Lost in the dire predictions of higher tax rates and limits on tax exemptions, Federal budget brinksmanship is endangering the more mundane but critically important process by which municipal issuers purchase Treasury securities for refunding escrows.
As the so-called debt ceiling again approaches, a primary tool to be employed by the Treasury Department to manage its borrowings is for the Bureau of Public Debt to close the application window for State and Local Government Series securities (SLGS). The SLGS program provides municipal issuers with a mechanism to directly purchase custom-tailored new US Treasury securities that are often used in advance refunding escrows.
Historically, issuers have chosen between purchasing portfolios of US Treasury securities through the secondary market, via competitive bids (“Open Markets”), and directly-issued SLGS. Under certain conditions, there is a distinct cost advantage between one method and the other. The SLGS program process is more straightforward, simple and the preferred route recommended by bond counsel firms. In fact, unless a demonstrable advantage exists for Open Markets, many bond counsel firms will insist on using SLGS. As we move into extraordinarily uncertain periods such as the fiscal cliff budget battle, there is substantial reason to include Open Markets in the discussion as an important and prudent risk management decision.
As the Federal government uses the SLGS program as a debt management tool, it is under no obligation to provide market participants with significant advance notice of any temporary cessation in their acceptance of applications for the purchase of SLGS, a SLGS window closing. Further, although historically the Bureau of Public Debt has honored all SLGS applications that were received prior to any window closings, a review of the SLGS regulations makes it clear that they are not legally required to do so.
Traditionally, most municipal issuers consider Open Market escrow portfolios only when the purchase cost differential versus a SLGS portfolio exceeds a certain threshold that is unique to each issuer. A common rationale is that the economic benefit provided by a less expensive Open Market portfolio needs to offset any perceived additional cost, process steps and focus. Implicit in this assumption is that SLGS are a risk-free strategy. While this may be true in more a more normal market, it may not be the case in the very near future as SLGS subscriptions may not be available through, or honored by, the Bureau of Public Debt, and that bond issues may be delayed or bond closings may potentially be jeopardized.
A sudden and unanticipated closure of the SLGS window can disrupt a bond sale. In a typical bond sale, the cost of a SLGS portfolio is determined on the morning of pricing and the refunding issue is sized accordingly. If a portfolio of Open Market securities is put out for bid to the dealer community, the results are then compared with the SLGS portfolio cost and the bond size is correspondingly adjusted. Of primary concern is that the SLGS window may be suddenly and unexpectedly closed the day before or the day of the bond sale. Because it can take 48-72 hours to properly structure and complete a bid process, in a situation such as that, if SLGS are suddenly unavailable for subscription, there may not be sufficient time to structure and complete a tax-compliant bid process. This might necessitate a delay of several days, putting the economics of the refunding at risk as markets can move adversely during this period and targeted savings levels may no longer be achievable.
For refunding transactions scheduled to be sold during this period of uncertainty, it is imperative that Open Market securities be seriously considered as a risk reducing strategy even if it provides little, or even no, demonstrable economic benefit. Furthermore, as a matter of prudence, it is advisable to dual track both Open Markets and SLGS up until the day of pricing.