For most people, even municipal bond investors, the question is a bit esoteric, but it is also of potential interest to town, city and state officials and legislators who may not be directly involved in the bond process, but who are concerned about the very question.
Our firm is actually involved in helping governments select investment solutions to solve that very asset and liability matching problem. Here’s how it generally works:
Let’s say a city issues a long-term tax-exempt bond for 10s of millions of dollars to build a school, road, bridge, sewer plant, or some other public facility. When they issue the bond, they get all the money at one time, but they will not disburse the money immediately, and will pay it out in stages as the project is completed in stages. They will have a development schedule and a disbursement plan, but life being the way it is, reality and plans seldom match. The city has a need for a delayed and periodic but irregular and not entirely precisely timed payment schedule for the development project.
Therein lies the problem. The bond calls for just the opposite — immediate, periodic, regular and precisely timed payments of interest at a fixed rate. How does the city avoid the risk of having to use tax revenue to pay any portion of those interest payments before the money is disbursed for the public project?
The solution is a flexible withdrawal, guaranteed investment rate contract from an institution that can manage the cash flow vagaries of a flexible withdrawal feature. The city gets the bond money in and immediately invests it in such a flexible GIC.
Examples of companies that provide flexible GICs for this purpose include: AIG (NYSE:AIG), Citicorp (NYSE:C), Morgan Stanley (NYSE:MS), Bank of America (NYSE:BAC), MBIA (NYSE:MBI), Berkshire Hathaway (NYSE:BRK.A), and others.
The law limits the vehicles available for investment of municipal bond cash, to rock-solid assets like U.S. Treasuries. Therefore, the alternative to the flexible withdrawal GIC would be for the city to build its own Treasury ladder, but then they would have other risks — market risk if cash were needed before rungs on the ladder matured, or reinvestment risk if rungs of the ladder matured before cash is needed. The flexible withdrawal GIC eliminates both of those problems.
Bond issuers may have internal staff to analyze GIC bids to select flexible GIC providers, or they may call on advisors, such as our own firm, to analyze the proposals from various GIC providers bidding for the investment. That analysis makes sure that the detailed terms of the contracts, which are complex documents, actually respond suitably to the bond issuer’s needs and specifications. It organizes the various formats of data from the bidders to allow a meaningful side-by-side comparison of the bids. The investment advisor then recommends which of the bidders is the best choice for the city. Finally, the advisor coordinates activities to make sure that the winning GIC bidder gets the contracts issued timely and in conformity with the bid proposals.
The story is not yet over, however. The Tax Reform Act of 1986 created an effective 100% tax on excess interest earnings in repurchase agreements by municipal bond issuers. Simply put, if the GIC pays more interest than the municipal bond pays out, the bond issuer must surrender (rebate) the excess to the U.S. Treasury. However, if the GIC pays less interest than the municipal bond pays out (and that happens in some circumstances) the bond issuer is just out of luck and the U.S. Treasury does not refund prior excess payments. There are some rules that allow offset between a current losing GIC and a current winning GIC, but the noteworthy fact is that the Treasury generally intends to share in the bond issuer’s reinvestment profits, but stand back from its losses.
As a result of this federal regulation, the Internal Revenue Service issued IRS 26 CFR Part 1, Section 1.148-5, which allows municipal bond issuers to deduct the cost of advisors in the GIC selection process from any calculation of excess interest that the bond issuer may be liable to pay the U.S. Treasury. That is why the GIC providers are the ones who are now required to pay the advisor to the bond issuer. It keeps things nice and simple for the bond issuer to receive interest net of the advisory fee before it figures out if it owes Uncle Sam money.
That is how governments manage temporary municipal bond investments to match assets and liabilities.