9.3.2 Bond Document Provisions
The bond document provisions must strike a balance between allowing the public agency133 flexibility to generate investment income and protecting bondholders against the risk that funds will not be available to pay debt service when due for one or more of the following reasons:
| Capital loss: | The obligor fails to pay debt service. |
| Market loss: | The market value of the investment security decreases because, for example, market interest rates rise. |
| Illiquidity: | The municipal debt issuer or the trustee is unable to convert the investment security to cash because of an inability to sell it or because the terms of the security do not require the obligor to provide cash for a stated period from the time requested (e.g., a notice period for withdrawal). |
How the balance is struck may depend on the type of transaction, the requirements for obtaining desired credit ratings on the bonds, and the purposes for which invested bond funds are to be used.
A public agency should consider several questions when deciding how to invest bond funds, and the answers to these should be reflected in the bond documents:
WHO DETERMINES INVESTMENTS? – Public agencies are generally given control over investments, subject to the requirements set forth in the bond documents and the agency’s investment policies. If funds are held by a bond trustee, the trustee is directed to follow the agency’s investment instructions, and the bond documents generally provide that if the trustee does not receive instructions, funds are to be held uninvested or to be invested in a money market fund such as the trustee’s sweep account. See Section 9.4.2, Investments Specific to Bond Funds. Within the agency the responsibility for investing bond funds may be assigned to the debt management staff or to a unit performing general treasury services such as investments and payments. There is no right approach and, as discussed earlier, it is in the agency’s best interests to convene a working group to assess its needs and opportunities and make decisions about how the funds should be managed before the bond funds become available.
WHERE DO INVESTMENT EARNINGS GO? Earnings on the investment of bond funds can be routed in several ways:
- Retained in the fund for which the investment relates
- Transferred to the debt service fund
- Released to the public agency
Bond documents may, for example, provide that earnings on the investment of DSRF monies be retained in the DSRF if the DSRF is not funded at its required level and otherwise transferred to the debt service fund. Construction, program, and capitalized interest funds may be “gross refunded” (sized from bond sale proceeds assuming no investment earnings) with investment earnings transferred to the debt service fund or “net funded” (sized from bond sale proceeds assuming the receipt of investment earnings) with investment earnings retained in the fund. Because investment earnings are “bond proceeds” for federal tax purposes, it is generally advisable that they not be mixed with other funds that are not bond proceeds.
WHAT TYPES OF INVESTMENTS ARE PERMITTED? – Bond documents generally include a list of “permitted investments,” “investment securities,” or “authorized investments” and require that funds held by the bond trustee be invested only in investment securities on the list. The list is generally structured so that the risk of capital loss is no greater than the risk that the public agency will fail to make timely debt service payments on the bonds (expressed a different way, so that allowing investment in a particular investment security will not result in a lower rating on the bonds). Investments are generally limited to high grade debt securities.
WHEN MUST INVESTMENTS MATURE? – To avoid interest rate risk and liquidity risk, bond documents generally require that bond fund investments mature “on or before the dates on which money is anticipated to be needed for disbursements.” For debt service funds, the funds will be needed on scheduled debt service payment dates and for construction funds there may be an anticipated expenditure schedule. DSRFs, by contrast, may not be used until the issuer makes the final payment on the bonds, although to minimize market loss risk DSRF investments may be limited to specified term (e.g., not more than 5 years).
WHAT INVESTMENT SECURITIES ARE REQUIRED FOR A LEGAL DEFEASANCE? – A public agency may generally discharge its debt service payment obligations by depositing investment securities in an escrow fund, typically held by the bond trustee. The interest earned on the investment securities, as well as the principal received when those investments mature, together with cash in the escrow fund, must be sufficient to pay the “defeased” bonds through maturity or prior redemption. See Section 2.4.10, Discharge and Defeasance and Section 3.7.6, Refunding Bonds. Because the holders of defeased bonds may look solely to amounts in the escrow fund for payment, bond documents generally require that investment securities used for defeasance be of very high credit quality. Bond documents vary, but a requirement that “defeasance securities” be direct obligations of or obligations guaranteed by the U.S. Treasury is common.