Advisors vigilant as arbitrage issues lurk despite low-rate environment

In a prolonged low-interest-rate environment, many issuers may have paid little heed to arbitrage on bond proceeds.

But that could change, and municipal advisors and bond counsel are staying vigilant on their clients’ behalf.

“Declining interest rates make it generally easier to manage arbitrage,” said Adam Harden, partner at Locke Lord in Texas.

“If an issuer issues bonds with, for example, a 3% yield to construct a new wing of their hospital, and then the interest rates continue declining during the construction period, the issuer may not even have the opportunity to earn arbitrage even if they wanted to,” he said.

“Where you may start to see some issues is in an inflationary market in which bonds are issued with that same 3% yield for new construction, gradually, or maybe even suddenly, the interest rates skyrocket, and there exist boundless opportunities to out-earn the yield.”

Arbitrage in the municipal market is the difference between the interest expense paid by the bond issuer and the earnings from the invested proceeds. For investors, arbitrage is an opportunity. For issuers of tax-exempt bonds, it’s a risk.

Federal arbitrage compliance rules are designed to prevent issuers of tax-exempt bonds from benefiting from the investment of the tax-advantaged bond proceeds into higher income-generating investments.

An issuer that borrowed money at 3% and invested the proceeds in instruments bearing 8% returns would experience a “rebate” that could threaten the tax-exempt status of its bonds or require some explaining to the Internal Revenue Service.

At one of the nation’s top financial advisory firms, the importance of post-issuance compliance gained notice with the announcement of several additions to the team.

HilltopSecurities Asset Management, a unit of HilltopSecurities, in July hired Brian Helming, Antoinette LaBarre, Melissa Pauling, and Yolanda Herrera from BNY Mellon Trust Company where they provided arbitrage compliance services to tax-exempt bond issuers.

Bill Johnson, head of HSAM’s Rebate Department, said the foursome’s “proven abilities will increase the overall experience and knowledge base available to our clients and will lead to best-in-class methodologies, processes, and expand the capabilities of the combined department.”

Helming brings more than 27 years of experience to his role as managing director. Before his move to HSAM, Helming notched 12 years at BNY Mellon Trust Company as group manager of the Arbitrage Compliance Group.

LaBarre’s 28 years in public finance also includes 12 years in BNY Mellon’s Arbitrage Rebate Group as vice president.

Pauling has 17 years in public finance, including 12 years at BNY Mellon Trust Company as vice president.

Herrera joins HSAM as a rebate analyst, the title she held at BNY Mellon for five years.

Earlier this summer, the Indianapolis-based firm Ice Miller picked up a seven-member team from BNY Mellon to expand its on-the-ground expertise in arbitrage rebate compliance.

BNY Mellon has announced that it was exiting the arbitrage rebate field.

“The expansion of our arbitrage rebate practice by combining with very experienced finance professionals was a natural fit for us given our historical rebate practice and added more depth to our full service bond capabilities,” Ice Miller partner Tyler Kalachnik told The Bond Buyer last week via email. “This expansion was not driven by interest rates or current profit margins.”

Johnson also said that expansion of HSAM was not event-driven but an indication of Hilltop’s overall growth strategy.

The Dallas-based firm, perennially tops among financial advisors in Texas and the Southwest region, has been on a hiring streak since the firm was created in 2018 by the merger of First Southwest Co. and Southwest Securities.

“These more recent hires demonstrate our continued commitment to growing our public finance business and supporting our clients with a comprehensive suite of services to meet the full scope of their needs,” Johnson said. “We are expanding across all of our public finance business areas to ensure we give our clients the best service possible.”

Regarding recent trends, Johnson said that low investment interest rates have in some cases had a negative impact on issuer compliance. With little “profit” to be made, there is a lower risk of non-compliance, he said. Budgets strained by unexpected COVID-19 expenditures meant that some services, such as rebate calculations, may have been deemed nonessential.

“Prices for rebate services have become very competitive,” he said. “Purchasing departments appear to be controlling the contract process with fees being an important decision in the process.”

Johnson noted that some rebate specialists have left the business or merged into a different organization.

“Post-issuance compliance is a tough sell in today’s investment environment. Nevertheless, compliance is required by the IRS for issuers to receive the tax-exempt subsidy,” he said.

“HilltopSecurities believes that our clients need to remain compliant in tough times and the good times,” he said. “By doing so, there are no major surprises related to payments required to be made to the Treasury, no fire drills for IRS audits, and since rebate calculations are cumulative from the date of issue, no budgetary issues for multiple year catch up calculations because they were not performed in the current interest rate environment.”

When higher investment interest rates do return, it may catch issuers off guard if they are not spending their project funds within three years of the date of issuance, Johnson said.

“HilltopSecurities is not waiting for interest rates to rise to start staffing up,” he said. “We are investing in the best available talent now so that we are prepared to give our current clients advance notice as changes occur and have the capacity to get new non-compliant clients back into compliance.”

Locke Lord’s Harden said that in recent years an issuer that experienced staff turnover and had no idea about the post-issuance compliance procedures nevertheless accidentally complied with the arbitrage restrictions based solely on the declining interest rate environment and the inability to out-earn the yield.

“That is precisely where post-issuance teams and regular check-in calls are worth their weight in gold, and it would not surprise me if that is where we are heading based on what we are seeing with inflation,” he said. “If inflation is not transitory and rates increase, either gradually or dramatically, there may be accidents ahead.”

Yvette Shields contributed to this story.