Sometimes, though, unusual interest rate spreads invite a bond issuer to try to game the system, particularly by using low-cost proceeds from tax-exempt debt to find higher yields elsewhere in the markets. It’s a potentially risky play given longstanding federal rules, but that’s not to say there aren't some opportunities for savvy — and cautious — public financiers.
First, though, some relevant historical context: The issuance of tax-exempt bonds was long thought to be a constitutional right under the 10th Amendment and the associated concept of reciprocal immunity — that under the separation of powers, the two levels of government, state and federal, cannot tax each other. In 1988, however, the Supreme Court ruled that the federal tax exemption was not a constitutional right but rather a legislative grant to the states from Congress and thus subject to tinkering on Capitol Hill.
Even before then, the congressional tax committees had put some restrictions on what forms of debt could qualify for the tax exemption, and the IRS had set rules to prevent “abusive” transactions. One of those rules is a prohibition against arbitrage — profit-making by muni bond issuers who invest yet-unspent proceeds from their tax-exempt issues in taxable paper at higher yields.
For example, Oakland, Calif., cleverly figured out in 1985 that it could issue tax-exempt bonds to fund its underwater pension plan, the proceeds of which it in turn would invest in normal pension portfolio holdings like taxable stocks and corporate bonds with a higher long-term return. It was a strategy almost certain to make a profit over time, even with the ups and downs in the stock market, but it didn’t take long for the IRS to put an end to that ploy as an abuse of the tax exemption. Thereafter, the IRS ruled, such pension bonds must be taxable.
Likewise, the arbitrage police have played cops-and-robbers with clever public financiers who invest their cash during construction periods at interest rates higher than their tax-exempt cost of money. Using today’s interest rate levels, for example, a tax-exempt 20-year AAA-rated bond can be issued with coupons around three-and-a-half percent and the proceeds reinvested in Treasury bills and notes at 4 to 5 percent. In almost any year like this one, there’s a profit to be gleaned when borrowing tax-exempt and reinvesting at taxable rates.
In some cases, the abuses of such “municipal arbitrage” can disqualify the entire bond issue from tax exemption, which is the public finance equivalent of a falling sword of Damocles: Investors would be likely to blackball such localities and sue them for misrepresentation to recover their foregone tax savings, and Uncle Sam would penalize them.
But more commonly, the standard control mechanism has been arbitrage rebate, a requirement that issuers who make disallowed profits from the reinvestment of proceeds from tax-exempt securities pay those profits over to the U.S. Treasury. In other words, the IRS arbitrage vampires suck all the profits out of such deals.
This takes away all the fun of playing this game, while also inviting all kinds of nonsense with shady brokers scheming up ways to get around those rules.
Safe Harbors
Inside those parameters of rules and regulations, however, there is a host of allowable practices. For long-term debt issued for public facilities construction, for example, there is in some cases an allowable “temporary period” of a few years during which the proceeds can be invested at a profit. In the case of short-term borrowing for operating budgets, so-called revenue anticipation notes are allowable as long as they mature within a defined time period. In IRS-speak, these are known as “tax and revenue anticipation notes,” or TRANs. Likewise, some states and localities make it a customary practice to issue short-term notes during their construction period, with the intent to issue long-term bonds once the project is completed. These bond anticipation notes are IRS-allowable, albeit with limits on when they must be refinanced.
For 2024 and going into 2025, it’s pretty likely that the U.S. Treasury yield curve will remain inverted, with short-term taxable rates exceeding most yields on longer-term municipal paper, so the arbitrage issue will be pervasive. The arbitrage window will close only when the Federal Reserve allows the Treasury yield curve to normalize with short rates drifting to levels materially lower than the rates on muni debt. That seems unlikely until T-bills start trading two full percentage points lower than they are in today’s market — probably not sooner than late 2025, barring a recession.
There is also a new controversy brewing in a niche sector of the muni bond market, in which issuers of taxable bonds are finding an opportunity to refinance at lower tax-exempt rates. Investors are suing them. It’s premature to guess how this issue will be resolved in the courts, but worth watching.
Arbitrage Compliance
This situation is hardly new. The public finance community has been dealing with arbitrage requirements for decades, and a cottage industry has even evolved for the investment of bond proceeds and the tracking and tax reporting of possible muni arbitrage profits that risk ultimately being rebatable to Uncle Sam.
Most muni bond issuers are already well aware of these rules. But with 2024 a ripe year for issuance of new tax-exempt bonds — already running at robust levels this calendar quarter — it’s a good idea for CFOs and finance committees to double-check their compliance operations to make sure everything is shipshape given the high risk that they could become subject to the rebate rule.
Municipalities with capital financing needs that could be funded with interim instruments like bond anticipation notes, or with operating budgets eligible for TRANs, also should double-check their opportunities for advantageous strategies that they may not have exploited in the past. For smaller communities, it may not be worth the hassle and expense, but larger entities may discover an unused strategy worth discussing with a financial adviser.
The Advance Refunding Game
As interest rates drift lower in tandem with hoped-for disinflation, muni bond professionals are starting to chat up the idea that soon we’ll see a wave of advance refundings, in which a municipality can refinance its debt at a lower interest rate. In corporate America, the finance team must usually wait until the issue’s maturity or call date before refinancing. In muni-land, however, there is a unique situation that is peculiar to the tax-exempt world: the opportunity to issue new bonds to replace the old ones at a lower interest rate before their scheduled call date — typically within 10 years after issuance — by setting up an escrow fund to pay off the original debt when it is callable.
It doesn’t take a math or market genius to figure out that this advance refunding strategy is susceptible to abuses. In theory and previously in practice, it could be repeated several times over the life of the original bonds: wash, rinse and repeat. So the IRS caught on to this and Congress put a limit — of one — on such deals. To accommodate this unique feature of the muni market, the Treasury Department even created a special class of its own securities, known as the State and Local Government Series (SLGS, or “slugs” in industry jargon), which bear interest rates equal to the new borrowing rate to preclude the arbitrage profit gambit.
The political challenge for municipal officials today is that underwriters and advisers are keen to promote these advance refundings as soon as they become feasible. Some will compete with each other to make the first pitch to win an engagement even if it’s not optimal longer term. The motto of some hucksters is “whoever gets to the decision-makers first, wins.” All they really want is the engagement fees; to them, a dollar earned today is worth more than a dollar tomorrow, so they get lathered up without necessarily showing their clients the potential to save even more if they wait a couple years for even lower rates. This year and next could be just such a time period, depending on when you think the next national recession will occur.
Mostly it will be the muni bonds sold in 2022 and early 2023, when interest rates were peaking (above 4 percent on AAA paper and maybe 5 percent for lower ratings), that the advance-refunding promoters will pitch. Just remember that the IRS rules now prohibit multiple advance refundings: It’s one bite of the apple, and there will be an opportunity cost for jumping the gun ahead of lower long-term interest rates in future years. Although short-term interest rates are expected to decline, it’s not so obvious that the longer end of the Treasury and muni bond yield curves will follow in this business cycle, at least until the next recession. Refundings are almost always timely in recessions, but can be premature in the middle of an interest rate cycle.
The only reason I can see for an issuer to jump the gun with an advance refunding this year would be a worry that in the next recession, when muni yields would likely be lower than today’s, the interest rates on shorter-term Treasury notes will be even lower. Such “negative arbitrage” could be disadvantageous.
Of course, it’s always possible that in the middle of a recession our benevolent Congress could allow a second advance refunding for a limited period. That’s the muni lobbyist’s dream, but it may be a pipe dream and hardly a base-case scenario that deserves conviction and hard-headed consideration.
A stronger case can be made that during or after the next cyclical recession — whenever that occurs — a congressional fiscal stimulus package and inevitably higher federal budget deficits will subsequently drive long-term interest rates higher across the board, so I tend to favor conventional bond issuance on favorable terms now while rates are manageable, or certainly no later than mid-recession.
Before anybody pulls the trigger on an advance refunding, state and local CFOs need to be firm in their demands that would-be advisers and underwriters provide comprehensive modeling of several possible economic and interest rate scenarios including those here, in the context of a full business cycle and the resulting three-dimensional interest rate shifts. Just look before you leap.
Governing's opinion columns reflect the views of their authors and not necessarily those of Governing's editors or management. Nothing herein should be construed as investment or specific issuance advice.
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