Bond Industry Calls for Easing Of Transferred Proceeds Penalty
WASHINGTON - Bond industry officials are urging the Treasury Department and Congress to ease the transferred proceeds penalty for current refundings, saying this will allow state and local issuers to refund high-coupon tax-exempt bonds and at the same time bring in some revenues to the federal government.
The penalty is so onerous right now, they say, that it discourages issuers from doing current refundings - financings that would benefit the Treasury by removing high-coupon tax-exempt debt from the municipal market.
Treasury officials and congressional aides say they are considering the idea of reducing the penalty. They worry, however, this would mean changing rules that have been in place for years to unfairly benefit a few issuers at the expense of bondholders who would want to hold onto those high-coupon bonds. They also worry about the potential for abuse if the rules are changed.
All of the parties are discussing the issue to see if they can come up with a proposal that provides relief to issuers as well as revenues to the Treasury, but also addresses the concerns about fairness and avoids potential abuse.
"We're trying to figure out how can we help issuers and create revenues without creating abuse," said one industry official.
A congressional aide said, "The golden rule here is to do good things but don't give anything away."
The transferred proceeds penalty has existed for years. It has, however, recently caused major problems for issuers that were forced to refund bonds in the early 1980s, when rates were high, to get rid of restrictions in bond documents and that now want to refund those high-coupon bonds to lower interest rates.
Under Treasury rules, when bonds are refunded the unspent proceeds of the bonds being refunded transfer to, or become the proceeds of, the refunding bonds as the refunding bond proceeds are used to pay debt service on the prior bonds.
These "transferred proceeds" become subject to the same arbitrage restrictions as the refunding bonds and generally have to be invested at a yield that does not exceed the yield of those bonds.
But a huge penalty results when transferred proceeds rules are applied to low-to-high-to-low refundings - refundings of high-coupon bonds that previously were issued to refund low-coupon bonds.
The main problem is that low-to-high refundings are structured so that the low-coupon bonds being refunded remain outstanding to maturity and the proceeds of the high-coupon refunding bonds are escrowed and invested long-term at high rates.
If the high-coupon bonds are refunded later, a substantial amount of proceeds remains unspent and must be transferred. But, because those proceeds are locked into long-term investments, the yield on the other invested proceeds of the new low-coupon refunding bonds must be adjusted downward to blend with the higher rates from the escrow and to produce a lower rate than the refunding bond rate.
The downward adjustment of the yield is called the transferred proceeds penalty.
For example, an issuer refunds 6% bonds with 12% bonds to get rid of restrictions in bond documents that said he could not issue new debt as long as the 6% bonds were outstanding. Now the issuer wants to refund the 12% bonds with 7% bonds. But because the proceeds of the 12% bonds are unspent and have been escrowed and invested long-term at a rate near 12%, he must invest the proceeds of the new 7% refunding bonds at a very low rate, that when blended with the near-12% rates of the transferred proceeds, will produce a rate that is below the 7% refunding bond rate.
It is effectively "a 100% penalty" that takes away any economic incentive for many issuers to do refundings, said Micah S. Green, executive vice president of the Public Securities Association.
"If you set federal income tax rates at 100% would anyone have any incentive to work?" he asks, adding, that "in essence, that's the way the transferred proceeds penalty works."
Public Securities Association and Treasury officials met in June to discuss the idea of a reduced penalty. "We'd like to see the penalty set at a level that allows refundings to take place but that also reflects policy and raises some money" for the Treasury, said Mr. Green.
The PSA's efforts follow those of a few bond lawyers who last year took proposals for reduced penalties to members of Congress. The Joint Tax Committee found that the proposals would raise revenues for the federal government.
Congressional aides and Treasury officials say they are sympathetic with the plight of issuers. "The penalty is so bad that the net effect is that people don't do refundings," an Internal Revenue Service official agreed.
But he said, "The biggest concern from the federal government's standpoint is really one of fairness. All of these issuers who did low-to-high refundings did them knowing full well what the transferred proceeds penalty impact would be. The question is, should we change the rules mid-stream to benefit these issuers now? And what about the bondholders?"
Industry officials say dozens of issuers, such as the Lower Colorado River Authority in Austin, Tex., and Tallahassee, Fla., are currently stuck with high-coupon bonds because of the transferred proceeds penalty problem.
"There are at least 20 to 30 big issues around the country that are stymied by this problem," said one bond lawyer in New York.
The Lower Colorado River Authority, for example, refunded all of its outstanding bonds in 1983 to get rid of several restrictive covenants in bond documents. The bonds that were refunded had interest rates as low as 4% and 5%. The $383 million refunding issue had rates as high as 10 3/4%. The authority would like to refund those 1983 high-coupon bonds.
"The pure market savings would be great, but the Treasury's transferred penalty would kick in and eat up all of those savings," said Bill Freeman, chief financial officer with the authority. After years of debate, the authority has decided its only option is to wait for a 1993 call date and defease the 1983 bonds with current revenues. "But that's causing us to debt finance our internal capital needs in the short-run," said Mr. Freeman.
Tallahassee refunded all of its outstanding electric debt in 1985 to modernize its bond documents. The refunding issue, which was sized at about $100 million, had an average interest rate of about 9 1/2%. "If we could refund those bonds and issue new debt at market rates, the city would get a significant savings," said Robert Inzer, the city's treasurer-clerk. "But with the transferred proceeds penalty the savings associated with the refunding basically goes away." Mr. Inzer hopes Treasury will reduce the penalty.
"We're still looking at it," the IRS official said, "But I can't predict where it's going to go."