PURPOSE:

The purpose of this report is to request the City Council�s authorization to convert the City�s Pension Obligation Bonds from the current variable rate mode to a fixed rate in order to avoid costs associated with potential interest rate increases.

BACKGROUND:

On June 22, 2004, the City issued $25,120,000 of taxable Pension Obligation Bonds (POBs). The POBs were structured as variable rate bonds bearing a monthly interest at a rate equal to the 30-day LIBOR plus a margin of 30 basis points (0.30%).  The bonds were purchased by Depfa Bank.  LIBOR, or the London Inter-Bank Offered Rate, is the interest rate banks charge each other for short-term money, and is a commonly used index for establishing short-term bond rates.  Interest rates are set monthly, and the bonds amortize on June 1 of each year from 2005 through 2024.

In connection with the bonds, the City established a $10 million reserve as a hedge against potential volatility of the variable rate debt.  In addition to scheduled amortization payments, the City planned to make additional principal prepayments in an amount equal to the difference between the actual variable interest rate and an assumed fixed rate (5.00%) that was in effect at the time of the initial Council approval in 2004.  To date, the City has made a total of approximately $545,000 in prepayments from that interest rate differential.

However, since June 2004, the Federal Reserve Board has increased short-term interest rates an unprecedented 15 times.  In turn, the 30-day LIBOR rates have increased from approximately 1.45% at the outset to 5.12% recently. To those interest rates is added the 30 basis point margin, making the most recent rate on the City�s POBs equal to approximately 5.32%.  As a result, the current variable rate now exceeds the original assumed fixed rate. This report addresses the impact of fixing the rates on the POBs as a means of avoiding costs associated with future increases in the POBs� variable rate.

ANALYSIS:

The City can take one of two basic approaches to fixing the rate on its POBs: (1) fix the rate directly with Depfa or (2) sell refunding POBs to the public.

Option 1:  Depfa Approach. Under this approach, Depfa would simply agree to a fixed rate on the POBs through maturity or any other period (shorter or longer). As with the original bonds, this would be considered a private placement. There would be need only to amend the City�s bond resolution and the existing Depfa agreement.  The process would be very fast and straightforward � the rates can be fixed the day after Council approval.

• Interest Rates. Depfa indicated that it would set the rates based on the U.S. Dollar LIBOR swap curve plus a margin of 25 basis points. The LIBOR swap curve is adjusted continuously throughout each day and is readily verifiable through online reporting services.  In addition, the margin of 25 basis points is a reduction in 5 basis points from the current margin of 30 basis points. Under the market conditions as of April 20^th, the City�s new fixed rate would average approximately 5.89%.

• Transaction Costs. The transaction costs would be approximately $35,000 for bond counsel, financial advisor, and Depfa Bank fees.  The inclusion of these fees would cause the City�s all-in borrowing costs to be approximately 5.90% as of April 20^th.

• Reduced Prepayment Flexibility. In fixing the rates with Depfa, the City would retain the flexibility to prepay the POBs in whole or in part at any time, but any such prepayment would be subject to market breakage costs.  If rates decline, and the City chose to prepay or refund the fixed rate bonds, the City would incur a prepayment or termination fee; if rates increase the City could potentially receive a payment from Depfa if the City chose to prepay or refund the bonds at that time.  The City could also build in an option in the structure of the new bonds to prepay the POBs at par after a given date and eliminate the risk of a prepayment penalty; however, that would result in a higher interest rate of approximately 20 basis points. In other words, a prepayment option would result in a premium being added to the new bond interest rates.  The City would only prepay or refund the bonds in the future if then current market rates resulted in savings that far outweighed the prepayment or termination fee.

Option 2:  Public Offering. Under this approach, the City would refund the POBs with publicly offered taxable debt. As with the City�s other bond issues, this approach would require new bond documentation, the preparation of an official statement, credit ratings and most likely bond insurance, and involve the usual cast of participants (bond counsel, underwriter, financial advisor, trustee, etc.). The process would entail a minimum of 3 to 4 weeks to prepare substantially final documentation, with the ability to set rates approximately 1 week after Council authorization.

• Interest Rates. The interest rates would be set by the underwriter as a spread off U.S. Treasury rates for like maturities (2007 through 2024).  That spread is market-driven and could vary between 40 to 80 basis points off the Treasury curve. As taxable investors prefer maturities with large blocks of bonds (e.g., $5,000,000), the relatively small size of the POB transaction could result in higher spreads to the Treasury curve. Nonetheless, the nominal rates of a publicly offered bond should be somewhat lower than a privately placed bond.  As of April 20^th, market rates for similar type bond issues would be an approximate average of 5.85%, compared to the 5.89% rate estimated for Depfa.

• Transaction Costs. The public offering would entail significantly higher transaction costs, totaling approximately $344,000. The City would need to pay an underwriter�s fee, a bond insurance premium, rating agency fees and higher bond counsel/financial advisor fees due to the more extensive nature of the documentation. These higher transaction costs negate the interest rate advantage of the public offering. The addition of these transaction fees would cause the City�s all-in borrowing rate under the public offering approach to be approximately 5.97%, compared with an estimated 5.90% all-in rate under the Depfa approach.

• Reduced Prepayment Flexibility. Typically, taxable bonds are marketed either as non-callable or with a �make-whole� provision. The make-whole provision would require the City to pay a premium if it chose to prepay the POBs if rates fall; if rates increase, the City could prepay or refund the bonds at par. Including an 8- to 10-year call feature would cause interest rates to increase by a premium of approximately 15 to 25 basis points, similar to the Depfa approach.

FISCAL IMPACT

Market experts assume that the Federal Reserve Board is likely to increase short-term interest rates at least one more time.  In addition, other economic and non-economic factors could cause interest rates to increase (higher inflation, expansion of the war in Iraq, another �Katrina�, etc.).  Leaving the POBs at a variable rate exposes the City to further increases in interest rates and costs, and make the City�s future POB costs unpredictable. Under current market conditions, fixed rates are still relatively attractive.  The following tables analyze the comparative costs of the two fixed rate approaches:

To provide an �apples to apples� comparison of the two approaches, the following methodology was used:  staff determined the annual probable interest rates and interest payments under each approach assuming no re-amortization of the existing principal, without regard to transaction costs; then, staff discounted the difference in interest payments at the public offering rate (5.85%) as of April 20th.  This methodology shows that the public offering approach has a total present value benefit of approximately $119,300; this advantage can change depending on market conditions.

However, the interest cost savings of $119,300 is negated by the higher transaction costs associated with the public offering; the City would pay approximately $308,810 more in transaction costs ($343,810 - $35,000). Therefore, the public offering approach would actually cost the City approximately $189,510.

The following table compares the two approaches for fixing the rate on the City�s POBs (assuming interest rates as of April 20, 2006):

* Interest rates as of April 20, 2006  ** Inclusive of all costs

This comparison suggests the Depfa approach would represent the most effective means for fixing the interest rate on the City�s POBs.  

OTHER ISSUES

The principal remaining issues then become:

• Should the City fix the POBs in the first place or should it maintain some or all of its POBs as variable rate? Staff believes that in the current market environment, the prudent course of action is to convert the entire outstanding balance to a fixed rate.

• How should the City apply the $10 million currently being used to hedge against rising interest rates on the variable rate POBs?  There are a number of different ways the $10 million could be used:

1. Use all or a portion to pay down the outstanding principal before converting the balance of the POBs to a fixed rate. In keeping with the original intent of the Council in establishing the reserve, staff would suggest that a portion be used to pay down the debt.

2. Keep a portion in reserve to help fund the City�s future OPEB (Other Post Employment Benefits) liability.  Staff is currently evaluating the OPEB liability to determine future budget requirements.  Pending the completion of staff�s OPEB analysis, it would be prudent to hold some of the $10 million in reserve. 

3. Use all or a portion of the $10 million to pay down the City�s current and/or future CalPERS pension liability.  Staff is also investigating this strategy and no conclusion has been reached regarding either the ability to exercise this option or the financial impact on the City�s future pension costs.   

CONCLUSION:

Under the current market environment, short-term rates may continue to increase.  If so, then the City�s bond payments will continue to increase, perhaps exceeding what the bond payments would be if the City were to convert the pension bonds to a fixed rate now.  By fixing the bond rates now, the City would avoid future cost increases resulting from continued increases in short-term interest rates.  Interest rates are relatively volatile and the City should move quickly to convert the bonds to a fixed rate. Although a public offering would result in slightly lower costs over the life of the new bonds, doing so would entail a potentially lengthy process, during which time interest rates could move higher, thereby resulting in higher costs for the City.  Fixing the rate on the pension bonds through an amendment to the agreement with Depfa Bank will enable staff to move quickly and lock in fixed rates sooner. In addition, this action will free up the $10 million currently reserved for hedging against rising interest rates.

RECOMMENDATION:

1. Staff recommends the City Council adopt the Resolution approving the conversion of the POBs from a variable rate to a fixed rate through Depfa Bank.

2. Staff recommends that $5 million of the $10 million reserve be used to pay down the principle prior to fixing the rate. 

3. Staff further recommends that the balance of the reserve, $5 million, be reserved to be used as needed in the future to fund the City�s OPEB liability, future pension costs or other City priorities.

4. Staff Recommends the City Council adopt a resolution amending the fiscal year 2005/06 budget by appropriating from the pension bond reserve $35,000 to cover the related fees of the conversion to a fixed rate mode, and $5 million to reduce the outstanding bond balance prior to executing the conversion.

K:\Administration\Pension Bond 2006\Staff Report (May 2006)table 1.doc

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