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ADVISORY

Issuing Taxable Debt (1998 and 2012) (DEBT)

Background.  Debt is commonly issued by governments around the world to finance capital projects. State and local governments in the U.S. have traditionally issued tax-exempt debt; however, the globalization of the capital markets and increasingly burdensome U.S. tax rules relating to tax-exempt financing, have increased the viability of taxable debt as an option for governments seeking to gain operating flexibility or expand their financing options. 

In most instances, tax-exempt debt offers lower cost financing.  However, there are a number of reasons that an issuer might contemplate the use of taxable debt in its financing structure.

Evaluating the Use of Taxable Debt.  The most common reasons that an issuer may consider the issuance of  taxable debt is to obtain operating flexibility (e.g., avoid IRS restrictions regarding the operation of projects financed with tax-exempt bonds).  Unlike tax-exempt debt, capital projects financed with taxable bonds do not prohibit the use of certain types of management agreements and management contracts, such as those that provide for a profit-sharing arrangement between the issuer and the operator.   Consequently, taxable bonds are often issued in conjunction with public-private partnerships (P3s), stadiums/concert venues, and many commercial/retail, housing, and mixed-use projects financed by municipalities. Additionally, bonds issued to finance Pension (POBs) and Other Post Employment Benefit (OPEB) obligations must typically be issued on a taxable basis under IRS regulations.  Finally, taxable bonds are not subject to arbitrage restrictions.

This discussion does not cover the issuance of direct subsidy taxable bonds such as Build America Bonds (BABs), which have the same use restrictions as traditional tax-exempt debt but have the same pricing/structuring issues as taxable debt.  See GFOA’s Best Practice titled “Issuing Build America and Other Direct Subsidy Bonds”.

Recommendation. The Government Finance Officers Association (GFOA) recommends that state and local governments carefully consider whether issuing taxable debt is the best financing option for their proposed project, and develop a thorough understanding of the differences between the tax-exempt and taxable markets before proceeding with a planned sale.  Each issuer and its financial advisor should conduct an analysis of how these differences will affect the overall financial plan and ability to manage its debt program, and consult appropriate counsel, and advisors.  In evaluating whether to issue taxable debt, each issuer should consider the following factors:

Legal
  • Evaluate applicable federal and state constitutional and statutory debt legal provisions.   Various state and federal securities law requirements apply to both taxable and tax-exempt debt.   Taxable offerings often must meet the same state law requirements as tax-exempt debt and issuers should not assume that the absence of some federal tax code restrictions on "private activity bonds" allows for these bonds to be issued without restrictions.  In some cases, taxable debt may be subject to various federal, state, and local laws, including state laws restricting the lending of the issuer’s credit to private entities (“lending of credit”).  Issuers should consult with counsel about the various tax issues that arise with taxable bonds.
  • Some jurisdictions may have additional restrictions on the issuance of taxable debt and the jurisdiction’s debt policy should be reviewed to determine if it specifies when taxable debt may be issued.

Debt Structure
  • Evaluate the total cost of issuing taxable debt, including legal, marketing, and other up-front costs and the interest cost over the life of the bonds, in relation to the financing objectives to be achieved. The cost of taxable debt will generally be higher because investors are not able to deduct interest earnings from taxable income.  Consideration also should be given as to how proceeds will be invested to minimize possible negative arbitrage.
  • Consider structural features that can provide long-term benefits, such as amortizing debt as quickly as possible or embedding early call provisions in order to have the ability to call debt if the project being financed generates excess cash flows.  In some instances issuers may wish to use a hybrid structure: a combination tax-exempt and taxable issue to satisfy certain IRS sizing, cost of issuance, private use restrictions, etc.  An ”interim” taxable issue may also make sense when there is uncertainty regarding a project’s ability to comply with IRS requirements.  If an issuer and their bond counsel are uncertain as to the amount of “private use” of a project, it may make sense to issue all or a portion of a financing on a taxable basis, since taxable bonds can be reissued on a tax-exempt basis at a later date, albeit at some cost.

Call Provisions
  • Issuers should recognize that some features that enhance flexibility, such as an early call provision, may be more costly to exercise for taxable debt than for tax-exempt debt.  “Make-whole call provisions”, common in the taxable debt market, generally preclude the opportunity to refinance the bonds in the future for debt service savings.

Market Considerations
.  Investors of taxable debt are different than those of tax-exempt debt, and may require additional information about state and local government credits in order to better understand the underlying credit of the bonds.
  • Develop an understanding of the market well in advance of the planned sale, including types of investors, structural features, and size requirements needed to attract investor interest.
  • Evaluate whether there are advantages to selling bonds outside of the U.S. domestic market and the costs associated with this approach, such as the costs of registering with a foreign exchange. Legal counsel familiar with particular international capital markets should be involved in order to review specific regulatory and disclosure requirements that may differ from U.S. markets. Also, governments must be sure they have sufficient staff time and expertise to manage taxable debt offered in the international marketplace.
  • Allow sufficient time to educate investors, including potential investors, who may be less familiar with state and local credit, about the offering and the issuer.  Care should be taken to properly label an issuer’s debt as taxable so that investors and other interested parties are able to distinguish it from tax-exempt debt.

Pricing
  • Evaluate the market for taxable state and local government bonds prior to the pricing process, including identification of comparable issues and interest rates, including the use of variable rate debt. 
  • Issuers and their financial advisor should be especially vigilant since less frequent issuance of taxable state and local government bonds increases the risk that a government may pay an interest rate penalty when its bonds are priced.

References.

Approved by the GFOA’s Executive Board, October, 2012.