It is not unusual for School Districts to receive large sums of money through the issuance of bonds. When this occurs, many districts are unprepared for the responsibility that goes along with investment of significant cash, especially in consideration of Internal Revenue Service (IRS) regulations related to restricted earnings on bond proceed investments. The goal when investing bond proceeds is to safely maximize the interest rate spread differential between the bond yield and the proceeds reinvestment yield within the guidelines of investment policy and specific bond covenants. This means that simply keeping your bond proceeds in a bank account, money market fund or investment pool may not be the wisest decision. Investment return is often an essential part of project funding and should be taken seriously. Earning even an extra quarter point of interest can translate into significant real dollars. To illustrate, a $5 million investment with a yield of 6.25% will earn $12,500 more than an investment yielding 6%. Alternately, it may not be wise to stretch for the highest yield available and assume a high degree of risk, if excess earnings will ultimately be rebated back to the government.Before investing any proceeds, an investor should be prepared to consider the following:
The Use of Bidding Agents
Three basic investment alternatives most commonly used when investing bond proceeds:
- How much money will be invested? (Have some of the funds already been spent?)
- How quickly are proceeds likely to be spent? (An estimated draw schedule is essential!)
- How certain are these anticipated draws?
- Will any arbitrage spending exceptions be met or will the district be required to rebate excess earnings to the government?
- What is the arbitrage yield? (This will represent the benchmark rate that the district should seek to achieve.)
- Is it possible to achieve a positive spread? (Can funds currently be invested above the arbitrage yield?)
- What securities are authorized in the District's investment policy and specific bond covenants? (Be especially careful not to invest in securities that are unauthorized!)
- Investment Pools or Money Market funds
- This is often a good choice when the bond size is relatively small, when there is no dedicated investment staff, the draw schedule is very uncertain or when a positive spread cannot be earned at the present time.
Advantages: Familiarity, ease, full liquidity, no need to project cash flows
Disadvantages: Return will vary daily, positive spread is not "locked in"
Individual Securities Portfolios
Definition - Purchasing securities with maturities that correspond with the expected draw schedule of the District's construction project.
- This is a good choice if the District has a less restrictive policy, the issue size is at least $5 million, the District has a dedicated internal investment staff or uses an investment advisor, cash flows are relatively certain and the District is likely to meet a rebate exception.
Advantages: Higher yield potential, actual securities are held in safekeeping and yields can be "locked in."
Disadvantages: Higher transaction costs, security accounting required, lack of liquidity in the event of unanticipated draws.
Flexible Repurchase Agreements ("flex repos") or Guaranteed Investment Contracts ("GIC's")
Flex definition - A contract between an investor and with a primary dealer or a bank, in which bond proceeds are exchanged for collateral and the investor earns a coupon rate of interest and may withdraw money as needed to pay construction expenses. A GIC is similar to a flex and is usually issued by an insurance company.
- This is a good choice when the issue size is at least $7 million, the District will be subject to arbitrage rebate, a positive spread can currently be "locked in", and the entity does not have a full-time investment officer.
Advantages: No direct cost, simple to understand, flexible, ability to lock in a positive spread, no reinvestment risk
Disadvantages: Collateral value must be monitored
A "flex" agreement must be competitively bid in adherence with strict IRS compliance requirements. A district may chose to employ a bidding agent to assist them in the process. This agent, who is paid a maximum of 5 basis points (.0005) by the winning bidder, will help analyze investment options, develop bid specifications, assist with contract language and assist in preparing required IRS documentation.The Selection of Bidding Agents
There are a number of Registered Investment Advisors in Texas who have experience in the flex bidding process. Criteria to consider when selecting an agent are the amount of bidding experience, public sector references and any related services that may be included as part of the service.Final Thoughts
- Draw schedules are inherently uncertain, so plan for adequate liquidity. If you purchase securities, plan on leaving 10% to 20% in a pool or money market fund so that an unexpected draw doesn't force a security sale at a loss.
- When possible, try to gain enough yield to obtain a positive spread when you expect to be subject to IRS rebate.
- Safely maximize yield when exempt from arbitrage yield.
- Carefully document your trade process.
This article is reprinted with the permission of:
First Southwest Asset Management
700 Pacific Avenue, Suite 500
Dallas Texas 75201