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 Forward Purchase Agreement Forward Purchase Agreements/Float Contracts can be structured to offer an issuer an up-front cash payment or yield over time in exchange for a commitment by an issuer to direct the monthly debt service principal and interest payments to a counter party for their use prior to semi-annual debt service payments. This contract provides long term yields on short term cash flows. The contract is also very effective in reducing negative arbitrage in escrow portfolios. These contracts can be structured on a collateralized or un-collateralized basis. Debt Service Reserve Fund The Debt Service Reserve Fund (“DSRF”) has traditionally been invested in a long term treasury security combined with a simultaneous purchase of a par put option to insure liquidity and par value of the treasury. The problem with purchasing the treasury put is that it can be expensive (up to 100 bps), reducing the overall yield of the DSRF and furthermore once purchased a treasury put is relatively illiquid with little resale value. Sometimes, the long term treasury is bought “naked,” that is, without the put option, which eminently sets up the issuer for a probable underfunded DSRF sometime in the future. The DSRF Forward Purchase Agreement (“FPA”) provides essentially the same long term rate as long term treasuries, while eliminating the need for a treasury put option. The DSRF FPA works as follows. A FPA provider would initially deliver a 90 day T-Bill to the trustee. When that T-bill matured the FPA provider would deliver a new 90 day T-Bill in exchange for the cash resulting from the previous maturing T-Bill. This cycle would continue for the term of the agreement. The yield for this type of instrument is fixed for the term of the agreement. The agreement is extremely safe, as the issuer always has either cash or a T-Bill in the trustee possession, and will be approved by most bond counsel. If allowed by the indenture, the interest to be earned for the term of the FPA can be taken over time or taken up front as a lump sum payment. An issuer can partially fund the DSRF by taking earnings up-front which reduces the overall bond issuance amount. The up-front payment can represent 25-50% of the total DSRF requirement. Similarly, if an issuer had bought a long term treasury in a lower interest rate environment to fund a DSRF which is now underfunded, a partial up-front payment from an FPA can bring the DSRF back to par, eliminating the need to look to other sources of monies to fill the requirement. The remaining interest can then be taken over time or be taken up-front to release locked DSRF funds for other uses. We fully endorse this product as safe alternative for the DSRF but because certain restrictions and guidelines exist, each transaction must be looked at individually to determine its’ applicability. Debt Service Fund Debt service funds are usually required to be deposited with a trustee or in another segregated manner on a monthly basis to meet semi-annual debt service interest payments (1/6 per month) and annual principal payments (1/12 per month). Traditional investment techniques result in these monies being invested short-term and earning short-term rates of interest. As an alternative, a debt service fund forward purchase agreement offers an issuer a higher rate of return on invested monies, along with the option of receiving an up-front payment equaling the present value of that future stream of income. These agreements can be structured on either a delivery versus payment (DVP) or swap basis. On a DVP basis, the counterparty will deliver to the issuer or issuer’s trustee a U.S. Treasury security maturing prior to the semi-annual debt service payment date with a face value equaling the debt service amount deposited with the counterparty. On a swap basis, the issuer transmits the actual semi-annual earnings on U.S. Treasury Bill investments (variable) in exchange for the guaranteed rate (fixed). On this basis, the counterparty can deliver an upfront payment of a fixed yield over time. Collateral on the agreements can range from treasury securities to agency securities to commercial paper to uncollateralized. The collateral requirement corresponds directly with the yield. In the event the issue is refunded, a breakage fee may be incurred requiring a payment to the counterparty, thereby reducing the earlier received cash payment. For instance, if an issuer were to enter into an agreement and receive an up-front payment of the cash flow for thirty years, the issuer is contracting to deliver a 20-year stream of monthly cash payments. If the issuer later chooses to call the bonds after seven years, the issuer will be subject to a breakage fee because the issuer will be unable to deliver this stream of cash. To avoid this the issuer can limit the agreement to the first call date rather than out to the final maturity of the issue. Escrow Fund Historically, municipal issuers have used treasury forward purchase agreements (“FPA”) in defeasance escrows as a supplement to a portfolio of treasury securities. That is, issuers have purchased the most efficient portfolio of securities available, and then entered into an FPA to extract the value remaining in the inefficiencies of the portfolio. While this approach has been relatively successful to date, there are two potential problems associated with it: first, the two-step bidding process (one for securities followed by one for the FPA) can be cumbersome, particularly since there is little overlap between providers of government securities and providers of FPA contracts: second, the FPA market efficiency decreases with the size, length and frequency of deliveries under the contract. Hence, many smaller refundings have not been able to use the two-step approach to minimize the potential negative arbitrage in the escrow portfolio and have lost potential savings. Sound Capital Management, Inc. (“SCM”) can competitively bid an FPA structure that both simplifies the structuring and bidding processes and maximizes the efficiency of FPA pricing. Under this structure, an issuer does not purchase the initial portfolio of treasuries, but rather gross funds the defeasance requirements while simultaneously entering into an FPA that monetizes (present-values) all future investment earnings, effectively net funding the escrow. As with a standard escrow FPA, the provider then periodically delivers treasuries with maturity values equal to the cash available. Because the escrow is gross funded, the maturity value of the securities delivered is always sufficient to defease the escrow requirements. In the event that the gross funded FPA results in a yield in excess of the bond yield, the bidding process then requires that the providers be given the maximum cost of the portfolio which results in a yield below the bond yield. Based on the total cost the providers will bid a date that sufficiently meets the escrow requirements at the pre-determined cost. The FPA will be awarded to the earliest date bid. By structuring the entire defeasance as an FPA, rather than a combination of a fixed portfolio of securities and a supplemental FPA, an issuer can streamline the refunding process with a single, extremely efficient escrow investment vehicle. |
