The Arbitrage Rebate

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Glenn R. Casterline Managing Director
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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Discussion Outline

• Why Should Treasurers Care?
• Fundamentals of the Arbitrage Rebate and Yield
  Restriction Requirements
• Amounts Subject to the Requirements
• Arbitrage Rebate Payments vs Yield Reduction
  Payments
• Investing Bond Proceeds
• Exceptions to the Arbitrage Rebate Requirements

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Why Should a Treasurer Care?

• Finance Directors responsibility (really?)
• Arbitrage Bonds Taxable Bonds
• Fixed earnings target
• Making a payment is a good thing
• Basic understanding of the arbitrage rebate
  yield restriction requirements will influence
  your investment strategies
• Bond proceeds are often the forgotten assets

• Arbitrage Bonds Taxable Bond
• Making a rebate or yield reduction payment is a
  good thing

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Fundamentals - General

• 2 separate requirements though related
• Need to comply with both requirements to avoid
  bonds being declared Arbitrage Bonds

• The arbitrage rebate and yield restriction
  requirements are related but are also two
  separate requirements
• Need to comply with both requirements

Arbitrage Rebate
Yield Restriction

• Arbitrage rebate issuers can achieve
  compliance by remitting a rebate payment to the
  IRS
• Yield restriction issuers can achieve
  compliance by
• Investing yield restricted amounts at a yield
  below the bond yield or..
• Remitting a yield reduction payment to the IRS

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Fundamentals Arbitrage Defined

• Borrow at tax-exempt rates and invest at higher
  taxable rates without incurring any additional
  risk
• Positive and negative arbitrage
• When the yield curve is upwards sloping
  tax-exemption of bond interest allows for
  positive arbitrage

• Positive arbitrage can be offset by negative
  arbitrage

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Fundamentals Legislative History

• Tax-exemption is a federal subsidy
• System was abused
• Laws and regulations were established to
  discourage issuers from
• Issuing more bonds than needed
• Issuing bonds sooner than needed
• Leaving bonds outstanding longer than needed

• Tax exemption is a Federal subsidy
• Regulations discourage Issuers from
• Issuing more bonds than needed
• Issuing bonds sooner than needed
• Leaving bonds outstanding longer than needed

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Amounts Subject to the Requirements

• Arbitrage Rebate
• Gross proceeds
• Sale proceeds amounts received from the sale of
  the bonds
• Investment proceeds earnings on sale proceeds
• Replacement proceeds typically amounts pledged
  to pay debt service
• Transferred proceeds prior bond proceeds that
  become proceeds of the refunding bonds

• Yield Restriction
• Amounts remaining beyond applicable temporary
  period (3 years)
• Amounts beyond the reasonably required reserve,
  Maximum of . .
• 10 of par amount
• 125 of average annual debt service
• Maximum annual debt service
• Advance refunding escrows
• Transferred proceeds

• Most amounts with a nexus to the bond issues are
  subject to the rebate requirements
• Some amounts are subject to the yield restriction
  requirements

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Amounts Subject to the Requirements

• Most amounts with a nexus to the bond issues are
  subject to the rebate requirements
• Some amounts are subject to the yield restriction
  requirements

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Arbitrage Rebate Payments vs Yield Reduction
Payments

• An arbitrage rebate or yield restriction
  liability compares.
• Actual earnings
• What you would have earned had you invested the
  same proceeds at the bond yield
• Arbitrage rebate and yield reduction payments
  consist of the net amount of positive arbitrage
  required to be remitted to the Federal government
• An arbitrage rebate payment is net of any yield
  reduction payments (You are not paying twice)

• Liability actual earnings vs earnings at the
  bond yield
• Rebate payments are offset by yield reduction
  payments

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Arbitrage Rebate Payments vs Yield Reduction
Payments

• Liability actual earnings vs earnings at the
  bond yield
• Rebate payments are offset by yield reduction
  payments

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Arbitrage Rebate Payments vs Yield Reduction
Payments

• Liability actual earnings vs earnings at the
  bond yield
• Rebate payments are offset by yield reduction
  payments

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Arbitrage Rebate Payments vs Yield Reduction
Payments

• Liability actual earnings vs earnings at the
  bond yield
• Rebate payments are offset by yield reduction
  payments

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Arbitrage Rebate Payments vs Yield Reduction
Payments

• Arbitrage rebate and yield reduction payments are
  required to be paid no later than 60 days after
  each 5th Bond Year and 60 days after the final
  redemption date
• My bonds have been refunded, so they are no
  longer subject to the arbitrage rebate and yield
  restriction requirements.
• Defeased vs Redeemed

• Payments are due 60 days after every 5th Bond
  Year and after the final redemption date of the
  Bonds
• Bonds are subject to the arbitrage rebate and
  yield restriction requirements until the Bonds
  are redeemed in full

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Investing Bond Proceeds - Fundamentals

• Fundamental investment objectives include..
• Safety
• Minimize credit risk to investment principal
• Liquidity
• Assure appropriate liquidity for required
  withdrawals
• Minimize market risk
• Minimize reinvestment rate risk
• Duration of investments, accessibility to funds
• Yield
• Generate consistent risk-adjusted returns

• Investment fundamentals
• Safety
• Liquidity
• Yield

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Investing Bond Proceeds - Objectives

• Avoid or limit opportunity costs
• Interest costs accrue on bonds immediately
• Negative carry increases financing costs
• Improved investments lower overall bowering costs
• Net-funded project funds
• More earningsless debt issued
• Reserve Funds
• More earningsless net debt service

• Avoid or limit opportunity costs
• Higher earnings less debt issued
• Higher earnings on the reserve less net debt
  service

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Investing Bond Proceeds - Objectives

• Investing bond proceeds requires an unique
  investment philosophy
• Unlike most entities, tax-exempt issuers can
  develop a perfect investment strategy
• Plan for any rebate or yield reduction payments
• Positive arbitrage is a good thing, as long as it
  is not a surprise
• Example surety bond vs cash funded reserve

• Avoid or limit opportunity costs
• Avoid surprises. Plan for rebate or yield
  reduction payments

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Investing Bond Proceeds - Objectives

• 50,000,000 new money financing
• 25 year amortization
• Bond yield 4.54
• Construction Fund 4.19

• Avoid or limit opportunity costs
• Avoid surprises. Plan for rebate or yield
  reduction payments

• Total debt capacity may play a key role in
  determining whether to purchase a surety bond or
  fund a Reserve Fund

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Exceptions to the Arbitrage Rebate Requirements

• All or a portion of the bond proceeds may be
  excluded from the arbitrage rebate requirements
  if they meet a spending exception
• If you earned positive arbitrage and met an
  exception you allowed to keep the earnings
• Spending exceptions
• 6 month spending exception
• Gross proceeds need to be spent within 6 months
• Gross proceeds do not include amounts deposited
  in the Reserve Fund

• All or a portion of the bond proceeds may be
  excluded from the rebate requirements if they
  meet a spending exception
• Positive arbitrage can be retained if a spending
  exception is satisfied

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Exceptions to the Arbitrage Rebate Requirements

• Spending exceptions (continued)
• 18 month spending exception
• Spending requirements
• 15 in 6 months
• 60 in 12 months
• 100 in 18 months
• Gross proceeds do not include amounts deposited
  in the Reserve Fund

• All or a portion of the bond proceeds may be
  excluded from the rebate requirements if they
  meet a spending exception
• Positive arbitrage can be retained if a spending
  exception is satisfied

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The Arbitrage Rebate Yield Restriction
Requirements What Every Treasurer Must Know
Exceptions to the Arbitrage Rebate Requirements

• Spending exceptions (continued)
• 24 month spending exception
• Applies to construction bonds only
• Only includes available construction proceeds
• Construction Fund
• Capitalized Interest Account
• Reserve Fund earnings
• Spending requirements
• 10 in 6 months
• 45 in 12 months
• 75 in 18 months
• 100 in 24 months

• All or a portion of the bond proceeds may be
  excluded from the rebate requirements if they
  meet a spending exception
• Positive arbitrage can be retained if a spending
  exception is satisfied