WASHINGTON — Washington State Treasurer James McIntire is urging the Internal Revenue Service not to adopt its proposed issue price rules, warning they would increase issuers' borrowing costs.
"We firmly believe that the current rules, coupled with prudent IRS enforcement, are and will continue to be highly effective in achieving the interrelated goals of minimizing borrowing costs for issuers, minimizing arbitrage yields and minimizing the amount of interest income exempt from federal tax," McIntire wrote in a letter, dated Nov. 27.
Issue price is extremely important because it is used to help determine the yield on bonds and whether the issuer is complying with arbitrage rebate or yield restriction requirements, as well as the amount of federal subsidy payments the issuer receives for direct-pay bonds such as Build America Bonds. Issue price also plays a role in complying with other rules such as the 2% limit on issuance costs for private activity bonds and the size of debt service reserve funds.
Under the current rules, the issue price for each maturity of bonds publicly offered is the first price at which a substantial amount of the bonds is reasonably expected to be sold to the public, with substantial defined as 10%. The issue price is usually determined based on reasonable expectations when the bonds are priced, before closing.
However, the proposed rules would eliminate the reasonable expectations standard and instead base the determination of issue price on actual sales of the bonds. The Treasury Department has proposed a safe harbor under which the issue price is the price at which the first 25% of the bonds is actually sold to the public.
McIntire wrote that "it is critical to the continued effective functioning of the municipal bond market that any revised issue price rules retain a 'reasonable expectations' provision and maintain the definition of 'substantial amount' or 'safe harbor amount' at or close to 10%."
The change to a safe harbor of 25% of actual sales "creates strong incentives" for issuers and underwriters to price bonds at interest rates that guarantee that 25% of each maturity of an issue will be sold to the public at the list price on the date of sale, McIntire wrote.
Qualifying for the safe harbor would eliminate the costs and time commitment needed to monitor secondary market trades for weeks, the need to perform potentially complex yield adjustment calculations, the risk of having to make yield-reduction payments and the risk that an underwriter could be accused of flipping bonds post-sale. However, pricing bonds to qualify for the safe harbor also will result in bonds having higher interest rates, he said.
When Washington state does negotiated sales, it negotiates with underwriters to get itself the lowest possible all-in cost for a bond issue. As a result, it is common for some maturities to be fully or partially underwritten by the underwriting group, rather than being sold immediately to end investors on the sale date, McIntire wrote. But if there is a "practical requirement" to immediately sell 25% of each maturity to the public, the state will have less of an ability to negotiate for higher prices or lower interest rates for the bonds.
Therefore, the state would generally have higher all-in interest costs on negotiated sales as well as higher arbitrage yields. The sale of bonds at lower prices and higher yields would also lead to more interest income excluded from federal taxes and more opportunities for investors and underwriters to flip bonds in the days and weeks after a bond sale, McIntire wrote.
Not only would the proposed issue price rules hurt issuers during negotiated sales, but they could even more severely disrupt the functioning of the competitive new issue market by introducing significant uncertainty and administrative burden," McIntire wrote.
In competitive sales, there are only limited opportunities for dealers to pre-market bonds to investors, and "underwriters bid for entire bond issues at prices they expect but have no assurance will enable them to sell most of the bonds to the public and other dealers," McIntire wrote. If there's a need to ensure that 25% of each maturity will be sold quickly to the public at list price, underwriters will be inclined to bid lower prices and higher yields. Washington issues most of its debt through competitive sales, so its cost of capital would increase.
Additionally, McIntire wrote that it would be difficult to accurately apply the proposed rules if they went into effect. Platforms like the Municipal Securities Rulemaking Board's EMMA system do not provide secondary-market trading information that is 100% accurate, and the information provided can be hard to interpret. Also, intra-entity trades and dealer firms' distribution affiliation agreements can complicate trade tracking, he said.
Treasury published the proposed rules in September and public comments are due Dec. 16.