WASHINGTON - Federal regulatory officials are concerned that some of the new advance refunding techniques designed to make refundings feasible in the current market may violate Treasury Department regulations.
They say that deals employing these techniques may run afoul of tax rules because they involve an arbitrage play and result in more bonds being issued than necessary or bonds being left outstanding longer.
The investment bankers and bond lawyers doing these deals, however, say they were designed solely to eliminate negative arbitrage from advance refundings so that it does not eat into the potential savings from such deals. Negative arbitrage is the loss an issuer faces when its investment yield is well below its bond yield.
These bankers and lawyers insist that such deals do not violate tax rules. They say there is no arbitrage earned from the deals because the overall investment yield is below the refunding bond yield. They also say these deals are only being done because of unusual market conditions.
As the rates of short-term Treasury bonds have fallen extraordinarily low, the rates of long-term municipal bonds have remained relatively stable. This huge spread between taxable short-term rates and tax-exempt long-term rates has created problems for issuers doing refundings who typically put short-term Treasuries or other government securities in an escrow to refund prior bonds.
The yield from their refunding escrow is so far below their bond yield that they have to issue more refunding bonds to generate the cash to do the refunding. Increasing the size of the refunding issue offsets the potential savings and may undermine the economics of the deal.
The new refunding techniques try to avoid this by creating a pot of investments that is separate from the refunding escrow and that is invested above the bond yield. The yields from the investments and the refunding escrow are then blended to create a higher overall investment yield that is below the refunding bond yield.
In one of the most common of these techniques, the refunding issue is structured so that payments of principal do not have to be made in the early years. This frees up the issuer's revenues that had been earmarked to pay debt service in those years.
The freed-up revenues are invested in a sinking fund at a yield above the bond yield. The blended yields of the refunding escrow and sinking funds create an overall higher investment yield that is below the refunding bond yield.
This deal also can be done with zero coupon bonds, for which debt service payments are not due until maturity.
In another such deal, high-coupon bonds and low-coupon bonds are refunded at the same time. Since the low-coupon bonds are being refunded from a low rate to a higher rate, they are left out to maturity, and the escrow set up for them is invested long at a yield above the refunding bond yield. The blending of the yield of that escrow and the yield of the escrow for the high-coupon bonds produces an overall higher investment yield that is below the refunding bond yield.
Federal regulatory officials and some bond lawyers say these deals appear to violate the Internal Revenue Service's artifice and device rule. Under that rule, a bond transaction is an artifice and device if it enables the issuer to exploit the difference between tax-exempt and taxable rates to gain a material financial advantage, and if it increases the burden on the market for tax-exempt obligations.
There is an arbitrage play because the pool of investments is invested above the yield of the refunding bonds, they say.
"Negative arbitrage is a terrible thing, but that doesn't mean that you can get rid of it with arbitrage," one official said, adding that the Treasury and IRS could try to stop these deals in forthcoming consolidated arbitrage rules.
The deals result in an increased burden on the tax-exempt market because more bonds are issued than necessary or existing bonds are left outstanding longer, they say.
Another complaint is that these deals abuse the efforts that have been made to date by the Treasury and IRS to write simpler and more reasonable bond rules. Arbitrage rebate rules issued in 1989 contained an anti-yield blending rule that would have prohibited such deals. But that was dropped from recent refunding rules that contained broad anti-abuse provisions instead of detailed restrictions to stop abuses.
"It is at least very disappointing to see this happening after we issue a reasonable rule that permits some blending" in non-abusive situations, another federal official said.
Bond lawyers are divided about whether these deals violate tax rules. At least one major firm that has a conservative reputation is giving opinions on them. But lawyers from some other major firms say they will give opinions on these deals only if the issuer can demonstrate a non-arbitrage reason for needing to do them.