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Minimize Refunding Negative Arbitrage or Maximize Savings?

  
  
  
  
  

"Don't ever get your speedometer confused with your clock, like I did once, because the faster you go, the later you think you are."  - Jack Handey, Deep Thoughts

We see lots of public finance refunding situations. Between our consulting for banks and FAs and just handling tech support calls for SmartModels, we see refundings all the time. And in this market, with Treasury yields at all time lows and spreads to munis still relatively high, we also see a great deal of emphasis on minimizing negative arbitrage in the deal. To the uninitiated, negativeconfusion image arbitrage is the amount of additional escrow cost above and beyond the “perfect” escrow price i.e. the cost if the escrow was able to earn exactly the refunding bond yield (or technically a tiny bit less to make the Service happy…).

Looking at this a bit more generally, the cost of the escrow simply reflects the price of retiring the old bonds. It can be seen as the issuer’s price for buying back their bonds, though they have to use USTreasury yields, often SLGS, to price them to the call date. With Treasury yields so low vis a vis munis the price or escrow cost is high.  

But the savings however is the thing that by definition occurs after the call date once the existing bonds are gone. This savings can be taken anywhere from closing on out the curve but exists because of the lower borrowing cost (and higher price) the issuer can get from the new financing relative to the old.  And it is this savings that needs maximizing.

Now we completely understand the lower the yield of the escrow the higher the cost which requires a larger refunding size, lowering savings. But we see in many cases a focus on negative arbitrage that misses the forest for the trees, particularly when the overall economics of the refunding are compelling. Is the goal of the financing to minimize negative arbitrage or to maximize savings? 

 

Comments

what exactly do you mean by......"anywhere from closing on out the curve"
Posted @ Thursday, September 11, 2014 10:35 AM by marcell
Thanks for the question Marcell and sorry I wasn't more clear. What I meant was you can target where cash flow savings relative to the original bond issue are generated by changing the amortization of the new refunding bonds. All savings could be taken at closing of the new deal. Or cash flow benefits could be generated anywhere between closing and the long end of the yield curve at 30 years or so, assuming the issuer's credit is good out there. That clarify things?
Posted @ Thursday, September 11, 2014 12:51 PM by Peter Orr
It wouldn't allow me to reply directly to your post via email, so needed to post again but, you are suggesting whether the issue pockets savings all upfront effectively as a lump sum OR has lower cash flow drain via a lower debt payment?
Posted @ Thursday, September 11, 2014 1:06 PM by Marcell
Exactly - though it could be a combination as well. Some cash could be taken at closing while also keeping some cash flow benefit in future periods. 
Anything is possible by playing with the refunding amortization.  
My email is peterorr@intuitive-analytics.com. Feel free to contact directly if you like.
Posted @ Thursday, September 11, 2014 1:25 PM by Peter Orr
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