Philadelphia went "insurance swapping" this week in a deal that sets the stage for the junk-rated city to sell roughly $160 million of triple-A bonds later this month.
The key to the upcoming general obligation sale was an advance refunding, sold Tuesday by Kidder, Peabody & Co., of a seemingly unrelated issue from the Pennsylvania Convention Center Authority.
By securing an agreement with Financial Guaranty Insurance Co. to effectively shift coverage of outstanding authority debt to the city's bonds, Philadelphia, the lowest rated major city in the nation, has found a way to sell up to $385 million of GOs over the next two and a half years at triple-A rates.
At the same time, the authority, which thought it was stuck with $290 million of 30-year noncallable debt, has advance refunded the issue and added a new 10-year call feature.
Noncallable debt is rarely advance refunded because the Internal Revenue Service requires that investment earnings on the escrow account be no higher than the yield on the refunding bonds. At best, then, such a refunding would be a wash for the issuer as far as interest rate savings are concerned, and a loss when transaction costs are taken into account.
Philadelphia's strategy does not overcome that basic market dynamic. In fact, the convention center refunding is expected to lose money for the city, which backs the convention center authority's debt through a lease agreement. But because of the side agreement with FGIC, the upcoming general obligation sales are expected to generate savings that more than offset the losses from Tuesday's refunding.
Without the insurance agreement, for example, Philadelphia's double-B ratings would cost the city about $5 million more in higher interest costs on the $50 million new-money portion of the upcoming sale, according to Clearance D. Armbrister, the city treasurer. And since FGIC has agreed to back up to $385 million in outstanding principal over the next two and a half years, future GO sales are expected to generate even more savings for the city.
The extra expenses to the city created by the convention center deal add up to about $2.8 million, which equals the transaction costs on the advance refunding, according to Armbrister. The expected $5 million in savings from the GO issue this month will more than offset those costs, he said.
Insurance "recycling" is not a new phenomenon to the municipal market. Eric J. Shapiro, a director at FGIC who worked on the Philadelphia transaction, said New York City pioneered the idea about two years ago. Since then, Shapiro said, bond insurers have made agreements with several other major issuers to refund outstanding debt and apply the freed-up capacity to new bonds from the same issuer.
What makes the Philadelphia transaction unique is that it enables the convention authority to advance refund its noncallable debt and produces a way for a junk-rated city to tap a major vein of bond insurance.
FGIC's fee, according to sources involved in the transaction, is about 100 basis points - extraordinary high by bond insurance standards but not surprising given Philadelphia's underlying ratings. The savings generated by FGIC's triple-A rating more than offset the price.
Under the structure, FGIC's insurance for the old convention authority bonds remains in place. But since the authority's debt is now backed by an escrow account that renders it triple-A, FGIC's overall exposure to the Ba credit is reduced substantially. That frees up the insurer to apply its backing to the same amount of new city debt.
Ralph Saggiomo, a senior vice president at Kidder who helped structure the deal, said it would have been a waste to use FGIC's guarantee on the convention center deal. The IRS' yield restrictions mean the city is technically indifferent to the yield on the refunding bonds, so applying insurance to trim the coupons would not generate additional savings to the city.
By effectively shifting that insurance capacity to the city, Philadelphia not only wins extra interest cost savings, but the gilt-edged rating also vastly increases the city's flexibility to use such techniques as derivatives, Saggiomo said.
And although Philadelphia is technically indifferent to the yields on the convention center deal, market sources say the results were far better than the city's double-B ratings would have suggested.
"The issue came at a fairly high price relative to where a double-B should come," said Peter Allegrini, a portfolio manager at Fidelity Investments, which bought a portion of the deal.
In fact, Philadelphia even outperformed some low investment-grade deals that came to market in recent weeks. For example, the final maturity in 2017 on a triple-B rated Chicago Calumet Skyway issue last month yielded 7.097%. The convention center's final maturity, in 2019, yielded 6.875%.
"We were willing to buy the whole loan," said Andrew Jennings, vice president and manager of municipal trading at the Franklin Group of Funds.
Unlike in 1991, when Franklin succeeded in purchasing nearly the entire $50 million unenhanced portion of Philadelphia's first trip to the bond markets as a non-investment grade credit, this time around Franklin only won a portion of the deal. And in another sign of the market's embrace of the city's turnaround, Kidder said a total of 49 buyers participated this time, compared to just two on the 1991 transaction.
In fact, most market sources say they expect the rating agencies sometime this year or early in 1995 to catch up with the market's perception of the credit as already investment grade.
"We don't think we're going to be carrying Ba credit on our books very much longer," FGIC's Shapiro said.