WASHINGTON – The National Association of Bond Lawyers has written a paper describing at least seven alternatives to tax-exempt advance refundings following the new tax law’s ban on them.

The four-page paper also describes five structures for new bond transactions that could minimize problems stemming from the ban.

President Donald Trump, right, shakes hands with Senate Majority Leader Mitch McConnell, R-Ky., during a tax bill passage event with Republican congressional members of Congress on the South Lawn of the White House on Dec. 20. Trump signed the bill two days later.
President Trump and Senate Majority Leader Mitch McConnell, R-Ky., after the enactment of tax law changes that banned tax-exempt private activity bonds after Dec. 31. Bloomberg News

In tax-exempt advance refundings, which were most often done to reap savings when interest rates dropped below the rates of outstanding bonds, refunding bonds were issued and the proceeds were invested in securities that would be escrowed until the bonds could be called. Governmental and 501(c) (3) bonds could be advance refunded once before the ban.

The first section of the paper deals with alternatives to tax-exempt advance refundings for outstanding bonds.

The alternatives cited by NABL include tax-exempt current refundings, which were not banned by the tax law changes enacted in December. These are refundings that occur within 90 days of the call date of the bonds to be refunded.

Taxable advance refundings are another option. This would be a good approach if the issuer wants to: eliminate certain covenants; achieve interest rate savings because taxable rates are less than the rates on the bonds to be refunded; or restructuring existing debt, according to NABL.

If bonds are held by a limited number of investors, it might be possible for the issuer to negotiate a change in the interest rate or a waiver of call protection, NABL said. If the bonds are widely held, the issuer can offer to purchase them via a tender offer, the group said.

But negotiated changes could trigger a reissuance, where a material change in the terms of the bonds means the bonds are
considered to be reissued and subject to the latest tax laws. A reissuance would be treated as a current refunding, which is still allowed. Nevertheless, bond counsel should consider whether interim changes in the tax law would apply to the reissued bonds and whether a new IRS Form 8038 should be filed for them, NABL said.

Another alternative is so-called “Cinderella Bonds” where bonds are issued as taxable and convert to tax-exempt bonds at a specified time, such as within 90 days of the redemption date of the bonds to be refunded. The tax-exempt rate is locked in at the time the bonds are sold even though the conversion is expected to occur in the future.

NABL said investors may demand a higher interest rate for locking in the tax-exempt rate for the future conversion. Further there is a risk that the conversion may not occur if the tax law is changed before the conversion takes place.

“Practitioners will need to determine what structuring elements, if any, are necessary to ensure that the taxable bond is in fact treated as retired on the ‘Cinderella date’ and replaced with a tax-exempt bond,” NABL said.

Forward delivery bonds are also an option. This is where an issuer sells tax-exempt bonds to an underwriter under a bond purchase agreement with a longer-than-normal delivery date so that the closing occurs within 90 days before the redemption date of the bonds to be refunded. NABL said the same concerns exist as for Cinderella bonds -- that investors may demand higher interest rates or that something may prevent the refunding bonds from being delivered, like tax law changes.

Another alternative is forward-starting swaps, which the issuer could use to hedge against rising interest rates and lock-in interest rates at the time current refunding bonds are issued.

The swap could be entered into more than 90 days before the call date of the bonds to be refunded. The hedged bonds would not be issued until 90 days of the call date. NABL examines two variations – swaps expected to be cash settled at the time of issuance of fixed rate bonds and swaps expected to be part of a synthetic fixed rate financing.

The sale of an optional redemption right is another option. This would be where an issuer sells its right to either redeem the bonds or agree to an extension of the date on which it may redeem the bonds. Investors may be willing to pay the issuer an upfront amount for the sale or extension, but the sale or extension may give rise to a reissuance of the bonds, NABL said.

The second portion of the paper deals with structuring new transactions to limit the problems stemming from the loss of tax-exempt advance refundings.

Issuers can sell new tax-exempt bonds that allow redemption to occur at par before the traditional 10-year par call. A variation of this would be issue bonds with shorter calls and/or a declining redemption premium, NABL said. A declining redemption premium would give investors some call protection and added compensation as well giving the issuer the option of a shorter call.

Issuers can also sell bonds with make-whole calls, in which the bonds are callable at any time as long as bondholders are be paid an amount equal to the present value of the remaining principal and interest payments, NABL said.

Variable rate bonds can be sold because they can be called at any time.

Finally, issuers can privately place bonds with banks, NABL said. The lawyers’ group pointed out, however, that the new tax law’s reduction of the corporate rate to 21% from of 35% may have dampened banks’ demand for tax-exempt bonds or may have increased the interest rates that banks charge.

“Of course the viability of any of these approaches will depend on factors including market interest rates, demand for bonds, federal tax issues, and state law considerations,” NABL said. “Given the creativity of investment bankers, municipal advisors, lawyers and issuers, it is likely that approaches in addition to those identified in this paper will develop over time.”

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