Minimize Refunding Negative Arbitrage or Maximize Savings?

Posted by Peter Orr on Mar 19, 2012

"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, negative
 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?