By Michael Quint March 1 (Bloomberg) — Natalie Brill , chief of debt management for Los Angeles, would like to take advantage of record- low interest rates to save at least $4.55 million by refinancing bonds for the second-most populous U.S. city. Except Ben S. Bernanke ’s monetary policy would wipe out much of the savings. Brill, 47, is caught in an unintended consequence of the Federal Reserve chairman holding overnight rates near zero to ease the worst recession since the 1930s. The city, facing a $212 million budget deficit for the current fiscal year, could sell tax-exempt obligations yielding less than 4 percent to retire 5 percent debt sold seven years ago. To do so, Brill would first have to park the proceeds of the new bonds in U.S. government securities that under Bernanke pay as little as 0.53 percent . Local governments and other borrowers in the municipal market sold a record $378 billion of tax-exempt bonds in 2009, when yields fell to the lowest in at least 40 years. At the same time, so-called advance refundings of existing notes shrank to $48.1 billion in 2009 and $28.9 billion the year before, from $82.4 billion in 2003 when municipal yields were at a then-record low, though Treasury yields were higher than today, according to data compiled by Bloomberg. “People are accustomed to thinking that lower Treasury yields are a good thing,” said Richard Tortora, president of New York-based Capital Markets Advisors , with about 300 government clients. “But in advance refunding, they can work against the borrower.” Short-Term Rates Bernanke and fellow policy makers have held the target for overnight loans between banks, the benchmark for other short-term rates, to a range of zero to 0.25 percent since the end of 2008. The low rates, plus Fed statements that they will stay that way for “an extended period,” have pulled Treasury yields to less than 1.5 percent for issues due in up to three years. “The Treasury yields are definitely a problem,” said Brill, whose city faces a gap in the budget year ending June 30 as tax collections decline. “Absolutely, we could refund more of our debt if they weren’t so low.” If Los Angeles were to advance refund $151.7 million of 5 percent bonds sold in 2003, new debt would be invested in the low-yielding Treasuries until the 5 percent issues are eligible for repayment on Sept. 1 of 2011, 2012 and 2013, according to bond documents. While Brill estimates the city could sell new bonds at less than 4 percent, that cost would be higher than the rates of 0.53 percent to 1.62 percent the Treasury pays on special securities with maturities matching the earliest dates the 5 percent issues can be repaid. Treasury Obligations The Treasury’s State and Local Government Series securities, which the agency calls SLGS , are sold only to municipalities for refinancing and can’t be traded like regular Treasury obligations. Their interest is set daily at 0.01 percentage point below the government’s estimated borrowing cost for each maturity. Treasuries are used “because anything less than securities backed by the U.S. government wouldn’t satisfy the rating companies” and to assure investors that the refunded bonds will be paid, said Chester Johnson , president of New York-based Government Finance Associates, an adviser to localities. Because Internal Revenue Service rules allow a bond to be advance refunded only once, “a refunding is always a gamble, because of the chance you could get a better deal by waiting,” Brill said. ‘Doesn’t Work’ “The math doesn’t work for us” partly from the loss in the Treasury investments and because the city’s borrowing costs haven’t declined as much as other issuers due to California’s $20 billion budget deficit and record large bond sales, Brill said. A cut in the city’s bond rating to AA- by Standard & Poor’s hasn’t helped. California, among the areas hit hardest by the recession, has the lowest credit rating of all U.S. states. It has sold eight bond issues of more than $1 billion totaling $18.7 billion the past six months, according to Bloomberg data. It faces a $6.6 billion budget gap in the current fiscal year and $13.3 billion in the 12 months starting July 1. Call Options To replace its 5 percent bonds, Los Angeles would also have to pay for costs of issuing new debt, of about $8.50 per $1,000 paid to underwriters, printers, lawyers and rating companies, based on expenses at a December sale of the city’s solid waste revenue bonds. It also must pay for the extra bonds in the investment account because $151.7 million of low yielding Treasury securities won’t produce enough money to pay interest on the old 5 percent bonds before they are retired. The city also looks at the value of its option to call, or repay before maturity, the old bonds and subtracts that from the expected savings of replacing them with lower cost securities, Brill said. While Los Angeles isn’t able to advance-refund debt, borrowers with stronger credit ratings, such as New York’s Westchester County, which has the highest median annual property tax bill in the U.S., are successful because they pay the lowest rates on new bonds. “The issuers hardest hit by the low Treasury yields are those rated A or lower, especially those who sold insured bonds,” said Joy Howard , principal of WM Financial, a St. Louis-based adviser to local governments. Westchester County With the collapse of municipal bond insurance on losses from home-loan related securities, many issuers can’t sell new bonds backed only by their own credit at rates low enough to economically replace their old, insured debt, Howard said. Only 9 percent of new municipal bonds were insured in 2009, down from 45 percent in 2007, according to BofA Merrill Lynch Global Research. Westchester, with AAA ratings from Moody’s Investors Service, S&P and Fitch Ratings, sold $96.5 million of bonds in January at cost of about 2.5 percent and invested in a pool of Treasuries yielding 2.31 percent. The financing replaced bonds due in 2011 to 2021 with interest rates of 3.125 percent to 4.75 percent and saved more than 4 percent on the refunded bonds, said Larry Soule, the county’s finance director. “You have to keep your eyes on two markets at once: the municipal market, to know the cost of the new bonds, and the Treasury market, to know your investment yield,” Soule said. To contact the reporter on this story: Michael Quint in Albany, New York, at mquint@bloomberg.net .
