Everything You Always Wanted to Know about Bond Structuring, But were Afraid to Ask 2016 ANNUAL CONFERENCE Hotel Monteleone–New Orleans October 5–7
(maybe not everything – just what will fit in the hour we have)
Lori Raineri, Moderator Shelley Aronson, Speaker Dave Abel, Speaker Win Smith, Speaker
Call Features - Tax-Exempt vs. Taxable Markets • Optional Redemption: The Right – But Not The Obligation – To Prepay All Or Part Of A Bond Before It Matures – Purpose of Issuance • Tax-Exempt: Projects too large to fund from operating revenues (intergenerational equity) • Corporate: Strategic low-cost part of a balance sheet;; typically shorter duration
– Source of Repayment • Tax-Exempt: Property, Income and Sales Tax;; User fees and Charges;; • Corporate: Proceeds of the next take-out financing;; claim usually senior to equity
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Call Features - Tax-Exempt vs. Taxable Markets • Optional Redemption: The Right – But Not The Obligation – To Prepay All Or Part Of A Bond Before It Matures •
•
Purpose of a Call Feature • Tax-Exempt: Longer amortization;; restructure;; re-defining security;; excess revenue calls • Corporate: Shorter bullets;; yield curve optimized at issuance, limited strategic value to the call Market Treatment Of A Call Feature • Tax-Exempt: Part of market culture from the beginning;; interplay with market discount rule • Corporate: Costly if needed;; difficult to hedge;; ARRA Programs encountered resistance 3
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Price-to-Call and Price-to-Maturity
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Pricing with a Premium Call
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Pricing for 4% and 5% Coupons
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Breakeven Call Premiums 15 Years to Maturity, 10 Year Call, 5% Coupon, 3% Yield
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Benchmark Curves - MMD and MMA Sample Curves as of July 7 (2016)
Theoretical Par Curve
Borrower’s cost if the OPTION IS NOT EXERCISED
Borrower’s cost if the OPTION IS EXERCISED
“Kick Spreads” – the difference between Yield to Maturity and Yield to Worst – always wider for Higher Coupon Bonds
There is no certainty the option can be exercised at the higher 5% coupon. If a Treasury escrow can be purchased at yield equivalent to the 3% YTC, but a 5% coupon was issued (with a lower allowable escrow yield), not calling the 5% coupon becomes a real sunk cost. 8
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Various Market Perspectives on Coupons • Preferences for High Coupon (Institutional Buyers) – Protection from Market Discount Rule treatment – Muted price decline with rising yields (pricing to the call date is less sensitive to yield) – Higher probability of advance refunding (Value converts from Issuer Credit Tax-Exempt Pre-Refunded)
• If Non-Callable (Or Not Economically Callable, Such As A Make Whole Call) – Also effective for Market Discount Treatment avoidance – Non-callable maturities have greater “convexity”, IE, price moves faster with yield – Will likely never be refunded (for economics), Investors think “Issuer’s credit spread to final maturity” 9
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Various Market Perspectives on Coupons • Preferences for Lower Coupons (Certain Buy-side Participants) – Casualty Insurance (self-describe as buy-and-hold) – Retail buyers resistant to high dollar prices (Optics) – Higher stated yield (YTW) – Best value buy is if “4-coupon YTM is just inside the 5-coupon YTM”
• “Gravitation” Toward Lower Coupons (Issuers And Advisors) – Bidder’s option couponing in competitive sales (low TIC to maturity award mechanics) – Refunding with 4% produce more savings (capturing a portion of the otherwise latent option value) – Legal limits on Bond Premium (Ohio and Connecticut issuers cannot use bond premium in project funds) 10
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Issuer’s Perspective on Advance Refunding PV Savings reaches a difference 5.5% between the 4- Coupon and 5-Coupons at approximately four years after issuance. The Higher Coupon reaches any given Issuer minimum PV policy threshold roughly 2 years earlier.
If the Yield to Maturity for the 4% and 5% coupons were “close”, IE, less than 10 basis points, expected value (much of which comes from rolling curve slope) can considerably out- perform the original lower TIC gain over time.
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Issuer’s and Bondholder’s Perspective on Advance Refunding Gain from advance refunding for a bondholder decreases as the call date approaches. Prices head toward “Par” as time approaches maturity.
When a bond is escrowed, it becomes Treasury backed to its call date as the new maturity date. It therefore trades to a lower point on the yield curve, at a higher priced Pre-Refunded.
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Typical Tradeoffs of Low vs. High Coupon Bonds LOW COUPON • • • • • •
HIGH COUPON •
Lower Scheduled Debt Service Lower Yield-to-Maturity Lower TIC Lower Option Value Less Likely to Refund Longer Duration Investors
• • • • •
Lower Expected Debt Service Lower Yield-to-Call Lower Arbitrage Yield Higher Option Value Highly Likely to Refund Shorter Duration Investors
Remember – Yield to Call is also the “Arbitrage Bond Yield” for purposes of setting escrow yield limits in an advance refunding.
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Comparing a Sample 5% & 4% Coupon Refunding 5% Coupon Refunding
4% Coupon Refunding
4's Vs. 5's
Year
Par $m
Coupon
Yield
Price
Y-T-M
"Kick"
Year
Par $m
Coupon
Yield
Price
Y-T-M
"Kick"
Yield
2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035
- - - 1.715 1.805 1.895 1.995 2.090 2.195 2.305 2.420 2.540 2.670 2.805 2.945 3.090 3.240 3.405 3.580
5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5
1.060 1.160 1.280 1.390 1.500 1.610 1.720 1.830 1.970 2.120 2.250 2.320 2.370 2.420 2.470 2.520 2.570 2.630 2.690
103.908 107.569 110.914 113.998 116.799 119.314 121.544 123.491 124.877 125.829 124.503 123.795 123.293 122.793 122.296 121.801 121.308 120.720 120.136
1.060 1.160 1.280 1.390 1.500 1.610 1.720 1.830 1.970 2.120 2.445 2.669 2.844 2.994 3.126 3.242 3.346 3.445 3.535
0 0 0 0 0 0 0 0 0 0 20 35 47 57 66 72 78 82 85
2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 2035
0.075 0.080 0.080 2.015 2.100 2.180 2.270 2.360 2.455 2.550 2.655 2.760 2.875 2.990 3.110 3.230 3.355 3.495 3.635
4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4 4
1.060 1.160 1.280 1.390 1.500 1.610 1.720 1.830 1.970 2.120 2.300 2.420 2.520 2.670 2.770 2.870 2.970 3.080 3.190
102.916 105.598 107.980 110.120 111.999 113.617 114.976 116.080 116.667 116.860 115.109 113.959 113.010 111.605 110.679 109.762 108.854 107.866 106.888
1.060 1.160 1.280 1.390 1.500 1.610 1.720 1.830 1.970 2.120 2.426 2.635 2.799 2.980 3.104 3.214 3.314 3.411 3.500
0 0 0 0 0 0 0 0 0 0 13 22 28 31 33 34 34 33 31
Higher
Lower
0.050 0.100 0.150 0.250 0.300 0.350 0.400 0.450 0.500
-0.019 -0.034 -0.045 -0.014 -0.022 -0.028 -0.032 -0.034 -0.035
Refunding Par
40,695,000
Bond Yield TIC to Maturity Escrow Yield
2.3022 2.8723 1.0474
Future Savings Present Value Average Annual Savings
4,193,550 3,074,919 220,713
PV% of Refunded Par Refunding Efficiency
6.858% 64.086%
Vs Arb
0.57 (1.25)
Refunding Par
44,270,000
Bond Yield TIC to Maturity Escrow Yield
2.4899 2.8149 1.0474
Future Savings Present Value Average Annual Savings
4,374,850 3,368,138 230,255
PV% of Refunded Par Refunding Efficiency
7.511% 63.040%
Vs Arb
0.33 (1.44)
Y-T-M
3,575,000 0.1877 (0.0574) - 181,300 293,219 9,542 0.65% -1.0%
Option Sensitivity … Rates lower by 25 basis points (0.25%) 5% Coupons … 32.5% PV savings increase 4% Coupons … 29.8% PV savings increase
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Ultimate Cost of 4% vs 5% Coupon
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Discussion Subjects – New Money • Is The Proposed Issue Of Sufficient Size Or Maturity That Future Couponing Optionality Has Meaningful Economics For The Issuer? • Competitive Sale: • • •
•
Process adjustments that are more likely to give a fair hearing to aggressively priced (and value rich to the issuer) higher coupons, while maintaining process transparency. 4.5% floor coupon The market can give or take an “05” in a single day: Consider the policy discussion of grouping the top three bids (within an “05”) and awarding (blind as to the underwriter’s identity until after a final decision) considered on the basis of best couponing? Lower restrictions on term bonds to allow syndicates to aggressively price for liquidity.
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Discussion Subjects – New Money • Is The Proposed Issue Of Sufficient Size Or Maturity That Future Couponing Optionality Has Meaningful Economics For The Issuer? • Negotiated Sale: •
Is there a reliable benchmark for a 5% coupon placement available? • Consider using a 5 structure as a “straw-man” to more aggressively price lower coupons
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Discussion Subjects – Miscellaneous Future Refunding Policy Themes: – If issuers and advisors invested effort to protect option value (lower coupon alternatives were presented but not used), should there be protective future refunding standards to avoid advance refunding too soon? – GFOA is updating their Refunding Debt Policy;; consider integrating themes to manage refunding timing.
Know The Limits Of Your Benchmark Curves – Couponing take-out value (optionality) will always be active after the call date. It can never be neutralized. – Will all coupon structures, credits and call features (long or short) be able to demonstrate consistent spread relationships to the MMD 5-Coupon curve over time? Should we begin “socializing” the 4- coupon and 3-Coupon curves? – There still is no true non-callable curve for the tax-exempt markets 18
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Discussion Subjects – Miscellaneous Inventing Something New - Win Analytics “Basis Call” – Preserves the positive price territory sought for discount avoidance – Augments the original issue proceeds to an extent that future refunding savings might be captured now – How will the market respond to the resulting “super high” dollar prices and no expectation of Pre-Refunding
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Conservation of Duration • In a bond issue structure, alternative coupon choices can lead to similar schedules of total debt service and nearly identical aggregate issue duration (ignoring calls). • Lowering the coupon of an individual bond lengthens its duration but raising the coupon shortens the duration. • Any change in a bond’s coupon must be compensated by resizing the earlier bonds so that the aggregate issue duration is preserved. • Therefore, coupon choices should not be viewed in isolation. The effect on the whole structure should be examined.
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Contact Information Win Smith Win Analytics LLC (303) 883-2535
[email protected] Win Analytics LLC neither guarantees the accuracy, completeness, suitability or validity of the information provided in this presentation nor will it be liable for any errors in this information or any damages arising from its use.
Dave Abel William Blair & Company LLC (312) 364-8820
[email protected] Per MSRB Rule G-17 and the SEC Municipal Advisor Rule, William Blair & Company, L.L.C. (“the Firm”), in its capacity as an underwriter of municipal securities, is not recommending an action to you as the municipal entity or obligated person. The information provided is not intended to be and should not be construed as “advice” within the meaning of Section 15B of the Securities Exchange Act of 1934. This information is being provided for discussion purposes, and you should discuss any information and material contained in this communication with any and all internal or external advisors and experts that you deem appropriate before acting on this information or material. Unless otherwise agreed, the Firm is not acting as a municipal advisor to you and does not owe a fiduciary duty pursuant to Section 15B of the Exchange Act to you with respect to the information and material contained in this communication. In our capacity as underwriter, our primary role will be to purchase the securities as a principal in a commercial, arms’ length transaction, and we will have financial and other interests that differ from yours. Views and opinions expressed by Dave Abel are not necessarily those of the Firm. Information and background, while expected to be reliable, is not guaranteed for accuracy, relevance or fitness for use for a particular purpose.
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Resources Relevant Articles from The Bond Buyer The Allure of 5% Bonds: Coupon Levitation Creates Magical Savings Andrew Kalotay, Friday, January 27, 2012 With Premium Callables, Worst-Case Metrics No Longer Work Peter Orr, April 26, 2016 Issuers Structure Deals to Meet Retail Demand for Lower Coupons Christine Albano, August 18, 2016 Taming Premium Bonds Winthrop Smith, August 10, 2016
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Resources – Conceptual Glossary The following Glossary is intended to help build your understanding of key concepts. The definitions are not necessarily standard or complete, but they are the sole responsibility of Win Analytics LLC. Glossary Contents Section
Slide #
Pricing
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Duration
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Options
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Refunding
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Taxes
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Glossary – Pricing 1/3 Price The bond price for an actual or hypothetical transaction is set by a mechanical process – it is the present value of the bond’s expected future cash flows, discounted at a pricing yield. The higher the yield, the lower the price. The yield reflects market conditions, the characteristics of the bond and the issuer, the needs and perceptions of those trading the bond, and tax considerations. There can even be feedback from the price back to the yield. For example, if high yields drive the price down far enough, market discount tax treatment may force the yield even higher to compensate for tax effects. Price and yield are two sides of the same coin. This can be confusing: if a headline says T-Bills are up, is that referring to prices or yields?
Pricing Yield The pricing yield on a bond is the rate of return that the bond’s cash flows must generate, relative to some price, so that a buyer and seller can agree to trade. If the bond is callable, more than one cash flow scenario must be considered, and the pricing yield will correspond to the scenario that generates the price-to-worst. The yields listed on the cover of an official statement are pricing yields. Note that “pricing yield” is not part of standard terminology, but we use it here to distinguish it from yield-to-call and yield-to-worst.
Premium If a bond pay an interest rate, or coupon, higher than the pricing yield, it is worth more than a similar par bond. The excess of its price over par is the premium.
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Glossary – Pricing 2/3 Discount If a bond pay an interest rate, or coupon, that is less than the pricing yield, it is worth less than a similar par bond. The excess of par over the bond price is the discount.
Price-to-maturity This is an intermediate price which sets the ultimate price if it is the lowest of all intermediate prices. It indicates the present value of the cash flows in the scenario in which the bonds run to maturity without being called early. The present value is discounted at the pricing yield. If the price-to-maturity is much higher than some price-to-call, the issuer will likely call the bonds to avoid delivering valuable cash flows at a bargain price.
Price-to-call There is a price-to-call for every potential call date. It is the present value of the cash flows, discounted at the pricing yield, assuming that the bond is called on that date. The ultimate price on the bond equals the price to a particular call date if it is lower than the prices to all the other call dates, and lower than the price- to-maturity. If the bonds are callable at par on every call date, premium bonds will price to the first call date and discount bonds will price to maturity. When there is a redemption penalty for a particular call date, the price to that call date includes the present value of that penalty.
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Glossary – Pricing 3/3 Price-to-worst MSRB rules set bond prices to the lowest of the price-to-maturity and every price-to-call. The buyer benefits by paying for the least valuable of the possible scenarios for the bond cash flows. For premium bonds with a par call, the least valuable scenario is to call the bonds on the first call date, and for discount bonds it is to run the bonds to maturity. Absent a shift in interest rates, any other scenario will be a bonus for the buyer and an injury to the issuer. Most issuers avoid such injury by refunding callable premium bonds.
Yield-to-call Given the price, the yield-to-call measures the return on investment if the bond is called. As with price- to-call, there is a yield-to-call for every possible call date, but if the calls are at par we are likely to be concerned only with the yield to the first call. A premium bond that is callable at par is priced to the first call date, and the yield-to-call matches the pricing yield. A discount bond is always priced to maturity;; its yield-to-call cannot be observed directly, but it does indicate investor’s return if the bonds are called.
Yield-to-maturity Given the price, the yield-to-maturity measures the return on investment if the bond runs to maturity. A discount bond is always priced to maturity, with the yield-to-maturity matching the pricing yield. A premium bond that is callable at par is priced to the first call date. In this case, the yield-to-maturity, or “kick yield”, represents a bonus to the investor if the issuer fails to call the bonds.
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Glossary – Duration Duration Duration is the Swiss Army Knife of bond finance. It simultaneous measures the time span of a bond’s cash flows and its sensitivity to changes in interest rates. For fixed cash flows, duration is the average time to the cash flows, weighted by their present value. In contrast to average life, which only considers principal payments, duration includes both principal and interest. Investors are more protected from upward shifts in interest rates if they hold short duration bonds. However, declines in interest rates can drive large gains for holders of long duration bonds.
Modified Duration The technical term for the duration of fixed cash flows, when used to measure the sensitivity of price to changes in interest rates, is modified duration. Modified duration takes simple duration, also known as Macaulay duration, and applies a slight adjustment. As an example, consider a ten-year zero coupon bond priced at 67.297 to yield 4%. The Macualay duration is 10 (there is a single cash flow at ten years) and the modified duration is about 9.8. If the yield drifts up by 0.10%, the price falls by about 9.8 x 0.10% x 67.297, which is about 0.007.
Effective Duration The cash flows on a callable bond are not fixed. The concept of effective duration takes into account the perceived likelihood of alternative cash flow scenarios. The effective duration on a bond that is very likely to be called in a year is close to a year.
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Glossary – Options 1/2 Call Option A call option, established at the time of bond issuance, gives the issuer the right, but not the obligation, to take back a bond at specified dates and prices. Bonds are often sold with a ten-year par call, meaning that the issuer can redeem the bond after ten years by paying the holder a call price of 100 and accrued interest. Bonds are typically callable on any interest payment date after the initial call date. Sometimes the first call price is at a premium, say 103, with declining prices for later call dates.
Option Value It is difficult to exactly specify the value of a bond option because the option is not priced or traded separately from the bond in which it is embedded. The value can be inferred using theoretical models, but there is no universal agreement on these models or the assumptions fed into them. Fortunately, all agree that option value has two parts: intrinsic value and time value.
Intrinsic Value At any point in time, the intrinsic value of an option is the value of exercising the option under current market conditions. If the bond is currently callable, this corresponds to the present value savings that a current refunding would generate. If the bond is not yet callable, the intrinsic value is the present value savings an advance refunding would generate. The intrinsic value cannot drop below zero because the issuer is not forced to exercise a costly option.
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Glossary – Options 2/2 In-the-Money/Out-of-the-Money An option is in-the-money to the extent it has positive intrinsic value. In this case, the bond can be refunded for some savings by replacing high coupons with lower yields in the current market. If a refunding would increase the issuer’s debt service, the option is out-of-the money.
Time Value The time value of a call option is created by future refinancing possibilities. Even an option with no intrinsic value can have some time value based on a probability that future markets could shift the option into the money. For a bond call option, the time value relates to the possibility that interest rates might decline in the future.
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Glossary – Refunding 1/2 Advance Refunding/Escrow/Defeasance/Negative Arbitrage Advance refundings allow new bonds to replace outstanding bonds by means of an escrow account holding government securities. The escrow trustee must apply the cash flows generated by the securities to pay interest on the refunded bonds until their call date. On the call date, the escrow pays for principal and any redemption penalty. If the escrow is properly constructed with appropriate securities (usually from the U.S. Treasury), the old bonds are considered to be defeased, meaning that the issuer can generally treat them as if they are not a liability. The combined yield of the escrow securities is limited to the arbitrage yield. The escrow is economically irrelevant if it has efficient cash flows and it earns the arbitrage yield (in that case, nothing matters but the characteristics of the old bonds and the new bonds). At present, unfortunately, advance refundings usually suffer from negative arbitrage because Treasury yields for escrow securities fall short of the arbitrage yield. The cost of negative arbitrage is the excess of the escrow cost over an ideal escrow earning the arbitrage yield. Not all tax-exempt bonds are allowed to be advance-refunded. Eligibility for advance refunding depends in part on how the proceeds of the original bonds were spent and on whether the bonds have been advance- refunded before. An advance refunding allows the issuer to exploit a call option without waiting for the call date to arrive. The potential to advance refund supplements a one-time call option with what has been termed the “advance refunding option” that can be exercised any time before the call date. The question of when to refund bonds is one of the most important decisions faced by issuers and their advisors.
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Glossary – Refunding 2/2 Current Refunding A current refunding occurs within 90 days of an existing bond’s call date. Bonds that cannot be advance-refunded are generally permitted to be current-refunded. Current refundings usually involve escrows. The negative arbitrage cost from a current refunding escrow can be modest because the escrow securities underperform the arbitrage yield for only a short period.
Arbitrage Yield The arbitrage yield on a bond issue is calculated at the time of issuance according to IRS regulations. It limits the earnings on the investment of bond proceeds, so that issuers do not abuse the tax exemption on bond interest. It is similar to the TIC except in its treatment of upfront costs and callable bonds. For premium bonds that are callable at par, the arbitrage yield calculation assumes that the bonds are called on the first call date.
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Glossary – Taxes Market Discount Tax Treatment For bonds acquired in the secondary market at a price below the de minimis threshold, the market discount is generally the difference between par and the purchase price (the calculation is modified for bonds with original issue discount). The market discount is taxable as ordinary income, undercutting the rationale for buying tax-exempt bonds and making the bond unattractive to typical tax-exempt investors.
De Minimis Threshold Investors in the secondary market are subject to market discount tax treatment if they purchase bonds at a price below the de minimis threshold. For bonds originally issued at par or at a premium, the threshold is determined by taking the remaining whole number of years to maturity, multiplying by a quarter point, and then subtracting this amount from par. The threshold for a bond with twenty years remaining to the maturity is 100 – 20 * 0.25 = 95. An investor purchasing this bond for 94 in the secondary market be subject to market discount tax treatment. Note that the threshold is not directly relevant to the original purchaser if they hold to maturity – they will not be subject to adverse tax treatment. However, if the original purchaser later brings the bond back to market, and its price has fallen below the threshold, the bond’s marketability will be impaired by its exposure to the market discount rules. For this reason, many investors prefer high coupon bonds which will only cross the de minimis threshold if the market yield climbs somewhat higher than the coupon.
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