With a rebound in tenders over the last few years — which are a way to generate savings following the elimination of tax-exempt advanced refunding under the 2017 Tax Cuts and Jobs Act — issuers can still leave savings on the table by forfeiting the option value.
Part of the problem, Andy Kalotay, president of Kalotay Advisors, argued while presenting a paper at the Brookings conference Tuesday, is that debt managers have been led to believe their job is to predict where interest rates will go instead of using accepted, well-understood analytical tools. Kalotay co-authored the paper with Martin Luby, director of the Center on Municipal Capital Markets at the University of Texas at Austin
During his talk, Kalotay took aim at the Government Finance Officers Association and the Municipal Securities Rulemaking Board, charging regulators and trade associations with dropping the ball.
Nikolai Sklaroff, the San Francisco Public Utilities Commission's capital finance director, took issue with many of Kalotay's arguments.
"It's unfortunate to have this discussion be an attack on issuers and attack on municipal advisors," he lamented during the verbal sparring with Kalotay.
It would be more productive, Sklaroff noted, to provide a tool people could deploy.
But since 2024,
Some issuers, "obsessed" with showing savings, turn to tenders to generate those savings, believing interest rates will rise, Kalotay said.
"If you think rates are going higher, you can hedge it. But the way they are doing it in these tender offers, where they are paying four points premium over market price, and then some transaction costs, is a very foolish way of hedging interest rates," he said.
However, refundings forfeit a call option, so it becomes a question of whether the savings are adequate for forfeiting option value,
Poorly implemented refundings prior to the call date are costly to taxpayers, as the savings don't justify forfeited option value, according to Kalotay.
However, Sklaroff took issue with some of the paper's contents, which should take a more "sympathetic" view of the practicalities issuers face.
It's hard to determine where interest rates will go, he noted. Issuers that turn to tenders — not their first choice — believe interest rates will go higher, thereby offering savings, he said.
It's easy in hindsight to measure whether something has achieved the "optimal" result, but in the meantime, for an issuer, those locked-in savings can just as easily disappear if the issuer waits to do a current refunding, Sklaroff said.
One tender SPFUC executed produced 9.5% net present value savings, representing over $85 million of savings and immediately benefiting ratepayers, he said.
However, to determine whether a tender is appropriate, debt managers should be familiar with option-based analytics, with refunding efficiency — a tool that measures the optimality of exercising a bond call option — as the right approach for decision-making, Kalotay said.
However, most municipal treasurers don't seem to know enough about standard fixed income, he said.
"They implement these very wasteful transactions. They report savings. They don't understand the option value that they are forfeiting, even though that information is readily available," Kalotay said.
However, Sklaroff argued, issuers are often former investment bankers and/or municipal advisors who understand the value of the call option.
This current wave of tender refundings is specifically about call value, all triggered by "taking bonds that were otherwise qualified to be tax-exempt and had been refunded on a taxable basis, and converting them into tax-exempt, and reintroducing call value," he said.
Additionally, municipal treasurers' and debt managers' jobs do not revolve around refunding bonds, Sklaroff said.
For him, his job is to ensure the "engines keep running efficiently on the construction program; we're delivering infrastructure across seven counties in Northern California and delivering service to four counties," along with providing capital at its lowest possible rate to ratepayers.
In educating the public finance community, Kalotay said, the GFOA and MSRB have left out option value in some instances.
The GFOA "Best Practice: Tender/Refunding of Municipal Bonds" does not mention option value, and the "Best Practice: Refunding Municipal Bonds" contains the word 'savings' 35 times and the word 'option value' one time, according to Kalotay.
Furthermore, the MSRB certification for municipal advisors does not include option valuation, according to the presentation.
Sklaroff, a member of the GFOA Debt Committee, took issue with the criticism of the GFOA, calling it "pretty unusual" because the GFOA had taken the lead in providing information to the marketplace.
While Sklaroff "welcomes" independent thoughts from academics and associations, "it's particularly ironic to criticize the transactions and employ some of the techniques in this paper," such as listing seven deals from different issuers.
The GFOA after all has recommended in those policies, after an extensive discussion of the call option, there's specific advice that these calculations are complex, he said. Therefore, issuers should work with their municipal advisors.
An audience member asked whether Sklaroff supported the viewpoint that municipal advisors are not regularly using this option value test in advising, wondering whether he would support their use of "this tool because that was the whole purpose."
Municipal advisors' role is to advise municipalities that are not so well constructed in the math as perhaps Sklaroff is, the audience member said.
SPFUC has five municipal advisors under contract, who regularly advise on call options, Sklaroff responded. "We have many sophisticated issuers, but also a very sophisticated base of advisors across the country advising."
