School districts are always looking for ways to save money, and now State law provides that a school district must refinance all outstanding debt for which a net present value savings threshold of 3% is achievable or risk losing state aid. N.J.S.A. 18A:55-3(e). To meet this new requirement many, business administrators are requesting a letter from their financial advisors preiodically to confirm whether or not their outstanding bonds should be refunded. With recent low interest rates, many districts have been able to successfully refund their bonds.
In order to have a cost saving refinancing, it is necessary for the outstanding obligation to have been issued with a call feature. That means the issuer would have the right to call in the obligations that were issued at the higher interest rate. At one time call features were unusual in general obligation bonds because tax-exempt bond rates did not fluctuate as widely as taxable bond rates. This has proved not to be true in recent years. Accordingly, today most recent issues have call features. (1)
Obligations that are issued with a call feature often will have a certain period of “call protection.” This is a period of time during which maturing bonds cannot be called for early redemption. Typically, this is a ten-year period, although it may be shorter. A period of call protection is necessary in order to issue obligations at the best interest rates.
Often the call option can be exercised only upon payment of a “call premium.” This is an amount that the issuer would pay to the holder of the bond to exercise its call option. A call premium allows the holder to be compensated for the fact that these obligations, which now bear interest at a rate higher than the market, are called for early redemption. School districts must obtain approval of a call premium by the Local Finance Board. (2)
The call premium must be set at an adequate level to make sure that the interest rates on the initial bond issue will not be affected. Usually, it is thought to be unwise to pay up front for the right to call bonds when it cannot be predicted whether that call will ever be useful or not. Today ten year call protection generally is sufficient to permit a par call for bonds maturing after ten years. A par call is a call at a redemption price equal to the amount of outstanding obligations to be refunded without paying an additional premium. Good financial advice is necessary to determine whether bonds should be callable, how much call protection is necessary and at what level any call premium should be established.
In order to have a cost effective refunding, rates must fluctuate fairly significantly. Also, the size of the issue will impact whether a call feature will be cost effective. There must remain enough principal outstanding after the call date, and the interest rates must have dropped significantly enough to make the refinancing cost effective after considering the costs of issuing new obligations and paying other expenses such as the call premium. Moreover, since there has been a general rule of ten-year call protection, the bonds must mature over a fairly lengthy period of time in order to make sure that enough principal will be redeemed early to make the call cost effective. Today, the cost effectiveness of most refunding transactions has been affected by the fact the issuers have not been able to purchase investments for the escrow fund at yields even as high as the bonds that are being issued. A financial analysis must determine whether a refinancing is cost effective in light of all these considerations.
If it is determined that refunding a bond issue is cost effective, the procedure for the refunding is set forth in N.J.S.A. 18A:24-61.1 through 61.12. The new bonds do not need voter approval.
The law appears to have been modeled after the refunding provisions of the Local Bond Law, which governs municipalities and counties. Basically, there is a requirement that the board of education adopt an ordinance. This is unusual since ordinarily boards of education act by resolution. The board must adopt a resolution by a vote of the majority of a quorum to introduce the ordinance after reading the ordinance by title only. After the introduction, the ordinance must be published in full in a newspaper circulated in the school district together with a Notice of Pending Ordinance. The Notice of Pending Ordinance must indicate the time, the date and the place of a public hearing to be held at least seven days after the publication date of the ordinance. After the public hearing on the ordinance at which all interested persons must be given an opportunity to be heard, the refunding ordinance may be adopted by the recorded affirmative vote of two-thirds of the full membership of the board of education
Prior to introduction, but on the date of introduction, it is necessary to have a document called a supplemental debt statement prepared by the chief financial officer of the municipality or municipalities comprising the district. This must be prepared as of the date of introduction of the ordinance and filed with the municipal clerk and the school board secretary. After introduction two copies must be filed with the Director of the Division of Local Government services in Trenton prior to final adoption of the ordinance. The supplemental debt statement is required to show the amount of debt that the refunding bond ordinance will authorize in excess of the amount of the bonds proposed to be refunded. Since the bond ordinance is prepared with a not to exceed authorization and the actual amount will be determined on the date of sale, the actual debt impact of the completed transaction can be adjusted by filing a new supplemental debt statement after the transaction is complete or it will be adjusted in the annual debt statement of the municipality filed in January of each year.
The ordinance cannot take effect until it has been approved by the Local Finance Board, an agency of State government located in the Department of Community Affairs that oversees municipal finance. An application form must be completed and filed with the Local Finance Board on their application filing dates about three weeks prior to their monthly meeting in order to be heard at that meeting. A certified copy of the ordinance as introduced on first reading must be sent to the Director of the Division of Local Government Services before final adoption as part of the Local Finance Board application, together with the executed application certification and a certified copy of a resolution authorizing the application. If those documents are received on a timely basis with the application or shortly thereafter, generally the application today will be considered on a consent agenda, and the board representatives will not have to appear at the hearing. The ordinance will not take effect until the Local Finance Board has approved the ordinance and its consent has been endorsed upon a certified copy of it as finally adopted.
The policy of the Local Finance Board is to approve refundings only where it can be demonstrated that the present value savings will at least equal 3% of the par amount of the bonds to be refunded. This calculation is done after taking into effect all of the costs of issuance. Presumably, this policy is to prevent a school district, municipality or other issuer from issuing large amounts of bonds and from paying large fees to gain a small benefit. This is simply the benchmark that the Local Finance Board uses for its approval. Interesting, a school district must refund if the 3% net present value benefit is achievable, but may not unless it is.
Once it obtains the necessary approval and finally adopts the bond ordinance, the board of education would have to adopt a resolution authorizing the sale of the bonds. This resolution must be adopted by two-thirds of the full membership of the board of education. The bonds can be sold either competitively or through negotiation. Often, it is desirable to negotiate refunding bonds in order to enter the market on a timely basis since refundings tend to be very time sensitive. Also, the size of the issue will have to be carefully calculated to provide sufficient money to take out the old obligations and not violate the Internal Revenue Code of 1986, as amended, by constituting an overissuance of obligations. That means the school district would not be allowed to issue more tax-exempt obligations than it needs. The size of the issue will depend in part on the portfolio of investments in which the proceeds are invested pending application to the redemption. The underwriter in a negotiated offering is helpful in securing these investments simultaneously with the sale and sizing of the issue.
Under the Internal Revenue Code of 1986, as amended, only one tax-exempt advance refunding is allowed for bonds issued after 1986. An advance refunding is where the bonds are issued more than ninety days prior to the maturity or call date of the prior bond issue. Once refunded, all bonds must be called on their first call date. The purpose of the tax code requirement is to prevent large amounts of tax-exempt bonds to be issued and outstanding in the market at one time. It also would have the effect of protecting a municipality or school district against any churning as well. It should be noted, however, that where a municipality or school district has used its one tax-exempt advance refunding, it can always have future refundings that are not advance refundings as the call date draws near. Generally, municipalities and school districts will consider an advance refunding rather than wait for a current refunding if the interest rates are currently at very low levels since there can be no assurance that those low levels will be sustained as the call date draws near.
As noted earlier, the proceeds of the bonds would have to be invested at a yield not in excess of the yield on the refunding bonds until needed to pay off principal and interest as it comes due and principal, interest and call premium on the first call date. Typically, an application for United States Treasury Obligations – State and Local Government Series (SLGs) would be filed to obtain appropriate investments. Under the Internal Revenue Code of 1986, as amended, it is important that such investments either be United States Treasury Obligations – State and Local Government Series or other investments that would meet the market price rules established by regulations promulgated under the Internal Revenue Code of 1986, as amended. Other market rate obligations could also be used for investment legally but it can be difficult to obtain the appropriate portfolio. Generally, where SLGs work, they work best as they can be purchased to meet the portfolio needs while still being at or very close to the bond yield without bringing additional IRS scrutiny as to the compliance with market price rules governing the acquisition of other investments.
In a high to low financing, that is, a financing where higher interest rate bonds are refunded through the issuance of lower interest rate bonds, the par amount of the refunding bonds issued will exceed the par amount of the bonds being refunded. This is because the new issue must provide for the costs of issuance and also it must provide a sufficient amount of bond proceeds to purchase investments at the lower interest rates currently in effect to be placed in escrow and used as the investments mature to pay principal and interest and then redemption price on the refunded bonds. While the gross debt and even the net debt of the municipal issuer will grow larger as a result of the refunding, the total debt obligation, including the payment of principal and interest on an annual and an overall basis, will be lower. In fact, in order to complete the transaction within the perimeters of the Local Finance Board approval, the present value of the total debt service savings must be 3% of the par amount of the refunded bonds as indicated previously.
Boards of education often wonder why the authorization in the ordinance and the application are much larger than the currently projected amounts. It is necessary to provide an outside limit in the ordinance and in the application that will allow the school district to take advantage of a reducing interest rate market. The large par amount may also cover the possibility of refunding earlier callable maturities that may not to be cost effective unless interest rates move even lower than the interest rates prevailing at the time of the application. The application must anticipate the possibility of various scenario.
A refinancing is a complicated transaction. It is important to consult with experienced financial and legal advisors to structure the transaction in the way that would be most advantageous for the particular circumstances of the issuer.
(1) If there were no call feature, the issuer could have a refunding for other reasons, but it would continue to pay interest on the original bonds at the original rates of interest. The proceeds of the new bonds would be escrowed to pay principal and interest on the old bonds as they came due but the yield on the investments of those sums would be restricted to the yield on the new bonds under current tax law. Accordingly, there would be no cost savings benefit to refinancing a bond issue unless the bonds of the original issue could be called for early redemption.
(2) This requirement is different than the requirements that govern municipalities, counties, local authorities and State agencies, which need no special approvals to include a call premium in a call feature. Since these matters are dictated by the market, it would seem appropriate to amend the legislation to delete this requirement.