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Flexible Repurchase Agreements
Summary Information
A Flexible Repurchase Agreement ("flex repo") is a short-term investment vehicle designed to meet the special needs of tax-exempt debt issuers such as school districts, cities, and counties. It has a fixed rate of interest allowing the entity to lock in a positive arbitrage spread during the construction period, and a fixed maturity. Repurchase agreements are an authorized investment for public funds under the Public Funds Investment Act (Section 2256.011, Texas Government Code). A repurchase agreement is defined by the Government Finance Officers Association as "the sale by a bank or dealer of a government security with a simultaneous agreement to repurchase the security at a later date." Repurchase agreements are used frequently by money market funds and local government investment pools and include a stated maturity date on which the repurchase will occur.

Flexible repurchase agreements permit a governmental entity to withdraw funds as capital expenditure needs arise, but have a final maturity date on which any remaining funds are returned. When a governmental entity issues debt for the building of new facilities or renovation of existing buildings, there is often an uncertain construction draw schedule requiring a high degree of flexibility. The flex repo addresses this concern by allowing the entity to draw down funds as needed. This high liquidity feature is what differentiates the flex repo from an ordinary repurchase agreement.

A repurchase agreement, including flexible repurchase agreements, are executed on a "delivery versus payment" basis. As such, the Provider must deliver the collateral securities to the third party custodian before the custodian will release the cash to the Provider. The repurchase agreement process is shown in the following chart:

To protect the governmental entity's funds, collateral is delivered to the third party custodian in an amount equal to at least 102% of the value of the funds delivered, and frequently collateral requirements are set at levels of 102% for U.S. Treasury securities and 103% for U.S. Agency securities. A BMA (The Bond Market Association) Master Repurchase Agreement governs the general terms of the repurchase agreement, including collateral requirements and downgrade protection provisions for the governmental entity in the event the Provider is downgraded. As further protection for such agreements, only certain financial institutions, such as primary dealers and major financial institutions, are requested by the governmental entity to bid on the agreement.

Summary of Benefits:
Flexible repurchase agreements provide several benefits for the investment of tax-exempt bond proceeds. The primary advantage of the flex is its simplicity. The coupon rate is locked in, and all payments from the repo are reinvested semiannually back into the principal at the guaranteed coupon rate, thereby eliminating reinvestment risk. Since the spread between the bond yield and the investment yield is locked in, there is no interest rate risk. Credit risk is minimized through the use of highly-rated dealer counter-parties. The repo is fully collateralized at a minimum of 102%, and the collateral is safekept in the entity's name at an acceptable third party custodian.

Another significant reason flexible repurchase agreements are used relates directly to the arbitrage rebate requirements. The arbitrage rebate rules introduced by the Tax Reform Act of 1986 require issuers of tax-exempt bonds to rebate to the Internal Revenue Service interest earnings that are greater than the yield on the bonds unless one of the few rebate exceptions are satisfied. Arbitrage rebate represents a 100% tax on the amount of interest earned in excess of the yield on the bonds. Therefore, unless an issuer expects to satisfy one of the available rebate exceptions, there is little incentive to earn significant amounts of arbitrage. A more practical investment strategy for bond proceeds subject to the rebate requirement is to guarantee a rate of return on the investment greater than the yield on the underlying bond issue, thereby assuring the issuer will earn the maximum legal amount of retainable interest earnings.

Other notable benefits of a flexible repurchase agreement include:
  • Fully collateralized investment with high quality credit counter-party.
  • Guaranteed rate locks in positive arbitrage assuring maximum retainable interest.
  • Withdraw funds when needed to pay project expenses.
  • Highly competitive yield guaranteed for the life of the flex.
  • All coupon payments are immediately reinvested at the coupon rate.
  • The entity reviews all bids, and approves the winner before award.
  • All draws are at the discretion of the entity.
  • Confirmations and transaction reports are sent directly to the entity.
  • Positive spread is locked in for the life of the flex, net of fees.
  • Fee is paid by the winning bidder. There is no direct cost to the entity.
  • Flex repos are an easy, widely used investment choice for municipal bond proceeds.
The governmental entity purchasing a flexible repurchase agreement will receive monthly statements from the provider showing the current balance, activity, and accrued interest on the outstanding balance. In addition, the custodian performs a daily market valuation of the collateral and provides a monthly report to the governmental entity detailing the collateral and it current market value.

This article is reprinted with the permission of:
First Southwest Asset Management
700 Pacific Avenue, Suite 500
Dallas Texas 75201
(214) 953-4031