Over the past 24 months, in order to battle inflation, the Federal Reserve has been increasing the Federal Funds Rate. This rate is used as a part of the “calculation” to set interest rates on most municipal issuances.
From the issuer’s perspective, the increase in interest rate affects current and future issuances of municipal debt. The volatility does affect existing bond holders, in that the value of their bonds decrease when interest rates rise, but this does not directly affect the municipal budget.
The two main types of debt issuances, new project financings and refunding financings, are impacted differently.
New Project Financings
The higher the interest rates, the more costly the financing of a new project is over the long run, thus increasing pressure on the municipal budget.
As a simple example, below we compare a $10,000,000 level debt service municipal financing at different rates.
- Example 1: 4.00% coupon rates, sold at par, with serial bonds that mature annually from year 1 to year 20.
- Example 2: The same $10,000,000 financing with 4.25% coupon rates, sold at par, with serial bonds that mature annually from year 1 to year 20.
The results displayed above show that an increase of just 0.25% on the bonds used to finance the project will cost the issuer an additional 6.25% in interest over the life of the 20-year financing, or in today’s dollars, an additional $220,830.25. (Please note: the results will differ depending on the structure of the bond financing, e.g., level debt, deferred principal payments, etc.)
Refunding Financings
The higher the bond yield environment, the less cash flow savings the refunding financing will achieve.
The yield and the coupon on a bond drive the price of the bond. As yield and price are inversely related, if the yield of a bond increases, the price decreases, and vice versa. In a high yield environment, an issuer has to sell more bonds to generate the necessary proceeds to fund an escrow (which pays off the old bonds), thereby decreasing the potential economics a refunding can produce when compared to a lower rate environment.
Refunding economics are based on replacing an existing transaction’s cash flow (the principal and interest payments of the “refunded” bonds) with a transaction with a lower cash flow (the “refunding” bonds). If the refunded bonds were sold in a higher coupon/yield environment than the refunding bonds, based on the structure of the refunding bonds (e.g., level annual savings), the annual interest payments made by the issuer would be reduced thus producing future cash flow savings and budgetary relief.
To show how both the coupons and the yield define the cash flow savings achieved from a refunding, below we compare refunding an outstanding $100,000,000 Series 2013 transaction with 10 years left until final maturity (initially issued with 4.50% coupons) with:
- A refunding transaction with 3.50% coupons/3.50% yields and a refunding transaction with 3.75% coupons/3.75% yields.
- A refunding transaction with 3.50% coupons/3.50% yields and a refunding transaction with 3.50% coupons/3.25% yields.
- A refunding transaction with 3.75% coupons/3.75% yields and a refunding transaction with 3.75% coupons/3.25% yields.
The results above display that the savings achieved by the refunding are drastically reduced by a 25bp (0.25%) change in the coupon on the refunding bonds (assuming the refunding bonds are to be sold at par). Note that the savings increase with the same refunding bond coupon when that bond has a lower yield.
If the refunding bonds were sold at 3.80% coupons/yield, there would be no future savings produced by the refunding bonds. The results also show that the lower the refunding bond’s yield, the more savings produced. You’ll notice the refunding bonds sold at 3.50% coupon/3.25% yield and 3.75% coupon/3.25% yield produce close to the same savings. This is due to the high price of the 3.75% coupon/3.25% yield bonds.
Conclusion
In summary, even the smallest change in interest rates/yields can have a large effect on:
- How much a project will cost an issuer
- The economics achievable by a refunding (refinancing) of an already outstanding transaction
As interest rates increase/yield increase, issuers must decide if the economics of projects are feasible, whether being paid off with future tax revenues or project revenues. On the refinancing front, the economics of a refunding must produce savings, or the issuer will have to continue paying off the existing outstanding bonds until maturity.
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