The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must
KnowGlenn R. CasterlineManaging Director
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
The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know
Why Should a Treasurer Care?
Finance Director’s 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
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
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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What Is Arbitrage?
Investment Yield Bond Yield
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
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
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
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
Arbitrage Rebate
Fund/Account Yield Restriction
Yes Construction Fund Amounts remaining after “temporary period”
(3 years)
Yes Capitalized Interest Account
Amounts remaining after “temporary period”
(3 years)
Yes Reserve Fund Only amounts above “reasonably required
reserve”
Yes Escrow Fund Beginning on the issue date
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
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
Summary of Arbitrage Rebate Analysis
Fund Computation InternalReference Fund Current Date Gross Rate of ExcessNumber Description Fund Status Valuation Earnings Return Earnings
1 Reserve Fund Active $4,222,050.03 $868,347.10 4.167482% ($85,639.16)2 Acquisition Fund (#282) Active $1,220,413.77 $3,291,460.12 5.683172% $778,253.673 Proceeds Transfer Fund Inactive $0.00 $5,141.38 5.005770% $594.60
Totals: $5,442,463.80 $4,164,948.60 $693,209.11
Summary - RebateArbitrage Yield: 4.537966%Return on Investments: 5.300656%Excess %: 0.762690%Actual Gross Earnings: 4,164,948.60Allowable Gross Earnings: 3,496,800.63Excess Earnings: 693,209.11FV of Computation Date Credit (December 9, 1998): (1,196.61)FV of Computation Date Credit (December 9, 1999): (1,144.10)FV of Computation Date Credit (December 9, 2000): (1,093.90)FV of Computation Date Credit (December 9, 2001): (1,045.89)FV of Computation Date Credit (December 9, 2002): (1,000.00)Less: Yield Restriction Liability: (19,580.64)Cumulative Rebate Liability: $668,147.97Rebate Payment Due: $601,333.17
Summary of Yield Restriction AnalysisYield
Fund Computation Internal RestrictedReference Fund Current Date Gross Rate of ExcessNumber Description Fund Status Valuation Earnings Return Earnings
2 Acquisition Fund (#282) Active $1,220,413.77 $154,494.92 5.309376% $19,580.64
Totals: $1,220,413.77 $154,494.92 $19,580.64
Summary - Yield Restriction 1
Arbitrage Yield: 2 4.662966%Return on Yield Restricted Investments: 5.309376%Excess %: 0.762690%Actual Gross Earnings: 154,494.92Allowable Gross Earnings: 134,914.28Yield Restriction Liability: $19,580.64Yield Reduction Payment Due: $17,622.58
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
Total Earnings - Acquisition Fund
$3,291,460.12$3,271,879.48
$2,513,206.45
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3,000,000
4,000,000
Acquisition Fund
Earn
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Retainable Earnings - Yield Restriction
Total Earnings
Retainable Earnings - Arbitrage Rebate
Yield Restriction Liability = $19,580.64
Arbitrage Rebate Liability = $778,253.67
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
Arbitrage Rebate & Yield Reduction Payments
0
100,000
200,000
300,000
400,000
500,000
600,000
700,000
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Acquisition Fund
IRS
Paym
ents Yield Reduction Payment
Rebate Payment
Arbitrage Rebate Liability = $778,253.67
Arbitrage Rebate Payment = $758,673.03
Yield Reduction Payment = $19,580.64
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
Description Original Bonds Refunding Bonds
Issue Date January 15, 1996 June 1, 2005
Debt Service Payment Dates April & October April & October
First Optional Redemption Date October 1, 2006 October 1, 2015
Defeasance Date June 1, 2005
Redemption Date
October 1, 2006
The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know
Investing Bond Proceeds - Fundamentals Fundamental investment objectives include…..
SafetyMinimize credit risk to investment principal
LiquidityAssure 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
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 costsImproved investments lower overall bowering
costs Net-funded project funds
More earnings=less debt issued Reserve Funds
More earnings=less net debt service
• Avoid or limit opportunity costs
• Higher earnings = less debt issued
• Higher earnings on the reserve = less net debt service
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
The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know
Investing Bond Proceeds - Objectives
• Avoid or limit opportunity costs
• Avoid surprises. Plan for rebate or yield reduction payments Surety Bond Reserve Fund
Amount Borrowed $150,000 $5,000,000
Investment Rate NA 4.90%
$50,000,000 new money financing 25 year amortization Bond yield = 4.54% Construction Fund = 4.19%
Total debt capacity may play a key role in determining whether to purchase a surety bond or fund a Reserve Fund
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
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
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
The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know
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