1. The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know Glenn R. Casterline Managing Director

2. Discussion Outline Why Should Treasurers Care? Fundamentals of the Arbitrage Rebate and Yield Restriction Requirements Amounts Subject to the Requirements Arbitrage Rebate Payments vs Yield Reduction Payments Investing Bond Proceeds Exceptions to the Arbitrage Rebate Requirements The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

3. Why Should a Treasurer Care? Finance Director’s responsibility (really?) Arbitrage Bonds = Taxable Bonds Fixed earnings target Making a payment is a good thing Basic understanding of the arbitrage rebate & yield restriction requirements will influence your investment strategies Bond proceeds are often the “forgotten” assets Arbitrage Bonds = Taxable Bond Making a rebate or yield reduction payment is a good thing The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

4. Fundamentals - General 2 separate requirements though related Need to comply with both requirements to avoid bonds being declared “Arbitrage Bonds” The arbitrage rebate and yield restriction requirements are related but are also two separate requirements Need to comply with both requirements Arbitrage Rebate Yield Restriction Arbitrage rebate – issuers can achieve compliance by remitting a rebate payment to the IRS Yield restriction – issuers can achieve compliance by……  Investing yield restricted amounts at a yield below the bond yield or..  Remitting a yield reduction payment to the IRS The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

5. Fundamentals – Arbitrage Defined Borrow at tax-exempt rates and invest at higher taxable rates without incurring any additional risk  Positive and negative arbitrage  When the yield curve is upwards sloping tax- exemption of bond interest allows for positive arbitrage Positive arbitrage can be offset by negative arbitrage The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

6. Fundamentals – Legislative History Tax-exemption is a federal subsidy System was abused Laws and regulations were established to discourage issuers from:  Issuing more bonds than needed  Issuing bonds sooner than needed  Leaving bonds outstanding longer than needed Tax exemption is a Federal subsidy Regulations discourage Issuers from: Issuing more bonds than needed Issuing bonds sooner than needed Leaving bonds outstanding longer than needed The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

7. Amounts Subject to the Requirements Most amounts with a nexus to the bond issues are subject to the rebate requirements Some amounts are subject to the yield restriction requirements Arbitrage Rebate Gross proceeds Sale proceeds – amounts received from the sale of the bonds Investment proceeds – earnings on sale proceeds Replacement proceeds – typically amounts pledged to pay debt service Transferred proceeds – prior bond proceeds that become proceeds of the refunding bonds Yield Restriction Amounts remaining beyond applicable “temporary period” (3 years) Amounts beyond the “reasonably required reserve”, Maximum of.. 10% of par amount 125% of average annual debt service Maximum annual debt service Advance refunding escrows Transferred proceeds The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

8. Amounts Subject to the Requirements  Most amounts with a nexus to the bond issues are subject to the rebate requirements  Some amounts are subject to the yield restriction requirements Arbitrage Rebate Fund/AccountYield Restriction YesConstruction FundAmounts remaining after “temporary period” (3 years) YesCapitalized Interest Account Amounts remaining after “temporary period” (3 years) YesReserve FundOnly amounts above “reasonably required reserve” YesEscrow FundBeginning on the issue date The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

9. Arbitrage Rebate Payments vs Yield Reduction Payments An arbitrage rebate or yield restriction liability compares….  Actual earnings  What you would have earned had you invested the same proceeds at the bond yield Arbitrage rebate and yield reduction payments consist of the net amount of positive arbitrage required to be remitted to the Federal government An arbitrage rebate payment is net of any yield reduction payments (You are not paying twice) Liability = actual earnings vs earnings at the bond yield Rebate payments are offset by yield reduction payments The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

10. Arbitrage Rebate Payments vs Yield Reduction Payments Liability = actual earnings vs earnings at the bond yield Rebate payments are offset by yield reduction payments The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

11. Arbitrage Rebate Payments vs Yield Reduction Payments Liability = actual earnings vs earnings at the bond yield Rebate payments are offset by yield reduction payments The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

12. Arbitrage Rebate Payments vs Yield Reduction Payments Liability = actual earnings vs earnings at the bond yield Rebate payments are offset by yield reduction payments The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

13. Arbitrage Rebate Payments vs Yield Reduction Payments Arbitrage rebate and yield reduction payments are required to be paid no later than 60 days after each “5 th Bond Year” and 60 days after the final redemption date “My bonds have been refunded, so they are no longer subject to the arbitrage rebate and yield restriction requirements”.  Defeased vs Redeemed Payments are due 60 days after every “5 th Bond Year” and after the final redemption date of the Bonds Bonds are subject to the arbitrage rebate and yield restriction requirements until the Bonds are redeemed in full DescriptionOriginal BondsRefunding Bonds Issue DateJanuary 15, 1996June 1, 2005 Debt Service Payment DatesApril & October First Optional Redemption DateOctober 1, 2006October 1, 2015 Defeasance DateJune 1, 2005 Redemption DateOctober 1, 2006 The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

14. Investing Bond Proceeds - Fundamentals Fundamental investment objectives include…..  Safety  Minimize credit risk to investment principal  Liquidity  Assure appropriate liquidity for required withdrawals Minimize market risk Minimize reinvestment rate risk  Duration of investments, accessibility to funds  Yield  Generate consistent risk-adjusted returns Investment fundamentals Safety Liquidity Yield The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

15. Investing Bond Proceeds - Objectives Avoid or limit opportunity costs Interest costs accrue on bonds immediately  Negative carry increases financing costs  Improved investments lower overall bowering costs  Net-funded project funds  More earnings=less debt issued  Reserve Funds  More earnings=less net debt service Avoid or limit opportunity costs Higher earnings = less debt issued Higher earnings on the reserve = less net debt service The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

16. Investing Bond Proceeds - Objectives Investing bond proceeds requires an unique investment philosophy Unlike most entities, tax-exempt issuers can develop a “perfect” investment strategy Plan for any rebate or yield reduction payments  Positive arbitrage is a good thing, as long as it is not a surprise Example: surety bond vs cash funded reserve Avoid or limit opportunity costs Avoid surprises. Plan for rebate or yield reduction payments The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

17. Investing Bond Proceeds - Objectives Avoid or limit opportunity costs Avoid surprises. Plan for rebate or yield reduction payments Surety BondReserve Fund Amount Borrowed$150,000$5,000,000 Investment RateNA4.90% $50,000,000 new money financing 25 year amortization Bond yield = 4.54% Construction Fund = 4.19% Total debt capacity may play a key role in determining whether to purchase a surety bond or fund a Reserve Fund The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

18. Exceptions to the Arbitrage Rebate Requirements All or a portion of the bond proceeds may be excluded from the arbitrage rebate requirements if they meet a spending exception If you earned positive arbitrage and met an exception you allowed to keep the earnings Spending exceptions  6 month spending exception  Gross proceeds need to be spent within 6 months  Gross proceeds do not include amounts deposited in the Reserve Fund All or a portion of the bond proceeds may be excluded from the rebate requirements if they meet a spending exception Positive arbitrage can be retained if a spending exception is satisfied The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

19. Exceptions to the Arbitrage Rebate Requirements Spending exceptions (continued)  18 month spending exception  Spending requirements 15% in 6 months 60% in 12 months 100% in 18 months  Gross proceeds do not include amounts deposited in the Reserve Fund All or a portion of the bond proceeds may be excluded from the rebate requirements if they meet a spending exception Positive arbitrage can be retained if a spending exception is satisfied The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know

20. Exceptions to the Arbitrage Rebate Requirements Spending exceptions (continued)  24 month spending exception  Applies to “construction” bonds only  Only includes “available construction proceeds” Construction Fund Capitalized Interest Account Reserve Fund earnings  Spending requirements 10% in 6 months 45% in 12 months 75% in 18 months 100% in 24 months All or a portion of the bond proceeds may be excluded from the rebate requirements if they meet a spending exception Positive arbitrage can be retained if a spending exception is satisfied The Arbitrage Rebate & Yield Restriction Requirements: What Every Treasurer Must Know