A mechanism for pricing bonds now — and settling the deal several months later as a replacement for advance refundings — is on track this year to surpass previous issuance levels.
With $1 billion of forward deliveries sold so far this year, according to Refinitiv data, and California planning to price another $1.1 billion next week, the funding mechanism could easily surpass previous records hit since 2015.
“The fact that we don’t have tax-exempt advance refundings as an option anymore compelled issuers and bankers to be a lot more creative,” said Terry Goode, a senior portfolio manager with Wells Fargo Asset Management.
The practice of issuing forward deliveries as a replacement for advance refundings, which were eliminated in the 2017 tax law, peaked in 2019 with $2.8 billion in par issued, more than half of the $5.8 billion issued using that method since 2015, according to Refinitiv. The financing mechanism dropped slightly in 2020 to $2.2 billion priced in 42 issuances.
The California treasurer office’s decision to embrace the refunding mechanism this year to refinance debt in two sizeable deals will help jack up those numbers.
Joint senior managers Goldman Sachs & Co. and Siebert Williams Shank & Co will price on Tuesday a $1.1 billion California general obligation bond refunding on a forward basis “to lock in attractive debt service savings,” said Tim Schaefer, deputy treasurer of public finance.
That deal will be the second forward delivery the state has done this year.
The first occurred when Jefferies LLC and Citigroup Global Markets Inc., lead managers in a 21-bank syndicate, priced $1.5 billion on March 2 in three series for the nine-campus University of California system that included a $411 million forward delivery tranche.
Tax-exempt forward delivery bonds are priced in the current market, but the bond closing is pushed out to comply with Internal Revenue Service rules around current refundings.
The investor community has generally accepted forward deliveries as an alternative method of refinancing debt since advance refundings are no longer an option, Schaefer said.
Forward delivery bonds had historically been used by high-yield issuers in the days before advance refundings disappeared.
“I can remember in my career doing no more than a handful of forwards, because you didn’t need them when advanced refundings were available,” Schaefer said.
When discussions began about using forward deliveries as a replacement, there weren’t a lot of examples to which highly rated issuers could turn.
“A lot of high yields had done it, and people who had sophisticated revenue bonds, or when corporate credits were behind a conduit deal,” Schaefer said.
California began considering it as option as they were looking out, as they regularly do, to which bonds in their portfolio were going to be callable in six to 24 months.
“We don’t speculate on interest rates, but we are conscious of what our maturities are looking like,” Schaefer said. And that includes not just the “gross amount we have to pay off, but what the interest rates are on what we have to pay off.”
The California treasurer’s office is managing a portfolio of outstanding debt totaling $71.2 billion as of Jan. 1, according to bond documents.
The aim is to seek out level debt service, so “we don’t have a lot of ups and downs,” he said.
The majority of the risk is on the investor, not the issuer with these deals. For the issuer, the risk is more one of a lost opportunity, Schaefer said, though forward deliveries do come with a yield differential to assuage some of the risk to the investor.
“Forward delivery deals were definitely popular in 2019,” Goode said. “Then in 2020, we saw it fall off a bit, because of the volatility in the market.”
Taxable refundings continued to be a popular method of refinancing tax-exempt debt in 2020, because Treasury rates were so low and it was economic to refund tax-exempt with taxable, Goode said.
Tax-exempt forward delivery bonds are priced in the current market, but don’t reach settlement for several months. California hopes to push the issuance date out roughly six months to September 2, Schaefer said.
Settlements generally occur anywhere from three to six months, but some states, like Washington have pushed the envelope.
And with rates so low, and demand for municipal bonds so strong, Goode said investors who would not have considered a forward delivery bond beyond three months are being forced to contemplate those settling much further out.
Washington State used the forward delivery refunding method to refinance a $396.3 million motor vehicle fuel tax G.O. that lead manager BofA Securities priced in November 2019 and didn’t reach settlement until 15 months later on Feb. 12.
The bonds sold as 5% coupons with yields starting at 1.76% on the one-year maturities and growing to 2.82% on the 20-year maturities.
The disclosures Washington’s treasurer filed during the period between the pricing of those bonds and settlement included one posted in May on the Municipal Securities Rulemaking Board’s EMMA website warning about revenue uncertainties due to the cost of combatting the pandemic.
The California Health Facilities Financing Authority served as conduit issuer on a $206.6 million forward delivery refinancing for Lucile Salter Packard Children’s Hospital at Stanford University that priced on April 9. The hospital plans to defease the bonds on May 17, 2022 and redeem the refunded bonds on August 15, according to the bond documents.
The yield premium was four or five basis points, but then the deal was well received, so it was bumped, and the spreads got tighter, Goode said.
Roughly $145 million of the $1 billion of transportation bonds that Connecticut is pricing the week of April 19 use a forward delivery method to current refund bonds. The state will settle on the forward delivery bonds on October 19, according to an online road show.
“Forward delivery is attractive to the issuer, because you can take advantage of lower interest rates,” Goode said. “The contract is conditional. For the California deal, it requires the bonds still be rated by S&P Global Ratings and Moody’s Investors Service, but it doesn’t require any kind of a minimum rating.”
The issuer typically pays higher yields to make up for the interest rate risk that investors take on with such deals, Goode said.
“We like them, because they come at an additional yield premium over a regularly settling deal,” Goode said.
In 2019, Goode said Wells Fargo was getting seven basis point premium a month above the settling price. In 2020, the premium was lower, and in 2021, he said, so far it’s been lower, partially because there has been a heavy demand for paper.
“There is so much demand for municipal bonds, and not enough supply to meet it,” Goode said.
The advantage from an investor standpoint, in addition to the potential for higher yields, is that the cash doesn’t have to be delivered until settlement is reached.
No funds are delivered until the closing date with a forward delivery, which allows the issuer to lock in rates at pricing, but not receive proceeds until the closing date, so the issuer complies with the IRS regulations for current refundings that funds are delivered within 90 days of the call date.
“You get the duration, yield curve position and added credit in the portfolio, but you haven’t had to deliver the cash,” Goode said.
In 2019, forward delivery bonds were fairly attractive, because interest rates were low, but going lower, so bonds were going up in price, Goode said.
But the scenario in 2021, when many market participants think rates will go higher, is that you are taking on higher risk buying a delayed delivery deal, he said.
“The 10-year Treasury is at 164 basis points now,” Goode said. “If it’s at 190 when the deal settles in September, then that bond is not so attractive now.”
