Title
Financing for Construction (B)
Explanation
In November 2007, the City Commission, (1) authorized the financing of up to $205 million of new money for payment of Costs of Acquisition and Construction (capital projects) through the issuance of fixed-rate bonds; and (2) approved the selection of Goldman Sachs as Senior Manager for the bonds and authorized the appointment of additional Co-Managers if doing so would enhance the distribution of the bonds. The $205 million authorized consisted of $100 million in tax-exempt Bonds and $105 million in taxable Bonds to fund construction expenditures.
GRU staff and our Financial Advisor now recommend that we also obtain authorization to issue the tax-exempt Bonds on a variable-rate basis.
In October 2006, GRU executed two separate interest rate swaps to hedge its borrowing cost on a portion of the $100 million of tax-exempt Bonds expected to be issued this year. At the time the swaps were entered into, it was expected that the swaps would not be terminated upon the issuance of the tax-exempt Bonds, and that those Bonds would be issued as variable rate Bonds. The swaps were executed at a rate that provides an all-in fixed rate of less than 4.50% on the hedged portion of the financing. Under the swaps, GRU will pay a fixed rate of 4.222% on the swaps, and receive a floating rate linked to the SIFMA short-term index. The actual cost of GRU floating-rate debt historically has been almost identical to the SIFMA index. Therefore, the net effect of issuing variable-rate debt and leaving the swaps in place would be a net fixed-rate obligation. GRU would receive a swap payment that is virtually identical to its variable-rate interest cost, and the 4.222% fixed swap payment would create "synthetic" fixed rate debt.
However, the swaps were structured to allow GRU the option to terminate the swaps and issue fixed-rate debt. Any gain or loss on the swap termination was expected to offset the effect of changes in long-term interest rates on tax-exempt bonds, thus delivering the sub-4.50% net fixed rate.
Bond issuers always face the choice of using either the "conventional" or "synthetic" markets as a means of achieving net fixed-rate financing. Typically, all-in conventional fixed rates are slightly higher than synthetic fixed rates. When the costs of these two alternatives are close to each other (e.g., within 15 basis points (0.15%)), most issuers elect to use the conventional market to borrow funds. However, most issuers use the interest rate swap market if they elect to hedge future borrowings. The swap market is far more liquid, cost-effective and "bid-able" as a means of hedging future transactions. These are the reasons that GRU adopted its original strategy of hedging in the swap market, but planning to borrow in the conventional bond market.
In November 2007, it appeared that a conventional fixed-rate tax-exempt financing would produce an "all-in" interest cost that would not be materially higher than a synthetic fixed-rate financing, which is why staff requested authorization to terminate the swaps and issue fixed-rate Bonds.
However, the much-publicized market events of recent months have altered significantly the typical relationship between conventional and synthetic borrowing costs. While conventional borrowing costs were roughly 15 basis points higher than synthetic rates throughout most of 2007, credit market concerns have had a much greater effect on conventional borrowing costs. Investors sought the safety of Treasury bonds and/or short-term investment alternatives. Therefore, rates on conventional tax-exempt bonds rose relative to rates on Treasury bonds and short-term debt. The interest rate swap market was less affected than the conventional bond market. The graph on page __ of the presentation materials highlights the change in relationship between the conventional and synthetic markets. What had been a roughly 15 basis point advantage for synthetic alternatives has increased to over 40 basis points.
Under current market conditions, in order for GRU to achieve the lowest all-in interest rate, it would be preferable to leave the swaps in place and issue variable-rate Bonds, as opposed to terminating the swaps and issuing fixed-rate Bonds. Several other large municipal issuers are making this same decision to access the synthetic fixed-rate market to avoid the additional cost imposed by the underperformance of the conventional bond market.
While the optimal financial structure will depend on market conditions existing at the time of execution, current market conditions indicate that variable-rate Bonds, combined with GRU's existing interest rate swaps, can deliver the lowest overall cost to GRU's ratepayers.
Staff continues to recommend that the portion of the construction expenditures that, under current federal income tax law, cannot be financed on a tax-exempt basis continue to be financed with fixed-rate taxable Bonds, as was authorized by the City Commission in November 2007.
Recommendations
The City Commission:
1. Authorize the issuance of variable-rate bonds that are converted synthetically to a fixed rate through the use of two existing "floating-to-fixed" interest rate swaps for $90 million of the new money for payment of Costs of Acquisition and Construction (capital projects) previously authorized by the City Commission on November 15, 2007; and
2. Authorize the Clerk of the Commission, the General Manager and other Authorized Officers to execute such documents as may be necessary to proceed with the transaction authorized in 1 above, subject to approval of the Office of the City Attorney as to form and legality, and to take such other actions as may be necessary or advisable to proceed with these transactions in accordance with this City Commission authorization.
Fiscal Note
Issuing new money debt at historically low rates will help manage future debt service costs.
Drafter
Prepared by Jennifer L. Hunt, Utilities Chief Financial Officer
Reviewed by Raymond O. Manasco, Jr., Utilities Attorney
Submitted by Karen S. Johnson, General Manager