California Debt and Investment Advisory Commission Arbitrage Compliance for Bonds

Hawkins Delafield & Wood LLP

California Debt and Investment California Debt and Investment Advisory Commission Advisory Commission

Arbitrage Compliance for BondsArbitrage Compliance for Bonds

February 3, 2011


Simultaneous Transactions to Exploit Difference in Yield or Price of Securities

Make Arbitrage by◦ Borrowing at Tax-Exempt Rate, and◦ Investing at Taxable Rate

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What is Arbitrage?


What is Arbitrage?What is Arbitrage?

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Figure 1 - Actual Investment Yield

3.00%

3.50%

4.00%

4.50%

5.00%

5.50%

6.00%

6.50%

7.00%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36

3 Year Construction Period (Months)

Yiel

d

Bond Yield @ 5.30% Investment Yield

Negative Arbitrage

Positive Arbitrage


What is Yield Restriction?What is Yield Restriction?The Internal Revenue Code imposes a general

requirement that proceeds of tax exempt bonds not be invested at more than the yield on the bonds.

Four Exceptions to general yield restriction Requirements (e.g. temporary period, Reasonable Required Reserve, Bona Fide Debt Service Fund and Minor Portion)

Yield Reduction Payments◦ Payable at Same Time as a Rebate Payment◦ Not Available in all Instances (e.g., Restricted

Reserve Fund Allocable to Advance Refunding)

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What is Rebate?What is Rebate?Certain proceeds can be invested at more

than the bond yield (e.g., make arbitrage during the temporary periods) but, any arbitrage must be rebated to the federal government unless an exception to rebate is available and qualified for.

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General Arbitrage and Rebate General Arbitrage and Rebate Rules Rules

General Arbitrage Rule: No Arbitrage is Permitted – Subject to Yield Restriction

Exceptions to General Arbitrage Rule:◦ Temporary Periods◦ Reasonably Required Reserve Fund◦ Minor Portion◦ Bona Fide Debt Service Fund

General Rebate Rule: Must Rebate if Arbitrage is Made Exceptions to General Rebate Rule:

◦ Spending Exceptions◦ Small Issuer Exception◦ Bona Fide Debt Service Fund Exception

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Importance of Temporary PeriodsImportance of Temporary Periods

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Reasonably Required Reserve Reasonably Required Reserve Fund (RRR)Fund (RRR)

Amount Invested Without Yield Restriction

3 Prong Test: The RRR is the Least of◦ 10% of Principal or Issue Price◦ Maximum Annual Debt Service◦ 125% Average Annual Debt Service

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Minor PortionMinor PortionLesser of 5% of Sale Proceeds or$100,000

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Bona Fide Debt Service FundBona Fide Debt Service FundDefinition: A Fund Used Primarily to

Achieve Matching of Revenues with Debt Service Within Each Bond Year

Requirement: Fund is Depleted at Least Once Each Bond Year Except for Carryover Amount Not to Exceed the Greater of:◦ Earnings in the Fund for the Bond Issue for

Immediately Preceding Bond Year, or◦ One-Twelfth of Debt Service on the Bond

Issue for Immediately Preceding Bond YearPage 10


Rebate and ExceptionsRebate and ExceptionsGeneral rule: All Arbitrage Must

be Rebated to U.S. (100% tax)Exceptions to Rebate:

◦ Any of Three Spend-Down Exceptions◦ Small Issuer Exception◦ Bona Fide Debt Service Fund Exception

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Rebate Spend-down ExceptionsRebate Spend-down Exceptions6-Month Rebate Exception (Any Expenditure)

◦ 100% of “Adjusted Gross Proceeds” at End of 6 Months

18-Month Rebate Exception (Capital Expenditures)◦ 15%, 60% and 100% of “Adjusted Gross

Proceeds” at End of Each 6-Month Period24-Month Rebate Exception (at Least 75%

“Construction Issue”)◦ 10%, 45%, 75% and 100% of “Available

Construction Proceeds” at End of Each 6-Month Period

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Small Issuer Exception to RebateSmall Issuer Exception to RebateGovernment Bonds for Issuers with Taxing Power;

◦ $5 Million limit;◦ $5 Million limit Increased when Financing Public

School Capital Expenditures by the lesser of $10 Million or so much of the aggregate face amount of the bonds attributable to financing the Construction

Conduit Borrowers Qualify if:Not private activity bonds (bonds and loans)Meets all requirement for small issuer exception

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Bona Fide Debt Service FundBona Fide Debt Service FundAmounts in BFDSF are Exempt

From Rebate if:◦ Governmental Bonds, Fixed Rate and WAM

>= 5 years ◦ Annual Earnings are <= $100K

100K Deemed Met if Weighted Annual Debt service is <= $2.5M

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Arbitrage RulesArbitrage RulesBond Year

◦ A One Year Period Ending on a Date Selected by the Issuer but not Later Than 5th Anniversary After Issue Date

◦ First or Last Bond Year May be Less Than a Year

◦ Special Rules for Variable Rate Issue◦ May Affect Amount of Rebate Payment

Particularly for Variable Rate Bonds

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Arbitrage RulesArbitrage RulesDetermination Dates

◦ Every 5th Bond Year or Earlier, and◦ Last Maturity or Redemption Date

Payment Dates◦ 60 Days After Every Determination Date

Payment Amounts◦ At Least 90% for All Determination Dates

Except the Last Determination Date◦ 100% of Accrued Rebate Amount for Last

Determination Date

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Rebate Amount DeterminationRebate Amount DeterminationUse Future Value MethodologyRebate Amount is:

◦ Future Value of All Payments (-) for and All Receipts (+) From Nonpurpose Investments Investments Deemed Sold at PV or FMV

on Determination Date◦ Future Value of All Computational Date

Credits $1,520 for a Bond Year in 2011 and

thereafter, the Credits will Increase Each Bond Year by the CPI

Double the Credit for the Last Bond Year

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Basic Examples - #1Basic Examples - #1

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$1,000,000 Invested @ 5%6% Bond Yield

FV @Date Price Interest Total 6.000%

01/01/00 (1,000,000.00) (1,000,000.00) (1,343,916.38) 07/01/00 25,000.00 25,000.00 32,619.33 01/01/01 25,000.00 25,000.00 31,669.25 07/01/01 25,000.00 25,000.00 30,746.85 01/01/02 25,000.00 25,000.00 29,851.31 07/01/02 25,000.00 25,000.00 28,981.85 01/01/03 25,000.00 25,000.00 28,137.72 07/01/03 25,000.00 25,000.00 27,318.18 01/01/04 25,000.00 25,000.00 26,522.50 07/01/04 25,000.00 25,000.00 25,750.00 01/01/05 1,000,000.00 25,000.00 1,025,000.00 1,025,000.00

- 250,000.00 250,000.00 (57,319.40)



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01/01/00 (1,000,000.00) (1,000,000.00) (1,218,994.42) 07/01/00 25,000.00 25,000.00 29,877.31 01/01/01 25,000.00 25,000.00 29,291.48 07/01/01 25,000.00 25,000.00 28,717.14 01/01/02 25,000.00 25,000.00 28,154.06 07/01/02 25,000.00 25,000.00 27,602.02 01/01/03 25,000.00 25,000.00 27,060.80 07/01/03 25,000.00 25,000.00 26,530.20 01/01/04 25,000.00 25,000.00 26,010.00 07/01/04 25,000.00 25,000.00 25,500.00 01/01/05 1,000,000.00 25,000.00 1,025,000.00 1,025,000.00

- 250,000.00 250,000.00 54,748.60



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01/01/00 (1,000,000.00) (1,000,000.00) (1,280,084.54) 07/01/00 25,000.00 25,000.00 31,221.57 01/01/01 25,000.00 25,000.00 30,460.07 07/01/01 25,000.00 25,000.00 29,717.14 01/01/02 25,000.00 25,000.00 28,992.34 07/01/02 25,000.00 25,000.00 28,285.21 01/01/03 25,000.00 25,000.00 27,595.32 07/01/03 25,000.00 25,000.00 26,922.27 01/01/04 25,000.00 25,000.00 26,265.63 07/01/04 25,000.00 25,000.00 25,625.00 01/01/05 1,000,000.00 25,000.00 1,025,000.00 1,025,000.00

- 250,000.00 250,000.00 -


Determination of Rebate Liability Determination of Rebate Liability and Yield Restriction Liabilityand Yield Restriction Liability

Fund by Fund Analysis◦ Rebatable funds may be netted against

each other◦ Yield restricted funds may generally be

netted against each other◦ Positive rebatable funds may be netted

against negative yield restricted funds ◦ Positive yield restricted funds must not be

netted against negative rebatable funds

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Required DocumentsRequired DocumentsOfficial StatementTax AgreementIRS Form 8038s (i.e., 8038-G, 8038

and 8038-B)Verification Reports, if anyL/C Reimbursement Agreement, if anyGuarantee Investment Contracts, if

anySwap Documents, if any

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Procedures – Data InformationProcedures – Data InformationReview Tax AgreementSources and Uses of FundsPrepare Cash Flow of Investments and

Expenditures (Purchases, Maturities, Sells, Interests, Transfers, and Withdrawals) for Each Fund and/or

Gather Trustee Records from Issue Date of Bonds to Last Day Proceeds Have Been Expended for Each Fund

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Procedures – Bond Yield Procedures – Bond Yield InformationInformation

Review Tax AgreementDetermine Fixed Rate or Variable

RateFixed Rate – No Further

InformationVariable Rate

◦ Interest Payments on Bonds◦ Principal Payments on Bonds◦ Qualified Guarantee Fees for Bonds

Qualified Hedges, if any

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Record RetentionRecord Retention Basic Records Relating to Bond Transaction

◦ The trust indenture, loan agreements, and bond counsel opinion;

◦ Documentation evidencing expenditure of bond proceeds;

◦ Documentation evidencing use of bond-financed property by public and private sources (i.e., copies of management contracts and research agreements);

◦ Documentation evidencing all sources of payment or security for the bonds; and

◦ Documentation pertaining to any investment of bond proceeds (including the purchase and sale of securities, SLGs subscriptions, yield calculations for each class of investments, actual investment income received the investment of proceeds, guaranteed investment contracts, and rebate calculations)

◦ Documentation of All Sources of Payments or Security for the Bonds, Including SWAP Payments and Receipts and Credit Enhancements

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Record RetentionRecord RetentionRecords Should Generally be Kept

Until 3 Years After Final Redemption Date of the Bonds.

Certain Material Records Relating to the Original New Money Issue and all Material Records Relating to the Refunding Issue Should be Maintained until 3 Years after the Final Redemption of Both Bond Issues.

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What are the consequences of late What are the consequences of late payment or nonpayment of the payment or nonpayment of the rebate amount?rebate amount?

The federal government may declare the interest on the bonds paid to the owners of the bonds to be subject to federal income taxation retroactive to the date of issue of the bonds

Late interest (accrues at underpayment rate under Section 6621 beginning on the date the correct rebate amount is due and ending on the date 10 days before it is paid) and penalties (i.e., non-private activity bonds 50% of liability all others 100% of liability)

Nonpayment or late payment, if not timely cured, may constitute a violation of the tax covenants made by the issuer with respect to the bonds.

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