
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© 2011 PFM Asset Management LLC
I Background
5.02%
3.25%
3.32%
0.00%
1.00%
2.00%
3.00%
4.00%
5.00%
6.00%
Mar
-09
Apr-0
9M
ay-0
9Ju
n-09
Jul-0
9Au
g-09
Sep-
09O
ct-0
9N
ov-0
9D
ec-0
9Ja
n-10
Feb-
10M
ar-1
0Ap
r-10
May
-10
Jun-
10Ju
l-10
Aug-
10Se
p-10
Oct
-10
Nov
-10
Dec
-10
Jan-
11Fe
b-11
Mar
-11
Apr-1
1M
ay-1
1Ju
n-11
Jul-1
1Au
g-11
Sep-
11O
ct-1
1N
ov-1
1D
ec-1
1Ja
n-12
Feb-
12M
ar-1
2
PSFY 30-year Treasury
Source Bloomberg, Treasury website (treasurydirect.gov/GA-SL/SLGS/selectQTCDate.htm).
PFM Asset Management LLC
Safe Harbor and IRS Bidding Regulations
Despite negative arbitrage environment, prudent course of action is to undertake a safe harbor-compliant bidding process for the purchase of investments
At least three bids from providers with no material financial interest in the bonds
All providers have an equal opportunity to bid
No courtesy bids are provided (cannot coerce an entity to submit a bid)
Commercially reasonable terms (no intent to reduce yield on any investments)
Award to lowest cost bidder
Document bidding process including record of bids received and solicitation used
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II Investment Options
PFM Asset Management LLC
Authorized Investments in the State of Texas
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I Background
Source State of Texas Government Code – Title 10, Subtitle F, Chapter 2256, Subchapter A. Authorized Investments for Governmental Entities.
Other regulations/policies may be more restrictive and should also be consulted:
Investment policy
Governing bond documents
Permitted investments for sinking funds tend to be quite limited (sometimes exclusively Treasuries)
Investment Notable Criteria
Treasuries
Government-sponsored Enterprises
Municipal Bonds Rated A or better
Certificates of Deposit Insured by FDIC/NCUSIF
Repurchase Agreements Secured by cash and/or obligations of governmental entities
Banker’s Acceptances Maturity of 270 days or fewer
Commercial Paper Maturity of 270 days or fewer, rated A-1/P-1 or better
Mutual Funds Dollar-weighted average maturity of 90 days or fewer
Guaranteed Investment Contracts Secured by obligations of governmental entities
Investment Pools
PFM Asset Management LLC
Attractive Time to Borrow
Municipal borrowing rates are close to historic lows
Lower investment returns indirectly increase borrowing costs
Temptation exists to hold funds in cash but market conditions likely demand a more tailored approach
Steep slope of yield curve provides targeted investment opportunities
0%
1%
2%
3%
4%
5%
6%
7%
8%
Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Dec-10
Borrowing and Investment Rates at Historic Lows
Fed Funds 3-year Agency Index 20-year AA MMD
Source Bloomberg, TM3.
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II Investment Options
PFM Asset Management LLC
Yields Low and Expected to Stay Low
Fed's commitment to keep rates low through late 2014 limits returns on short-term investments
0%
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U.S. Treasury Yields
6-month 2-year 10-year
Fed
Cut
s R
ates
to 0
%
QE1
Ope
ratio
n Tw
ist
QE2
Source Bloomberg, TM3.
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II Investment Options
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0%
2%
4%
6%
8%
10%
12%
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16%
18%
1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010
10-Year U.S. Treasury Yields 1965 - 2012
Long-Term Treasury Yields Have Fallen Dramatically
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Longest Bull Market in History
II Investment Options
Source Bloomberg.
PFM Asset Management LLC
Drivers of Investment Strategy
Historically low interest rates
Fed has announced its intent to keep the Fed Funds Target range unchanged through 2014
Outlook uncertain
Steep yield curve provides incentive to extend maturity
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II Investment Options
PFM Asset Management LLC
Sinking Investment Options
U.S. Treasuries & Direct Obligations – include SLGS, T-Notes, T-Bills, and T-STRIPS
Government-guaranteed Securities – include obligations such as Resolution Funding Corporation Interest STRIPS
Government-sponsored Enterprise Securities – obligations issued by government-sponsored enterprises (such as FHLMC and FHLB); not direct obligations
Money market funds – highly liquid, invested in short-term securities with the goal of maintaining a constant net asset value of $1
Forward Delivery Agreement (FDAs) – agreement stipulating the outright purchase of securities from a counterparty through time; typically provided by sophisticated broker-dealers and banks
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II Investment Options
PFM Asset Management LLC
Money Market Funds/LGIPs
Maintain a net asset value (NAV) of $1 per share
Due to historically low short-term interest rates, money market funds have recently been yielding very close to 0%
Element of credit and liquidity risk
Subject to ongoing reinvestment risk (will interest rates rise?)
An aggressive bet that interest rates will rise in the future
No budgetary certainty
Must be monitored on an ongoing basis for yield compliance
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II Investment Options
PFM Asset Management LLC
SLGS
United States Treasury Securities, State and Local Government Series (SLGS)
Purpose is to provide issuers of tax-exempt securities with investments for any amounts that:
Constitute gross proceeds of a tax-exempt bond issue
Assist in complying with applicable provisions of the Internal Revenue Code relating to tax exemption
Direct, non-callable obligations of the U.S. Government
Subscribed for directly from the Treasury; no secondary market and no bidding concerns (IRS regulations)
Rates set each morning, fixed all day (one basis point below open-market Treasuries?)
Coupon-bearing securities
Lower-yielding than non coupon-bearing securities
Reinvestment of coupons must be addressed every six months – inefficient
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© 2011 PFM Asset Management LLC
II Investment Options
PFM Asset Management LLC
Open-market Fixed-income Securities
Treasury Bills
Treasury Notes
Treasury STRIPS
“Separate Trading of Registered Interest and Principal Securities”
Sold at a discount, mature at par
Do not bear coupons
Obligations of government-sponsored enterprises
Resolution Funding Corporation Interest STRIPS
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II Investment Options
PFM Asset Management LLC
Structured Investment Types and Market Update
Guaranteed Investment contract (GICs) – unsecured pledge to pay principal and interest on investment; historically provided by insurance companies
Flexible Repurchase Agreement (Flex Repos) – agreement to purchase securities and resell back to counterparty in the future at a guaranteed yield; typically provided by broker-dealers and banks
Forward Delivery Agreement (FDAs) – agreement stipulating the outright purchase of securities from a counterparty through time; typically provided by sophisticated broker-dealers and banks
Historically a robust and viable investment alternative for municipalities
Before the most recent recession, each product had between 5 and 12 active providers
After the recession, due to a renewed focus on credit risk and new financial regulations, many providers have dropped out of the market
Difficult – if not impossible – to reach safe harbor requirements in 2011
GICs – 2 active bidders
Flex Repos – 3 to 5 active bidders (depending upon structure, credit quality)
FDAs – 3 active bidders
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II Investment Options
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Provider Update
Provider GIC FDA Repo Moody’s Rating Outlook
S&P Rating Outlook Unique Challenges
AEGON x x A1 Stable AA- Stable ABCP FDAs, Low Ratings (GICs)
Bank of America NA A2 Negative A Negative De-Leveraging
Barclays Bank x Aa3 Negative A+ Stable Active; Some Credit Sensitivities
Bayerische Landesbank x Baa1 Stable NR Ratings; Prefer to post SBA Collateral
Calyon (Credit Agricole) Aa3 Negative A Stable Ratings
Citigroup x x A3 Negative A- Negative Active
Credit Suisse x Aa2 Negative A Negative Going Through Approval Process
Deutsche Bank x x Aa3 Stable A+ Negative Active
Dexia / FSA Aa3 Negative AA- Stable Managing GIC Portfolio
JPMorgan Aa3 Negative A Stable Managing FDA Portfolio
Merrill Lynch Capital Services Baa1 Negative A- Negative MLCS did not transfer to BANA upon acquisition
Morgan Stanley x x A2 Negative A- Negative Can only do CP FDAs; Repo
Natixis x Aa3 Stable A Stable Ratings
RBC Capital Markets x x Aa1 Stable AA- Stable Selectively Bid on Repos
Societe Generale A1 Negative A Stable Managing GIC and FDA Portfolio
SunTrust Bank x Baa1 Stable BBB Stable Ratings
Trinity (GE Capital) A1 Stable AA+ Stable Left Reinvestment Market
Wachovia (n/k/a Wells Fargo) x A2 Negative A+ Negative Negotiated and/or Taxable Only
II Investment Options
PFM Asset Management LLC
Forward Delivery Agreement (FDA) Mechanics
Rolling delivery of Treasury and government-sponsored enterprise securities (if permitted) – interest accrues on sinking fund payments and rolling fund balance
School District is always in possession of cash or a security
New security delivered to account at least every twelve (12) months – matures prior to next deposit
Credit exposure of principal limited to underlying securities
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Provider
Bondholders
School District
Sinking Fund Payments and Rolling Fund Balance
Fixed-Income Securities
Final Payment of Principal
Sinking Fund Payments
Periodic Purchase of Securities
The securities, held by the trustee, mature every twelve months, at which time the funds are used to purchase a new security
(Every 12 months) Trustee
II Investment Options
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FDAs for Sinking Funds
FDAs are the only vehicle that provides a guaranteed rate of return if held to maturity
Lock in the rate today on all future deposits to the sinking fund
Structured to match future deposit dates and final withdrawal to pay principal to bondholders
Allows the issuer to lock in yields well above short term interest rates
FDA structure is bankruptcy remote – issuer purchases and maintains outright ownership of securities delivered under the contract
Tested during the Lehman Brothers bankruptcy
II Investment Options
Advantages Disadvantages
Locks in yield
Higher yield than short-term investments
Secured by short-term Treasury or government-sponsored enterprise securities (if permitted)
School District owns securities
Limited market value fluctuations
Bidding agent fees often can be netted from earnings
Underlying security risk – can be mitigated via limiting the eligible deliverables
Reinvestment risk in the event of counterparty default
No ability to reinvest at higher rates
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Sample Sinking Fund FDA Cash Flows
Assumes annual deposits made into the FDA beginning in August of 2012
Cumulative principal balance builds over time as deposits are made (shown as rolling balance below)
Interest on all previous deposits is compounded on a semi-annual basis at rate specified by the FDA
Treasury and government-sponsored enterprise FDA yielding 2.20% (sample investment yield)
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Deposit Rolling balance Interest
II Investment Options
PFM Asset Management LLC
FDA Investment – Required Discussion Topics
Difficulty meeting safe harbor
In the current market, it may not be possible to procure 3 disinterested bids
Market observation letter – outlines background to bid process and general market conditions
Overall rate of return on investment must be below PSFY
Previous investments
QAC incorporation
Legal fees – not QAC; must be backed out of FDA yield to determine “true yield”
Yield compliance methodologies
Solicit bids at PSFY with an “earliest maturity” award basis – 0% SLGS from maturity of the FDA to the final maturity of the QSCBs
Proportional deposits into 0% SLGS securities to blend yield down over time
Initial up-front deposit into 0% SLGS to blend yield down from structuring date is preferred
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25 © 2011 PFM Asset Management LLC
II Investment Options
PFM Asset Management LLC
Investment Options in the Current Market
Investment Yield Risks Considerations
Money market fund 0.10% Reinvestment Flexibility to extend duration
SLGS 2.55% Some reinvestment Coupons
Treasury Note 2.55% Some reinvestment Coupons
Treasury STRIPS 2.95% Effective asset-liability match
Resolution Funding Corporation Interest STRIPS
3.15% Effective asset-liability match
FDA 2.40% Credit of deliverables Safe harbor issues Budgetary certainty
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II Investment Options
All market yields estimated as of 4/11/2012 and representative of 15-year maturities except for the money market fund.
PFM Asset Management LLC
Summary of Investment Options
Money market fund yields are at historic lows with no end in sight
SLGS provide a low rate of return and are not ideal for sinking funds because they are coupon-bearing securities
One-time purchase of non-coupon bearing securities provides upfront yield benefit
Efficient for sinking funds because the maturity date of the investment is chosen to closely match the maturity date of the bonds
The amortization of the discount (difference between the par amount and purchase price) could be used to reduce future sinking fund deposits (pending bond counsel approval)
FDAs provide a guaranteed rate of return if held to maturity
Lock in the rate today on all future deposits to the sinking fund
Structured to match future deposit dates and final withdrawal to pay principal to bondholders
FDA structure is bankruptcy remote – issuer purchases and maintains outright ownership of securities delivered under the contract
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II Investment Options
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Disclaimer This material is based on information obtained from sources generally believed to be reliable and available to the public, however PFM Asset Management LLC cannot guarantee its accuracy, completeness or suitability. This material is for general information purposes only and is not intended to provide specific advice or recommendation. All statements as to what will or may happen under certain circumstances are based on assumptions, some but not all of which are noted in the presentation. Assumptions may or may not be proven correct as actual events occur, and results may depend on events outside of your or our control. Changes in assumptions may have a material effect on results. Past performance does not necessarily reflect and is not a guaranty of future results. The information contained in this presentation is not an offer to purchase or sell any securities.
Questions?