How tax reform will affect counties’ issuance of outstanding and future debt remains to be seen, but one tool is no longer available to them. The December 2017 bill eliminated state and local governments’ ability to use tax-exempt bonds to advance refund outstanding bonds, as of Jan. 1.
Tax-exempt advance refundings offered an important tool for state and local governments to reduce debt service costs, freeing up resources to be used for other important purposes, and minimizing taxpayer and ratepayer burdens. Advance refundings also restructured debt service payments or address problematic bond terms and conditions.
Similar to refinancing a mortgage, advance refunding means refunding bonds more than 90 days prior to the “call” date of the outstanding bonds, effectively retiring existing bonds by issuing new bonds and often taking advantage of better interest rates.
Federal tax laws previously allowed issuers to advance refund bonds on a tax-exempt basis. Since 1985, issuers were permitted a single advance refunding prior to the call date of the bond. In 2017, advance refundings represented approximately 20 percent of total tax-exempt municipal bond issuance.
Following tax reform, alternatives that provide similar outcomes are developing, as are changes to new bond issuances, but those new techniques also involve new and different risks.
GFOA best practices recommend utilizing the skills and expertise of Bond Counsel and Municipal Advisors in making financing or refunding decisions. GFOA also cautions many entities against entering into swap or derivative agreements.
Considerations for Outstanding Bonds
Market participants will likely recommend previously used tools or develop new tools or mechanisms to simulate the beneficial impacts of tax-exempt advance refundings. Potential alternatives may include taxable advance refundings, lock on interest rates or forward-purchase agreements, among other options.
Issuers should be particularly aware of the unique risks and uncertainties associated with these options and discuss their options with their municipal advisors and legal counsel. Additionally, issuers wishing to refund Build America Bonds (or similar tax credit subsidy bonds) will need to consult with their legal counsel and municipal advisors before proceeding.
Changes to tax laws and reduced corporate tax rates could affect outstanding bank loans or direct placements. “Gross up” provisions included in many bank loan agreements may result in increased interest costs effective immediately, and issuers should discuss possible solutions with their debt management team. Bank waivers or modifications of gross up provisions may trigger “reissuance” of the obligations.
Considerations for Future Bond Issues
Counties preparing to issue new municipal bonds may feel compelled to pursue issuance alternatives that provide early refinancing options in the absence of tax-exempt advance refunding provisions. That could include use of shorter call features, bullet maturities, derivative products and variable rate financing options. The same alternatives could also be pursued with current refunding bonds.
Issuers should be certain that specific benefits, risks and costs of any financial tool are fully understood and are consistent with the entity’s debt policies. For example, shorter call features may come with an increased cost premium at the time of issuance or other material changes to terms or costs. Performing diligent cost-benefit analysis of call features is likely to increase in importance.
Excerpted from The Government Finance Officers Feb. 13 Member Alert. Charlie Ban, senior staff writer, also contributed to this report.