Utilization of an improved forward delivery bond to enhance interest rate management.
Editor's note: Each year the Government Finance Officers Association awards its prestigious Award for Excellence to recognize outstanding contributions in the field of government finance. This article describes the 1993 winning entry in the capital financing and debt administration category.
The Port Authority of New York and New Jersey, like most issuers, has tried to take maximum advantage of the historically low interest rates that the municipal market has experienced during the past two years by refunding its highest coupon debt. The authority was able to do many transactions as current refundings because the seven- or 10-year call protection on those bonds had expired. Several of its issues, however, including those with the highest interest rates, were not yet callable and because of tax implications could not be advance refunded. This situation led to the authority's interest in and ultimate issuance of an improved forward delivery bond--the subject of this article. To set the framework for the discussion, some background on the Port Authority and its finances, as well as a detailed discussion of its forward delivery bond, follow.
The Port Authority of New York and New Jersey is a bistate agency, established in 1921, charged with the responsibility for planning, constructing, operating and maintaining transportation, commercial and trade facilities in the port district, an area roughly 25 miles in all directions from the Statue of Liberty. It operates and maintains three major airports, two tunnels, four bridges, the World Trade Center, port facilities, an interstate light rail system and various other facilities in New York and New Jersey. Much like a private business, it must rely on the revenues generated by its facilities to pay its operating and maintenance expenses and debt service. It receives no operating subsidies from either the State of New York, the State of New Jersey or the federal government. The authority raises the necessary funds for the improvement, construction or acquisition of its facilities on the basis of its proven revenue generating ability, its substantial reserve funds and its sound credit standing. The Port Authority is a capital-intensive agency that has invested more than $9 billion in the development of its facilities and has more than $4 billion of indebtedness currently outstanding related to this investment. As a public agency with an important impact on the cost of moving people and goods throughout the New York/New Jersey region, the authority must be highly sensitive to the cost structure of its facilities. As a result, the efficiency with which it can finance its capital improvements, as well as refinance outstanding debt during times of low interest rates, is critically important.
As a frequent, consistent issuer of debt, the authority has issued debt in both high and low interest rate environments over the years and was subjected to the extraordinarily high interest rates of the early to mid-1980s. While the agency did many things during that period to ameliorate the effect of those high long-term rates, such as instituting a tax-exempt commercial paper program and issuing one- to three-year notes to access the shorter end of the yield curve, some long-term debt was issued, most of which provided seven- to 10-year call protection in accordance with market requirements.
Searching for the Ideal Hedge
In the late 1980s, interest rates began to approach levels that seemed to make the refunding of the high coupon debt issued in the early 1980s very attractive. The Port Authority faced very imposing obstacles, however. It could not refinance this debt on a current basis because the bonds were not yet callable. It could not refund on an "advance refunding" basis because the bonds were classified as "private activity" debt under the 1986 tax law and thus were not legally eligible to be advance refunded. The authority issues debt on a consolidated basis, meaning its bonds are secured by the revenues of all of its facilities and the proceeds can be spent on any of those facilities. Since the issues in question were used in part for airports and ports, the entire issues were considered private activity and not eligible for advance refunding. (Subsequent to the Tax Act of 1986, the authority divided its issues into private activity and governmental purposes to avoid this problem.) Rather than just wait until this high coupon debt could be refunded on a current basis and hope that rates would stay low or go lower, the authority began looking for ways to hedge the then-low current rates until a current refunding could be done at the first call date.
The first approach was to challenge the Wall Street investment banks to come up with a way to hedge these issues until they could be refunded. The Port Authority's view always has been that the Wall Street firms are the experts on managing interest rate risk; therefore, it was preferable to buy a "rate lock," guaranteeing a rate for a future issuance and let the seller of the "rate lock" place the appropriate hedges and take the associated risks.
After numerous discussions with several investment banks produced a lot of interest but nothing concrete, the authority decided in early 1987 to take matters into its own hands. It hedged the then-current interest rates through the short sale of Treasury and municipal futures contracts in anticipation of a bond sale six months later, which would refund the $100 million 10 1/4 percent consolidated bonds, 49th series.
While this venture went exceedingly well, with the hedge providing significant savings that offset a rise in rates, the authority continued to look for "a more perfect hedge," one that would not expose it to the various risks in the futures market and one that would be more effective for hedging over a longer period. The authority found the improved hedge in forward bond transactions.
Forward Bond Transactions
The first indication that a more perfect hedge could be accomplished was when the first forward delivery bonds were done. While these transactions were intriguing and showed promise, they were relatively cumbersome and complex. Many entailed the establishment of taxable or tax-exempt escrows. Most involved the ultimate investor in the negotiation of the transaction and exposed the issuer to performance risk with the investor. These were complications in which the authority did not want to get involved. In addition, many of the early forward delivery bonds involved a fairly high forward premium. The forward premium on a forward delivery bond is composed of two components, a liquidity premium and a forward rate premium. The liquidity premium is the number of basis points needed to compensate investors for the fact that they cannot easily sell this investment during the forward period. The forward rate premium is necessary to compensate investors for the fact that they will have their funds invested at lower yields in short-term obligations until they take delivery of the long-term bond upon closing and begin receiving the higher long-term rate.
Because the authority was uncomfortable with the complications of the existing forward bonds, it established a goal of developing a forward bond that would come as close as possible to a standard bond issue with the only difference being that the transaction would involve an unusually long delay (from several months to two years) between sale and closing. The authority also wanted a bond that would have a reasonably small forward premium. In 1990, Wall Street was told that there were two bond issues in particular that the Port Authority wanted to refund on a streamlined forward delivery basis: the $100 million, 10 1/8 percent consolidated bonds, 50th series, first callable in December 1992, and the $100 million, 11 percent consolidated bonds, 51st series, first callable in June 1994. Not coincidentally, these two issues carried the highest interest rates of any of the authority's outstanding bonds. One of the major Wall Street firms approached the authority with a product that was close to what it had been looking for: a municipal forward bond that was fully underwritten by the firm with no escrows required and without many of the "outs" enabling the underwriter to cancel the transaction usually found in forward delivery bond purchase contracts. Working with this firm, the Port Authority fine-tuned the structure to meet its requirements and, in March 1991, entered into a contract with the firm for the delivery of $100 million consolidated bonds, 72nd series, on or about October 1, 1992. The transaction was to be used to refund consolidated bonds, 50th series, locking in present-value savings of $16 million. For the 19-month forward period, the bonds carried a relatively modest forward premium over the spot bond market.
Competitive Forward Bonds
At the time of the first forward transaction, it was not economical to provide for the forward refunding of consolidated bonds, 51st series, because the forward period of 37 months at that time would have demanded a prohibitive forward premium. In succeeding months, however, as the forward market became more liquid, forward premiums began to come down, and the first call date of those bonds grew closer. Later in 1991, the authority decided that the time was ripe for a forward refunding of the 51st series. Consistent with the desire of the Port Authority's Board of Commissioners to do most bond transactions competitively, the authority was determined to do this forward delivery bond on a competitive basis, something that apparently had never been done. The first step of the process was to issue a request for proposal (RFP) to the firms that had previously made forward refunding proposals. Within the broad parameters laid out in the documents, the firms were encouraged to be creative as possible. All of the invited firms submitted their ideas as required by September 11, 1991. The proposals fell into three major categories: forward swaps, forward bonds and tender programs.
After detailed analysis and review, the authority decided that the forward bond was the preferred vehicle because
* it was suggested by all of the firms who had more than one idea,
* it was much more straightforward than a forward swap with fewer moving parts and less risk, and
* the forward interest rate was absolutely fixed.
TABULAR DATA OMITTED
The authority initiated the second step of the bidding process by sending a letter to all of the firms, advising them of its plan to go ahead with the forward bond concept and its intention to sell bonds pursuant to a contract of purchase generally similar to that used for the sale of the 72nd series bonds. Proposals for forward delivery bonds were received from nine firms. As a result of those bids, the authority decided on the successful bid which, when delivered, will result in guaranteed present-value savings in excess of $26 million.
Choosing a Refunding Alternative
Although the forward delivery bond has been a very efficient refunding technique for the Port Authority, it is only one of the options available for managing outstanding debt. When looking at potential refunding opportunities, it is important to consider all of the various techniques available to an issuer, including advance refundings, forward delivery bonds and forward interest rate swaps. In addition, as part of this analysis, an alternative that should be considered is waiting until a bond can be refunded on a current basis. All of these methods have their advantages and disadvantages and must be evaluated carefully, one against the other.
As part of a regular interest rate management program, the Port Authority looks at all of its outstanding bonds at least quarterly to determine what action should be taken, if any, to change the characteristics of the debt. This is obviously a dynamic process because, as time passes, the general level of interest rates, as well as the shape of the yield curve, is likely to change and thus impact this decision. In addition, with the passage of time, bonds not yet callable get closer to their first call date. A bond not economically refundable on a forward delivery basis with a 36-month forward period may be economically refundable with a 24-month forward period.
The Port Authority closed on its first forward delivery bond in October 1992. This bond accomplished everything that the authority had hoped it would. While the forward delivery bond is not a panacea for municipal issuers, it can be a very effective tool to be employed in certain situations. Each issuer should evaluate this option, along with the other forward refunding techniques that are available, in light of its own strategic position.
Advance Refunding -- The refunding of an outstanding issue of bonds by the issuance and delivery of a new issue of bonds prior to the date on which the outstanding issue of bonds can be redeemed. Thus, for a period of time, both the refunding issue and the issue being refunded are outstanding. Forward Delivery Bond -- A bond which is to be delivered at a specific date in the future, the proceeds of which will be used to refund an outstanding bond at its first call date. All of the characteristics of the bond -- structure, interest rate, etc. -- are determined in advance and are outlined in a bond purchase agreement, which is executed prior to the delivery date of the bond.
Forward Interest Rate Swap -- A fixed-rate payer/variable-rate receiver interest rate swap, with payments to begin at a specified date in the future. In refunding transactions this swap would be combined with the issuance of a variable rate bond to provide the funds to refund the outstanding bond. The combination of the swap contract and the variable rate bond would provide the issuer with a synthetic fixed rate refunding bond. The swap payments would be scheduled to be effective at the time the variable rate bond would be issued which usually would coincide with the first call date of the bonds to be refunded.
Hedge -- A technique to provide protection against rising interest rates. One method of hedging is through the sale of the municipal futures contract. The value of these contracts moves inversely to interest rates. As interest rates go up, gains would accrue with a "short" futures position, offsetting those rate increases. All of the instruments described in this glossary can be used as hedges against adverse changes in interest rates during the period between execution of the hedge position and the issuance of the refunding bond.
Municipal Futures Contract -- A futures contract is an agreement to either make delivery (short position) or take delivery of a fixed amount of a specific asset at a future date. The Municipal Bond Index Futures Contract differs from traditional futures contracts in that no physical delivery takes place. Instead, the contract is settled in cash.
* Terms in this glossary are defined in the context of this article.
The Issuer's Guide to Forward Deals: What They Are, Why to Use Them
In cases where federal law rules out advance refunding, an issuer can try two other techniques for taking advantage of the current low interest rates: a forward transaction or a forward swap transaction.
In an ordinary forward transaction, the issuer locks in the rate and terms of bonds to be delivered later on. Investors receive a forward contract, which obliges them to buy the bonds when they are delivered.
To compensate the investor for waiting, the locked-in rate is higher than the rate the issuer would pay if the bonds were delivered today. The difference between the two is called the forward premium, and it is shaped by such factors as the level of long-term and short-term rates and the shape of the yield curve. Many market participants consider the forward contract a derivative because its value derives from the value of the bond to be delivered. For example, an issuer could sell forwards for noncallable, 15-year bonds to he delivered one year in the future. If the issuer priced similar bonds for immediate delivery, the bonds would yield 5 percent. So the forward bonds will yield 5 percent plus a premium. The premium compensates the investor for the lost opportunity of receiving interest on the investment for the period before the bonds are delivered. A small portion of the premium may also be compensation for the illiquid nature of the forward contract compared with an ordinary bond.
What is the value of the lost opportunity? If an ordinary bond had been purchased, the investor would receive 5 percent for the first year. Instead, the investor could buy a one-year security and receive less than half that rate. The Bond Buyer's one-year note index was at 2.28 percent on Dec. 23.
After the first year, the buyer of the ordinary bond continues to receive 5 percent interest. What rate should the forward buyer receive to garner an equivalent return?
One measure used to compare the relative return on cash flows is known as the internal rate of return. The internal rate of return is the discount rate at which the present value of the future cash flows equals the amount paid upfront. The internal rate of return on the ordinary bond, held to maturity, is 5 percent. To achieve an internal rate of return on the forward transaction of 5 percent, after receiving just 2.28 percent for the first year, the forward bond would have to yield about 5.28 percent.
The forward bond's rate premium might be higher or lower to account for illiquidity, supply and demand, or other factors.
When a forward transaction is used instead of an advance refunding, the issuer must consider the cost of leaving its current high coupon debt outstanding until the call date, against the costs of the forward transaction.
The issuer's interest costs will generally be higher on a forward transaction than on a simple advance refunding.
A Forward Swap
The forward swap transaction attempts to meld the advance refunding elements of a forward issue with the additional savings provided by synthetic swap-based issues. A forward swap structure can both boost the resulting savings and allow the issuer to get the money sooner rather than later. Instead of agreeing to issue fixed-rate bonds in the future, an issuer can agree to issue variable-rate bonds in conjunction with an interest rate swap.
The structure resembles a synthetic fixed-rate transaction. In those deals, an issuer sells variable-rate bonds and then enters a swap under which the exchanged interest payments are calculated according to the principal of the bonds.
The issuer pays the swap counterparty a fixed rate and the counterparty pays the issuer a variable rate close to or identical with the variable rate due on the bonds. The net effect for the issuer is fixed-rate debt service, usually 25 to 50 basis points lower than the issuer would have paid on ordinary fixed-rate bonds.
A forward swap transaction works in a similar fashion. While the terms of the deal are set immediately, the variable-rate bonds are not issued until later. The swap contract is entered immediately, but usually the issuer and the swap counterparty do not exchange payments until the bonds are issued.
The swap can be structured to provide an up-front payment to the issuer immediately. The swap counterparty makes a one-time payment to the issuer when the terms are set. Then, when the exchange of payments occurs in the future, the issuer pays a slightly higher fixed rate.
The up-front payment option makes forward swap deals particularly appealing because the issuer receives some of the future savings immediately. On a forward fixed-rate bond issue, the issuer receives no savings until the existing bonds are called and the new bonds are issued.
To account for the swap counterparty's risk in agreeing to lock in a future interest rate, the issuer must pay a premium on the swap. The fixed rate the issuer will pay once the bonds are issued will exceed the rate the issuer would have paid if the swap took effect immediately.
The premium can be substantial, although the entire transaction can still provide a lower net debt cost than a forward deal that uses fixed-rate bonds.
BRUCE D. BOHLEN, is assistant treasurer of the Port Authority of New York and New Jersey with responsibilities in the areas of cash, debt and portfolio management. He is a member of the GFOA and the Municipal Forum of New York.
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|Title Annotation:||includes related article|
|Author:||Bohlen, Bruce D.|
|Publication:||Government Finance Review|
|Date:||Feb 1, 1994|
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