Many revenue bond issuers are sending big checks to their trust departments because of rising interest rates.
Municipal revenue bond issuers have Debt Service Reserve Funds (DSRF) held with their trustees. The DSRF is 10% of the bond that is issued. Because they are borrowing money and paying interest, it only makes sense to get some return on the DSRF. To get any kind of a yield and fix their negative arbitrage, they go out longer on the yield curve. However, buying long-term investments puts the buyer at risk of an increase in interest rates. When interest rates rise, the value of bonds declines. The longer the maturity date, the more the investment value changes due to changes in the interest rates.
We do not want to single out any entity, so we are going to tell the story of a fictitious city with fictitious names. Our Midwest city, Sittle, has just completed the issuance of a $50 million revenue bond, Tax Increment Financing (a TIF), for an IKEA store and a strip outlet mall. The money is now with the trustee, and Mary, the financial officer, is happy that it is all over.
A few short months later, Mary gets a call from John the Bond Broker. John tells Mary that the $5 million sitting in the DSRF for the $50 million TIF bond is not making any money. He urges her to invest the money in a permissible investment that the bond indenture stipulates will increase her return. Mary thinks that the City of Sittle is borrowing the money at 4%, and on $5 million, she is not earning anything. This new investment makes a lot of sense to her. Mary is now receiving just under $150,000 per year from the coupon payments from the 10-year agency bond that is in her DSRF. All is well, for now.
Eight months later, Mary gets another call from John. She is informed that her 10-year agency in the DSRF is going to get called, and unless she replaces it with a new bond, the income will go back down to almost zero. John, then, makes another suggestion – this time, a 15-year callable agency, and it has a higher coupon rate. Mary likes the idea, and John facilitates the transaction with her trustee.
Twelve months later, Mary receives a call from John. The 15-year agency is being called. But, no worries, John has something even better – an 18-year AA-rated municipal bond that is just slightly higher in its yield to maturity. Mary, who now feels like a very experienced bond buyer, tells John to move forward with the muni.
December 2016: It is after the election. Mary gets a call from Joan at the trust department that is holding the moneys in the DSRF. Joan explains to Mary that the value of the $5 million DSRF must be maintained. She further explains that, currently, the value is down approximately 8%, and it is worth $4.6 million if sold today. The trust department needs the DSRF to be brought back up to $5 million. Joan asks Mary to send the trust department a check for $400,000. Mary is in complete denial and gets into a healthy argument with Joan.
After several minutes of talking to the trust department, the bond attorney, and her administrator, Mary has accepted the fact that the City of Sittle needs to write a check for $400,000 to the trustee. The administrator is not happy because he didn't know any of this was going on and now must explain a $400,000 check coming out of their limited funds being sent to the trustee. The board has new concerns about the competence of the financial officer and the administrator.
Next, Joan, our trustee, has to pick up the phone and call the City of Casey, to inform them that their DSRF is down by 6%.
Many issuers of revenue bonds are beginning to fully understand how interest rate risk works and how they are affected by rising interest rate risk. Some trustees and financial officers are gaining a reputation for not seeing, mitigating, or getting warning of interest rate risk.
Trustees and issuers of revenue bonds must have the tools and training to evaluate interest rate risk before they make such purchases. We have many financial officers, treasurers, and trustees across the nation who have never experienced a sharp rise in interest rates and are dealing with great losses of value.
Jim Koetting is the author of "Public Fund Investing for Dummies" and the CEO of PFITR, a bond accounting and analytics tool.
