The time has finally come when you, the Treasurer/CFO, has been given the green light to finance the much-needed improvements in your school district. You’ve probably been hearing for some time now that interest rates are hovering at near all-time lows and investors are searching for municipal debt. So, your next questions might be: how do I finance this project, and should I borrow on a short-term or long-term basis? What circumstances or advantages might there be for selecting one option over the other in this current market?
As a reminder, short-term financing or a Note is for a term of one year or less. This is not to be confused with a Permanent Improvement Tax Anticipation Note (“PI TANS”) that can mature beyond one-year. Conversely, long-term financing, whether through bonds issued as securities with an underwriter or in the form of a bank product, has a final maturity that extends beyond one year. The interest rate and debt service payments are usually fixed for the life of the term. The length of time you can borrow is based on the average useful life of the assets to be financed.
At maturity, a note is paid off by either issuing long-term bonds known as “bonding out” OR issuing a new Note that matures in one year or less, which is referred to as a note “roll” or renewal notes. Notes can be renewed annually under certain parameters in Section 133.22 of the Ohio Revised Code. It is important to remember that the interest rate will change or reset with each renewal depending on market rates at the time the new note is sold or priced.
Notes can be issued on a much faster timeline than a bond. Typically, from the start of funds being placed in the 004, the process is complete in as quickly as 3 to 4 weeks. The preparation time to issue bonds takes a little longer, on average 8 to 12 weeks until the funds are available to spend. This is due, in part, to preparing an Official Statement, which is comparable to a stock prospectus, for investors and securing a credit rating on the Bonds from one or more of the three major rating agencies. This brings us to one of the first factors to consider:
- Timing. During the Pandemic, lumber and steel prices soared in addition to a construction labor shortage. Many districts found themselves in a position of needing to secure contracts and lock-in materials costs before predicted costs increases. More commonly, districts can issue a short-term note to bridge the gap until tax revenues come in. If you find that you need to secure funds quickly to get a project underway, a short-term note issue followed by a bond issue as close to the Note maturity date as possible may be a preferred method. The downside is that certain issuance costs will have to be paid twice.
- Interest Rate Market. Overall, interest rates are at a near all-time low. Short-term rates are even lower. In a normal market, there is a steepening yield curve in which the difference between short-term and long term-rates increases. If the useful life of the asset is shorter, and your opinion is that short-term rates will remain low, it may make sense to issue notes for several years, paying down the principal on the note each year as you would a bond issue; albeit at a lower interest rate. You will pay issuance costs each year, but they are much lower for a note than a bond. This brings us to the next factor to consider:
- Market Risk. The industry has said for a while now that rates cannot get any lower, but rates seem to defy all logic these days. Except for a few periods of market volatility, rates have stayed at near-record lows. All good things must come to an end at some point, but no one holds the crystal ball to know when. The strategy of rolling a note year after year is good until it’s not. Renewing a note annually is essentially opting for a variable rate instrument. There is the possibility that rates will be higher at the time of renewal. Keep a careful eye on the market. If short-term rates are rising, you may want to consider a bond issuance before long-term rates rise.
Another risk is that there will not be a market for your notes when it comes time to renew, meaning there are not any investors willing to buy your renewal Note when the current Note comes due. We saw this at the start of the pandemic in March 2020. The market, in essence, shut down. Bond and note issues failed to sell for a period of a few weeks. It is important to have a contingency plan in the event you will have to front general fund dollars to pay off the current note until such time as a note can be sold and the general fund can be reimbursed.
- A Note offers greater flexibility to pay down or pay off debt faster than long-term financing. With each note renewal, a district has, with certain limitations, the option to pay down as much principal as desired. Whereas a bond issue has a fixed payment schedule without the ability to pay down principal until the call date if the issue is even callable. A quicker pay down of principal will reduce the interest cost. This strategy is best deployed by districts that are anticipating an in-flow of cash in the near-term whether through increased property tax collections due to natural gas pipelines or power plants, etc. or donation agreements from development projects, for example, an Amazon or FedEX distribution center within school district boundaries. As these revenue streams become more reliable, your district can choose how long to renew notes and how much principal to pay down and how much to eventually convert to long-term debt for longer useful life projects.
- Manage Millage Limitations or Expectations. A tactic seen less often these days, but one to consider, is to issue a note in conjunction with a bond issue to manage the millage expectations of your constituents. When projected assessed values do not meet expectations in the calendar year after a bond issue was passed, it may be possible to issue a small portion of the voted amount as a note to control the amount of total debt service required to collect in property tax for the first few years after the issue passed.
- Pending Federal or State Programs. Since the start of the pandemic, there has been much discussion about the economic recovery plans possibly including provisions for federal subsidy bonds akin to the American Recovery Reinvestment Act stimulus plan during the Great Recession in 2009, which offered a large interest subsidy for districts to build new buildings. It is not certain if or when similar programs will be included in any type of bill or budget item. If at the time your district is issuing debt to get a project underway and a provision for similar programs seem imminent, issuing a short-term note to be bonded out is one way to preserve access to these programs.
- Access to Bank Qualified “BQ” Buyers. A common strategy after a newly passed bond issue in November is to issue a BQ short-term note before the calendar year-end. A note can be designated as BQ if the district has issued less than $10 million tax-exempt bonds in a calendar year. Investors of BQ designated securities receive a tax break and as such, are willing to accept lower yield investments which is savings to you, the Issuer. In the following calendar year, the district could consider issuing BQ bonds in conjunction with a non BQ bond issue for the balance of the authorized bond amount.
All these factors should be carefully considered and discussed with your finance, accounting, tax, municipal advisor, and legal team. Short-term financing is usually temporary and offers flexibility, but you must weigh this against where long-term rates are as well. If long-term rates are low at the time of pricing your issue, it may be a better strategy to secure those rates and not bet on the futures market.
Emily Cannon has been a Director in the Public Finance Department of PNCCM. She can be contacted at firstname.lastname@example.org or 614.463.6614. 1
1This article is the opinion of the author and does not necessarily reflect the opinion of PNC Capital Markets LLC (PNCCM).