By Ryan Miles, Senior Investment Adviser | Managing Director,
Greg Johnson, Senior Municipal Advisor,
and Stephen Broden, Senior Arbitrage Consultant | Director of Arbitrage Consulting

Effective Bond Proceeds Management

Whenever tax-exempt debt is issued for a new project, it’s important to develop an investment strategy that coincides with the anticipated spend down of proceeds. Given the higher investment yields seen over the past few years, borrowers with unspent proceeds remaining from prior issues may unknowingly have an arbitrage liability. The profit that results from investing gross proceeds of a tax-exempt issue in higher yielding taxable securities is called arbitrage. Any arbitrage earned must be remitted to the Internal Revenue Service (IRS) in the form of a rebate and/or yield reduction payment unless an exception or exclusion can be met.

Key Considerations for Arbitrage Rebate & Yield Restrictions

Arbitrage rebate is not something to fear. If properly monitored, any rebate due can be estimated in advance. Investment strategies can be deployed in conjunction with efforts to spend down proceeds to manage, mitigate, reduce, or potentially even eliminate the rebate liability. There are also many permitted exceptions to rebate including small issuer, spending, bona fide debt service fund exceptions, and investment in tax-exempt securities.

Arbitrage yield restriction requirements mean gross proceeds of a tax-exempt issue can’t be invested at a yield that is materially higher than the arbitrage yield unless certain exceptions are met including:

• Three-year capital project temporary period (which can be extended to five-years in certain circumstances)
• Reasonably required reserve fund (such as a debt service reserve fund)
• De minimis exception
• 30-day exception for a current refunding
• Bona fide debt service fund 13-month temporary period
• Investment in tax-exempt securities

An Illustrative Example

For many issuers funding new capital projects with tax-exempt bond proceeds, spending exceptions to arbitrage and the three-year capital project temporary period for yield restriction are usually applicable. Let’s look at an example:

In 2021, a client issued $9,590,000 General Obligation Bonds on a tax-exempt basis to finance new projects and refund an existing obligation. The arbitrage yield on the Bonds was 1.786682%. At least 75% of the new money proceeds were to be used for construction expenditures, which were subject to the following conditions:

• At least 10% of construction proceeds including investment proceeds must be expended within six months
• At least 45% must be expended within one year
• At least 75% must be expended within 18 months
• 100% must be expended within two years except for reasonable retainage which must spent within 36 months.

After a swift first year of project spending, followed by several unintended delays, the issuer’s actual spend down results were as follows:

• 20% spent within six months
• 58% spent within one year
• 58% spent within 18 months
• 58% spent within two years

Because the issuer didn’t meet the prescribed spend down requirements associated with an exception to rebate, the potential for an arbitrage liability goes all the way back to day one. Fast forward to January 2025 and the issuer spent 80% of the proceeds. The bond issue now has accumulated an estimated rebate and yield restriction liability amount of $400,000. And while it’s only a matter of time before the rest of the project funds are spent, the issuer must account for the amount due to the IRS (so the construction fund doesn’t have to pay the IRS).

As of the date of this article, the issuer has sufficient funds to complete projects and hasn’t spent any of its $700,000 in net investment income. That full amount of net investment income is not entirely available for further project expenditures. Practically speaking, the issuer must take into consideration the contingent liability due to the IRS, which can only be known with certainty once the projects are closed out.  In this example, the issuer should spend down remaining proceeds and investment income before any new debt is issued, while also carefully monitoring its rebate liability, as it will be due on a date certain in the future.

If the issuer had spent all the construction proceeds in the amounts and intervals within the two-year spend down exception requirements, there would have almost assuredly been less investment income. But it may also have been possible to retain it all. Often municipalities wish to avoid annual debt issuance, if possible, to reduce the associated costs of doing so. Especially for the same project. However, if they are financing multiple years’ worth of capital projects or one that will unfold over an extended period of time and those initiatives experience unanticipated delays, arbitrage rebate and yield restriction payments may be triggered, potentially negating the cost-saving measures of not issuing debt each year, or at least over multiple years.

An Alternative Approach

Alternatively, issuers can take a more arbitrage-neutral stance and seek out investments that allow for reasonable income generation, while reducing the potential for rebate or yield restriction payments. This approach is only possible if issuers invest in tax-exempt securities, which may be difficult to find in the current investment environment.

Ehlers team of municipal advisors, investment professionals, and arbitrage specialists are available to navigate these requirements and assist with the management of tax-exempt proceeds after closing. It is important to know that there are exceptions to the arbitrage rebate and yield restriction requirements to help guide these decisions both at the time of issue and as projects unfold.

Required Disclosures: Please Read

Ehlers is the joint marketing name of the following affiliated businesses (collectively, the “Affiliates”): Ehlers & Associates, Inc. (“EA”), a municipal advisor registered with the Municipal Securities Rulemaking Board (“MSRB”) and the Securities and Exchange Commission (“SEC”); Ehlers Investment Partners, LLC (“EIP”), an investment adviser registered with the SEC; and Bond Trust Services Corporation (“BTS”), holder of a limited banking charter issued by the State of Minnesota.

This communication does not constitute an offer or solicitation for the purchase or sale of any investment (including without limitation, any municipal financial product, municipal security, or other security) or agreement with respect to any investment strategy or program. This communication is offered without charge to clients, friends, and prospective clients of the Affiliates as a source of general information about the services Ehlers provides. This communication is neither advice nor a recommendation by any Affiliate to any person with respect to any municipal financial product, municipal security, or other security, as such terms are defined pursuant to Section 15B of the Exchange Act of 1934 and rules of the MSRB. This communication does not constitute investment advice by any Affiliate that purports to meet the objectives or needs of any person pursuant to the Investment Advisers Act of 1940 or applicable state law. In providing this information, The Affiliates are not acting as an advisor to you and do not owe you a fiduciary duty pursuant to Section 15B of the Securities Exchange Act of 1934. You should discuss the information contained herein with any and all internal or external advisors and experts you deem appropriate before acting on the information.