The Feds Outlawed a Key State and Local Refinancing Tool. Now What?
By Route Fifty
Vermont Treasurer Beth Pearce recognizes that the demise of tax-exempt advance refunding bonds, and what it means for state and local public finance, may not be a front-and-center issue for many Americans.
“It's not something that is readily apparent,” she told Route Fifty in late April.
But that doesn’t mean the change is inconsequential. “It’s going to increase borrowing costs for state and local governments, which will ultimately be borne by the taxpayers,” Pearce said.
Last year’s Republican-led federal tax overhaul put the kibosh on tax-exempt advance refunding bonds. As of Jan. 1 the bonds are banned under federal law. They had served as a tool state and local governments commonly used to refinance and restructure debt.
Figures compiled by the Government Finance Officers Association show that at least 8,353 tax-exempt advance refundings took place across the U.S. between 2012 and 2016. These totaled $391 billion, and resulted in an estimated minimum savings of $11.7 billion.
The change in tax law has left finance officials chafing at the loss of an option to reduce borrowing costs. Meanwhile, the municipal finance world is eyeing possible alternatives to advance refunding, some of which could carry added expenses and new risks.
“I’m very disappointed, obviously,” Eric Johansen, debt manager for Portland, Oregon, said recently as he discussed the lost exemption. “We were frequent issuers of advance refunding bonds,” he added, “and had the opportunity to save hundreds of millions of dollars.”
Much of the government borrowing at the state and local level goes to pay for infrastructure, like roads, waterworks and schools.
President Trump has identified public works investment as one of his priorities. And his administration has indicated a preference for funneling federal aid to states and localities that can bring greater shares of non-federal money to the table for infrastructure projects.
Eliminating advance refunding puts a dent in the ability of states and localities to do that, finance officials say. “Whatever we're not saving because they’ve taken this tool away means less investment in infrastructure,” said Florida’s director of bond finance, J. Ben Watkins.
Florida executed roughly $14 billion of advance refundings between fiscal years 2011 and 2017, achieving gross savings of about $2.8 billion, according to Watkins.
Like other forms of municipal debt, investors’ interest earnings on advance refunding bonds were exempt from federal income tax prior to the new tax law taking effect.
By eliminating the advance refunding exemption, the lawmakers who crafted the tax package gained a roughly $17.4 billion offset over a decade to help pay for tax cuts for corporations and individuals, as well as other changes to the tax code, which are expected to erode upwards of $1 trillion of federal revenues in the years ahead.
“This was just a pay-for,” Watkins said of the axed exemption. “There was no thought behind the policy and the implications.”
He noted that during last year’s tax policy debate he made a case for preserving the advance refunding exemption to Florida’s congressional delegation. “They were sympathetic,” Watkins said. “But they had no say in what leadership put in that bill.”
Advance refunding offers municipal borrowers a way to issue new debt to refinance or restructure outstanding bonds more than 90 days before the outstanding bonds reach their “call date,” which is a date when the borrower is allowed to pay them off.
In contrast, a “current refunding” takes place inside that 90-day window. Tax-exempt current refundings are still allowed.
The advantage of an advance refunding for a state or local borrower is that they can take advantage of low interest rates available outside of the 90-day current refunding timeframe.
Johansen said Portland achieved just shy of $125 million in “present value” savings, over about five years, using advance refundings. The city’s total outstanding debt is currently about $3.2 billion, with water and sewer borrowing accounting for about 70 percent of that sum.
Portland had two advance refundings late last year it wanted to pull the trigger on, but couldn’t get them done in time to beat the ban imposed by the new tax law, according to Johansen.
He said going forward the city will closely watch when current refundings for bonds become possible, but noted “we’re really at the mercy of the market at the time that they become callable.”
Since the tax law was enacted, no overwhelmingly popular alternative to tax-exempt advance refunding has emerged, municipal finance experts said in recent weeks. Although the University of Dayton, in Ohio, drew attention last month when it turned to a “forward delivery” structure to refund about $49 million of debt.
With this structure, a borrower can sell tax-exempt bonds under a bond purchase agreement that is made outside of the 90-day timeframe for a current refunding. This allows the borrower to lock in an interest rate at that time. But the deal isn’t finalized, or closed, until a time that falls within the 90-day current refunding window.
“There's probably a market premium, or an interest rate increase, as a result of what the investors view as a risk of interest rates going up,” Dee Wisor, a Denver-based attorney who works on municipal bond deals for the law firm Butler Snow LLP, said of forward delivery.
These included vanilla options like current refundings, taxable advance refunding bonds, which are still permitted, or negotiating with existing bondholders. Forward delivery bonds made the list. As did exotic possibilities like “swaps,” which can refer to a range of "derivative" products, and “Cinderella bonds,” which are initially issued on a taxable basis and later convert to being tax-exempt.
“Those are kind of floating out there, but I haven’t really seen a lot of activity,” Lisa Washburn, managing director at Municipal Market Analytics, said in late April after referencing the paper.
“Keep in mind that a lot of the refunding activity was pulled forward before the new tax law went into effect,” she added.
The elimination of tax-exempt advance refunding might also raise questions for states and localities as they consider issuing new debt.
For instance, whether it could make sense to shorten the amount of time until bond call dates are reached to less than the traditional 10 years, which would allow for earlier current refundings. Or if a bank loan might offer more flexible repayment terms than bonds.
Johansen, who’s worked in finance since the early 1980s, was skeptical of the more esoteric advance refunding substitutes. “Everything that I can see about these things is they’re poor alternatives to what you could have done with an advance refunding,” he said.
He emphasized that if borrowers are considering untested, or complex alternatives, it is crucial for them to have a seasoned financial advisor.
“I can imagine that the investment bankers are going to be out there pitching these things and some of them may look really good,” he said. “But issuers need to have somebody on their side of the table to say: ‘OK, that’s all well and good, but here are the risks.’”
There is a nascent effort in Congress to revive the advance refunding exemption.
U.S. Rep. Randy Hultgren, an Illinois Republican, introduced a bill in February that would restore it. But the legislation has yet to gain serious momentum. It has 10 co-sponsors, including three Republicans, and has been referred to the House Ways and Means Committee.
There’s also been talk about whether municipal borrowers might carry out advance refundings, but make payments to the federal government to compensate for lost tax revenues.
But The Bond Buyer reported last month that a tax official with the Treasury Department said this would require approval from Congress.
Pearce, the Vermont treasurer, is also currently the senior vice president for the National Association of State Treasurers. She said the group continues to view the loss of tax-exempt advance refunding as a leading issue in discussions with lawmakers on Capitol Hill.
“Our job is to get the best value for our taxpayers and this is an important tool to make that happen,” she said. “We need to do all we can to restore it.”