Debt Issuance Decisions: Is Now the Right Time?

Over the years, (and there have been a lot of them), municipalities have asked me two key questions:  

 1. When should they issue debt?
2. What type of debt instrument should they issue in the current environment?

Let me answer the first question: Your guess is as good as mine.

When Should You Issue Debt?

The most obvious question is: When do you need the proceeds of the debt to finance the project? 

Some projects must be started today, while some can be delayed. If you can delay the financing, be sure to do your homework. Asking AI what investment rates are going to do over the next 3 to 6 months will get you an answer– but is it a guaranteed answer? 

The Unpredictability of Interest Rates

Let’s take a look at the below example:

Interest rates are expected to continue their downward trend over the next 3 to 6 months. The Federal Reserve has been cutting rates to combat inflation and stimulate economic growth. 

Recently, the Fed reduced interest rates by a quarter percentage point, bringing them to a range of 4.25% to 4.5%¹.

Experts predict that the Fed will continue to cut short-term interest rates gradually. 

The yield on one-month Treasury bills is expected to fall to about 3.5%, and the bank prime rate could reach around 6.75%. However, long-term rates, such as mortgage rates, are influenced by supply and demand and external buyers of U.S. debt².

If you have any specific financial plans or investments in mind, it might be a good idea to keep an eye on these trends and consult with a financial advisor for personalized advice.

Market Volatility Can Change Everything

Investment banks spend a lot of money to create “best in class” market analysis resource groups and tools to try to answer the “What will future interest rates do?” question. However, the reality is that as the world changes on a monthly, weekly, even daily basis, these resources come up with new results.

As an example, to my knowledge, no investment bank predicted the volatility that occurred from January 2022 to April 2022 due to (1) the start of the Russia-Ukraine War and (2) the cryptocurrency market due to the collapse of some FTX.

Evaluating Risk in the Current Market

Below is the Municipal Market Data (MMD) graph starting in January 2022. If you had delayed your issuance at the end of 2021, you would have never been able to secure 2021 investment rates again. As a result, it would have cost you more to finance your project over the life of the loan.

Note: Linear trendline

If you look at MMD over the last 20 years (graph below), current rates are somewhere around the average. The key question is how much risk do you want to take on if you don’t issue your debt now, especially given the general political and economic turbulence in the U.S. and abroad.

Note: Linear trendline

Market Timing and Seasonal Effects on Debt Issuance

One last thought: There are periods within a year when shifts in cash positions among potential bondholders could change the yield curve due to supply and demand pressures. 

Take for example, the legendary “January/July” effect.    

A significant percentage of bonds mature on January 1 and July 1, along with their associated interest payments. This means the general buyer universe should have more cash to buy bonds, increasing demand and thus lowering yields. 

By the same token, April 15—Tax Day—can have the opposite effect. Many investors, including bond funds, may need to sell investments to cover tax obligations, reducing demand for bonds and pushing yields higher. And then of course there are the Fed meetings which will often cause investors to not commit until the Fed announcement.

What Type of Debt Should You Issue?

Now that I have shown I cannot predict future rates, even several months forward, maybe I can answer the second question–why issue certain types of debt in particular market environments? 

(Important Note: This analysis does not consider the future ability of states or municipalities to issue tax-exempt debt.)

Below are two diagrams illustrating which financing tools to use depending on if the markets are at historical high yields or historical low yields, followed by definitions of each product.

^{*Use the following definitions to learn about each debt issuance type listed in the above diagrams.} 

Debt Issuance Definitions

General Definitions

1. (a) Arbitrage Yield

The arbitrage yield of a municipal bond is the maximum investment rate that tax-exempt bond proceeds are allowed to earn by the federal government without having to rebate. 

Essentially, it represents the highest yield that can be earned on the investment of bond proceeds without violating federal arbitrage regulations. 

This yield is crucial for ensuring compliance with tax laws and avoiding penalties.

1. (b) Negative Arbitrage

Negative arbitrage is when the interest rate a municipality earns on its investments is lower than the interest rate it pays on its debt (e.g., bonds).

Longer Duration Product Definitions/Structures

1. (a) Standard Call Bond 

Standard call bonds let you lock in today’s long-term rates with a fixed rate financing. This structure takes future interest rate and market access risk off the table. 

A standard call bond does lock in your long-term rates for at least 10 years (through the standard 10-year call period protection) eliminating any possibility of restructuring should interest rates decline prior to 10 years. 

This structure requires the entire construction fund to be funded at delivery date, creating the possibility of negative arbitrage (see above). 

If a capitalized interest account or a debt service reserve fund is required, there is the potential for additional negative arbitrage.

1. (b) Bond with a Make-Whole Call 

A bond with a make-whole call allows you to lock in today’s long-term rates with a fixed rate financing at a low yield, typically lower than a standard 10-Year call bond. This structure takes future interest rate and market access risk off the table. 

A bond with a make-whole call locks in rates long term but also gives the issuer the flexibility of refinancing the bonds (i.e., restructure the debt to create a different amortization) in the future but eliminates any potential savings of refunding the bonds should interest rates drop in the future. 

The inability to produce cash flow savings using a make-whole call is due to the nature of the calculation of the call premium.

     (c) Bond with a Short Call 

A bond with a short call allows you to lock in today’s long-term rates but pay for the flexibility (in additional yield cost) to call the bonds earlier than the usual 10-Year call protection. This gives the issuer the flexibility to refinance their long-term debt when interest rates are lower. 

Because of the shorter call provisions, there is a higher yield kick (yield to maturity) so it would be advantageous to issue this type of bond in a lower coupon (e.g., 4.00% coupons) environment. 

The cost of shortening the call can be calculated using an option adjusted spread analysis. If a capitalized interest account is required, (1) the call date should be after the capitalized interest period and (2) there is the potential for additional negative arbitrage.

    (d) Construction Draw Program

A construction draw program allows you to issue bonds on an “as needed” basis whenever proceeds are needed (e.g., issue bonds monthly if there is a monthly construction draw) to finance the project. 

This type of program slows the issuance of long-term bonds so the issuer can (1) take advantage of interest rates dropping and (2) reduce any potential negative arbitrage in any funds (e.g., construction fund). 

A construction draw program requires the issuer to have access to the capital markets on a continual basis. 

Another potential issue is the issuer does not have all the funds on day one to finance the project, so if they lose the ability to enter the capital markets in the future, they will have to find a substitute to finance the remainder of the project. 

This financing plan does add risk should interest rates increase in the future, though that risk is offset somewhat by lack of negative arbitrage. However, if interest rates decline, the issuer stands to save money.

   (e) The Structure for Accelerating Future Financing Needs 

You can lock in today’s rates with a fixed rate financing. With rates expected to rise in the future, the issuer should add future financing needs to today’s transaction. This structure takes future interest rate and market access risk off the table. 

The structure does lock in your long-term rates for at least 10 years (usual call period) eliminating any possibility of restructuring should interest rates decline prior to 10 years. 

It also requires a longer average life construction fund to be funded at delivery date, creating the possibility of more negative arbitrage. If a capitalized interest account is required, there is the potential for additional negative arbitrage.

     (f) The Structure for Split Financing

Instead of issuing one set of bonds to finance a project, issue a portion of the needs in the current interest rate environment and issue the remaining needs in a future interest rate environment. 

This opens the possibility of either (1) interest rates falling in the future and the second financing will be cheaper than the first, or (2) interest rates increasing in the future and the second financing will be more expensive than the first financing. 

This structure does lock in a portion of your long-term cost at the delivery of the first transaction. By selling multiple transactions over time, the issuer may be reducing their negative arbitrage in any funds but increasing their overall cost of issuance by issuing multiple transactions.

    (g) Forward Delivery Bonds 

Entering into a forward delivery bond contract allows you to lock-in fixed rates today. Bonds will be delivered in the future in the same methodology as standard call bonds. 

Forward delivery bonds usually have a yield penalty because the purchaser is committed to buying a bond in the future, taking on the risk that they could purchase another bond in the open markets in the future at a higher yield.

    (h) Tax-Exempt Commercial Paper (TECP) (Short Duration)

Start a TECP program by defining the maximum size of commercial paper that will be outstanding at any time. 

Issue TECP whenever proceeds are needed to finance the project. (TECP typically has a maturity length between 7 days and 365 days and can be re-issued when it matures.) Continue to sell additional TECP to finance the project when funds are needed. 

At any time, if the issuer feels interest rates have lowered to their target long-term fixed rate, they can fix out the TECP. This structure also eliminates any negative arbitrage in the construction account since the TECP draws eliminate any construction fund need. 

If capitalized interest is required, the issuer would just issue additional TECP to cover this cost. It’s important to note that when the TECP is originally created, the total amount of outstanding TECP at one time should include all future needs (e.g., construction draws, interest needs).

    (i)  Mandatory Put Bond 

Issue a portion or all the transaction using short term mandatory put bonds (e.g., 3-Year Put). 

At the put date, the issuer has the option to either (1) refinance the put bond with another put bond, (2) issue longer fixed rate bonds to pay off the put bonds, or (3) issue variable rate debt to pay off the put bonds. 

This structure requires a construction fund to be funded at delivery date, creating the possibility of negative arbitrage.

   (j) Variable Rate Debt

Issue variable rate debt (i.e., floating rate debt whose rate is pegged to an index and a spread) to fund the project, taking advantage of short-term interest rates compared to long-term interest rates. 

At any date in the future, the issuer has the option to either refinance the variable rate debt with any other financing vehicle. This structure requires a construction fund to be funded at delivery date, creating the possibility of negative arbitrage. 

If capitalized interest is required, a Capitalized Interest Account should be funded at the variable’s “max rate” as defined in documents. You must continue to pay ongoing letter-of-credit or line-of-credit costs while the variable is outstanding.

    (k) Short/Intermediate Term Bond 

Issuing short or intermediate-term bonds can provide a lower interest rate compared to long-term bonds. However, the documentation can specify that, for coverage purposes, the issuer assumes a 30-year amortization. This relieves the coverage constraint while allowing issuers to sell bonds at the shorter end of the yield curve. 

When a term bond reaches maturity, the issuer refinances it with a bond that has a shorter average life than the originally issued long-term bond.

   (l) Refundings 

If rates are low, but expected to increase, review the possibility of executing either tax-exempt current refundings or taxable advance refunding. 

(Note: Taxable refunding bonds can be refinanced back to tax-exempt bonds once the originally refunded bonds are called.)

Sources: 

¹ Fed Sees Fewer Rate Cuts in 2025: Kiplinger 

² Mortgage Rates 2025: Newsweek

Related Municipal Finance Reading

• Municipal Issuance Predictions for 2025
• Breaking Down the Math Behind Municipal Bonds
  
  
  
• From Bond Proceeds to Rebates: The Lifecycle of a Construction Account
  
  
  

Disclaimer: DebtBook does not provide professional services or advice. DebtBook has prepared these materials for general informational and educational purposes, which means we have not tailored the information to your specific circumstances. Please consult your professional advisors before taking action based on any information in these materials. Any use of this information is solely at your own risk