Stern Brothers University - Tax-Exempt Bond Financing Overview
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WHAT CAN (AND CANNOT) BE FINANCED WITH
TAX-EXEMPT BONDS? - As a rule, a tax-exempt bond issue can finance the following: |
| - Capital construction (i.e. projects with a useful life) |
| - Reimbursement for capital expenditures made prior to the bond closing* |
| - Interest on the bonds during construction, plus 6-12 months |
| - Costs of Issuance up to 2% of the par amount of the issue |
| - Credit enhancement related costs (irrespective of the 2% limitation) |
| - Debt Service Reserve Fund (typically required for a fixed-rate issue) |
| - Existing loans incurred for capital projects |
| - Various capital expense items (routine or one-time) that will occur over the next three (3) years |
| * Assuming that a “reimbursement resolution” has been passed by the Board. |
| Items that typically cannot be financed with the proceeds of a tax-exempt bond issue include: |
| - Facilities whose use is exclusively non-secular in nature (e.g. chapels, etc.) |
| - Loans from a related party |
| - Working capital (or to refinance existing working capital loans) |
| - Costs of Issuance in excess of 2% (an equity contribution by the Borrower is required for the balance) |
| - The portion of a facility used by a commercial enterprise (above a deminimous amount). |
| ISSUING AUTHORITY |
| Although 501(c)(3) organizations are non-profit and are generally exempt from paying taxes, they cannot issue tax-exempt bonds on their own. In order to secure the federal and state tax exemption, the bonds must be issued through a "conduit" authority (e.g. state agency, county or city), with individual state law determining which of these entities are permitted by statute to serve in this capacity. The issuing authority, in turn, enters into a “loan agreement” with the 501(c)(3) borrower setting out the terms for debt repayment. The Issuer will also ensure that the financing is consistent with their policies, pass appropriate resolutions, hold the necessary public hearings, and generally oversee the “pricing” (i.e. sale) of the bonds. |
| FINANCING STRUCTURE |
| The decision
as to the financing structure will have a significant impact on the
Borrower going forward. Both fixed and variable-rate debt have their
own unique characteristics that may make one more appropriate than the
other based upon the particular objectives of the borrower. |
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Fixed-Rate Bonds
Fixed-rate bonds sold to the broad capital markets (as opposed to Private Placements) are typically structured with a series of individual maturities ("Serial" bonds that mature annually during the early years, and "term bonds” that mature in the later years). At closing, the borrower is able to lock-in interest rates for the life of the issue (e.g. 25-30 years), thereby removing any uncertainty regarding the amount of funds needed to service the debt in the future. With fixed-rate debt, bondholders are given "call protection" for a period of years (typically 8-10) preventing the bonds from being prepaid during that time (although they can be "defeased' by funding an escrow with US Treasuries). Generally, during the first year or two when the bonds can be called, a premium is paid to the bondholder (e.g. 102%). Fixed-rate bond issues are generally larger in size than variable-rate financings due to the capital market's requirement of a Debt Service Reserve Fund equal to the maximum annual principal and interest on the bonds (see Structuring Elements below). In general, fixed-rate debt is appropriate for organizations that want the "peace of mind" that their debt service requirements will not change, or for those entities that cannot tolerate increases in debt service (if even for a relatively short period of time). Conversely, organizations that plan to redeem bonds on a more accelerated basis with the proceeds of a capital campaign or excess revenue typically do not achieve the flexibility that they need with a fixed-rate structure. Finally, fixed rate bonds can be sold based upon the rating of the borrower (if available), the rating of a credit enhancement provider (e.g. bond insurance or bank Letter of Credit) or unrated (often as a Private Placement). Variable-Rate Bonds By definition, the rate on a variable-rate bond changes based upon the particular interest rate mode in which the bonds are sold (e.g. daily, weekly, monthly, etc.). Variable-rate bonds can be "called" at par (without premium) on 30 days notice, thereby allowing the Borrower to redeem a portion or all of the bonds depending on its needs. If maintaining financial flexibility (e.g. paying down debt as capital campaign contributions are received) is important to the Borrower, variable-rate debt can achieve that objective. If variable-rate debt is the choice of the Borrower, the very lowest interest rate is achieved through the issuance of variable-rate bonds priced in the daily mode. During the past ten years, bonds sold in the daily interest rate mode have averaged 18-20 basis points (i.e. .18% - .20%) lower than bonds priced in the weekly mode. For budgeting purposes, many organizations that finance projects with variable-rate debt assume a somewhat higher interest expense (e.g. 6% - 7%) and self-fund a "reserve" to provide for those occasions when rates may "spike" for a short period of time. Historically, these spikes occur at year-end and around April 15 th . Hedging Techniques Organizations that have variable-rate debt sometimes elect to hedge against rising interest rates through the use of one of several techniques. These include such things as a: Cap - By making an up-front payment, the borrower can purchase an interest rate Cap with a "strike rate" tied to a floating rate index for a predetermined notional dollar amount (e.g. the par amount of the bond issue) and maturity (i.e. term of Cap). Collar – This technique allows a borrower to protect itself from rising interest rates by purchasing a Cap while simultaneously selling a “floor.” With a Collar, they will not pay more if rates rise above a predetermined level, but will not benefit if rates decline below the floor. Theoretically, the cost of these two actions can offset one another. Swap – Depending upon their financing objectives, borrowers frequently enter into a Swap agreement whereby they exchange the cash flow requirements of their floating rate debt for the cash flow requirements of a counter party with fixed rate debt resulting in a synthetic fixed rate for the borrower. As with other hedging vehicles, this is based on a predetermined notional amount and for specific period of time (e.g. 5, 7, 10 years), and the cost of the Swap is imbedded in the rate. |
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Capital Campaign Contributions received which are specifically restricted to a project financed with tax-exempt bond proceeds must either be: |
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| To achieve
the greatest flexibility, organizations are encouraged to solicit
contributions that support general capital improvements, rather than
specifically for the projects being financed with tax-exempt debt.
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Amortization of
Debt As a general rule, Borrowers should consider issuing bonds with a final maturity in the 25-30 year range. The logic behind this is that it provides the lowest annual debt service and the least financial burden to operations. While the longer amortization provides reduced debt service payments, it would not preclude redeeming bonds at an accelerated pace should capital campaign gifts or revenue significantly exceed projections. This would certainly be the case with variable-rate bonds and would also apply to fixed-rate bonds after the call period. |
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CREDIT ENHANCEMENT Credit enhancement enables bonds to be sold based upon the rating of a third party (e.g. bank, insurance company, etc.) as opposed to the credit of the borrower, and can be provided either by a letter-of-credit when issuing variable-rate bonds or by utilizing bond insurance when issuing fixed-rate bonds. While credit enhancement increases the cost of issuing bonds, if properly priced, it should provide the borrower with a lower "all-in" borrowing cost. In general, credit enhancement is available to institutions that are deemed to be creditworthy on a stand-alone basis, or may require a third party guaranty. As additional security for the Letter of Credit bank, a mortgage on the financed property may be required. |
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Letter of Credit
Letters of Credit are most often used with variable-rate financings and are typically issued for an initial period of 3-5 years with renewal ("evergreen") provisions. They are priced as a percentage of the outstanding principal amount of the bonds and paid annually. In addition, the bank providing the Letter of Credit charges an up-front arrangement fee, plus the legal costs associated with drafting the necessary documents. Bond Insurance Bond insurance is most often used in conjunction with a fixed-rate issue and generally achieves the same objective as a bank Letter of Credit (i.e. enabling the bonds to be sold based upon the rating of the insurance company). Bond insurers typically charge an up-front premium paid at closing which can also be financed with bond proceeds. The premium is quoted as a percentage of total debt service (i.e. principal and interest paid over the life of the issue). |
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STRUCTURING ELEMENTS
Project Fund When financing new construction (as opposed to refinancing existing debt), some portion of the bond proceeds are generally deposited into a Project Fund. The amount deposited can be the total amount needed ("gross funded") or an amount, when combined with the earnings from the investment on the funds during the construction period (based upon a projected draw schedule) ultimately provides the total amount required ("net funded"). Federal tax law provides guidelines relating to the expenditure of bond proceeds during the two-year period subsequent to closing, particularly as it relates to retaining any earnings above the bond yield. In general, for the borrower to retain any positive arbitrage earned on the investment of the Project Fund during the construction period, the following spend-down levels must be met or exceeded: |
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| If these minimum requirements are not met, the borrower will be required to rebate to the federal government any earnings above the bond yield. |
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Debt
Service Reserve Fund
For fixed-rate bond issues, bondholders typically require a Debt Service Reserve Fund to be put into place equal to the maximum annual debt service (i.e. principal and interest) for the issue. This can be financed within the bond issue. As a rule, Debt Service Reserve Funds are not required for variable-rate transactions. Capitalized Interest Interest on the bonds can be "capitalized" within the issue until such time as the project begins to generate revenue, plus a reasonable period thereafter (e.g. 6 - 12 months), which may be appropriate for projects that have a revenue source expected upon completion. Debt Service Fund All debt service payments are made from the Debt Service Fund. Capital campaign contributions received that are specifically restricted to a project financed with bond proceeds age generally deposited into this account and are used to redeem bonds within a twelve (12) month period. Assuming that it is not inconsistent with restrictions imposed by the donor, it can also be used to pay interest and principal on the bonds. |
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REIMBURSEMENT FOR PRIOR CAPITAL
EXPENDITURES Federal tax laws impose very specific guidelines when tax-exempt bond proceeds are used to reimburse a 501(c)(3) entity for capital expenditures made prior to the date the bonds are issued. Reimbursement Resolution In general, the borrower must evidence intent to reimburse itself with the proceeds of a tax-exempt bond issue for a specific capital project. There are various ways in which this intent can be evidenced, but it is best to do so through formal action by the Board of Trustees. Timing The institution may reimburse itself for capital expenditures made after the date of the official intent resolution and for expenditures made within 60 days prior to its passage. Accordingly, it is very important that the Board take formal action as soon as possible once a project has been identified. As a general rule, expenditures for architectural, engineering and similar "soft costs" made prior to the 60-day "look back" provision can be reimbursed. |
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ISSUANCE EXPENSES When issuing tax-exempt debt, there are a variety of issuance expenses that fall under three general categories: 1) Costs of Issuance, 2) Underwriter's Discount, and 3) Credit Enhancement related fees and expenses. Up to 2% of the proceeds from a tax-exempt bond issue can be used to pay Costs of Issuance and Underwriter's Discount (combined). Costs in excess of the 2% threshold must be paid by the borrower or financed on a taxable basis. Credit enhancement related fees and expenses are excluded from this requirement. It is reasonable to conclude that there will be some equity contribution required of the Borrower. Costs of Issuance Costs of Issuance represent all expenses associated with the issuance of the bonds, except for the Underwriter's Discount as well as credit enhancement related expenses. Specifically, this would include fees and expenses for: Bond/Disclosure Counsel, Trustee, Official Statement printing, Issuing Authority, Borrower's Counsel, rating agency fees, etc. Underwriter's Discount The Underwriter's Discount is the compensation paid to the Investment Banker for structuring, marketing, and selling/underwriting a bond issue. |
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FINANCE TEAM
Issuing publicly traded debt securities that are exempt from federal and state taxation is a relatively complex undertaking requiring the expertise of a number of individuals representing a variety of interested parties and will generally include the following: |
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REQUIREMENTS OF THE BORROWER
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"TEFRA" HEARING
REQUIREMENT The TEFRA hearing process is a public accountability procedure involving the legislative body of the local agency in which the proposed project is located. To comply with the 1986 tax act, the legislative body is required to conduct a public hearing providing members of the community the opportunity to speak on behalf of or against the proposed project to be financed with tax-exempt bonds. The legislative body will also be asked to adopt a resolution approving of the issuance of tax-exempt bonds for the financing. |
FINANCING SCHEDULEDepending upon the nature and complexity of the financing structure, a tax-exempt bond financing can generally be completed within 60-90 days. Factors that may extend the timing can be delays in securing additional credit enhancement for this issue from the bank group or issues related to the Borrower (e.g. construction related, difficulty in completing various tasks that are required of them, etc.). |