Debt Portfolio Management- An Issuer’s Perspective Edward C. Armendariz, President Southeastern Public Advisory Group (SEPAG) Greer, South Carolina APPA Business & Financial Conference Portland, Oregon September 2005

Debt is Good “Pay-as-you-go” Programs to fund System expansions or capital renewals and replacements are UNFAIR to your current ratepayers The Accounting “Matching Principle”- match the term of your assets to the term of your liabilities Allows you to spread the cost of your System improvements over their expected useful life, so the beneficial users of those assets share equitably in their cost over time Gives credibility and long life to your organization

General Structure of Municipal Debt Much like your home mortgage, long-term tax-exempt debt is generally issued with a 30-year maximum maturity, with essentially equal annual debt service (principal plus interest) payment requirements Again, this allows the issuer to ratably spread the costs of financing capital improvements over the beneficial life of those assets Interest Expense on debt should be budgeted as an operating expense each year Depreciation Expense (non-cash expense) should also be included in your operating budget. This becomes the resource to meet principal repayment obligations on the debt

The Call Feature Typically, municipal debt is issued with call protection. This generally allows the issuer to take advantage of future favorable market environments in order to reduce their ongoing interest expense Generally, the ability to call your debt early begins 10 years from the date of issuance, and includes a call premium which declines to par in three years: Year % Year % Year % At Triborough Bridge and Tunnel Authority, we were able to reduce the call premiums without impacting our ability to market the debt: Year % Year % Year %

The Call Feature (Continued) Call Protection is an asset that an issuer pays for up front. It needs to be nurtured, guarded and watched carefully in order to reap the potential financial benefits Typically, if Bonds are issued “non-callable”, they would carry a coupon rate of 15 to25 basis points below callable debt, depending upon existing markets If the call option is never exercised, it is a “wasted” asset

Refunding Opportunities The Goal of any effective Debt Management Program should be to reduce the ongoing cost of the debt to the organization Just as individuals might refinance their home mortgages to lower their monthly payments when interest rates become lower, municipal issuers have the opportunity to refund their outstanding debt for savings The 1986 Tax Act limited our opportunities to “advance” refund our debt to only two (2) times “Current Period” refundings, or refinancings within 90 days from the first call date, may be executed on an unlimited basis

Triggering Refunding Opportunities RULE OF THUMB: Typically, a refunding of existing debt will make economic sense to the issuer if the current market is at least 150 basis points lower than the market that the original Bonds were issued in To control the potential economic benefit to the issuer from a refunding transaction, most active issuers have developed a minimum 5.0% net present value savings standard (as a percentage of the par value being refunded), before triggering a refunding

Short-term Assets Back to the Accounting “Matching Principal”, assets with only 3 to 5 year lives (rolling stock, computer equipment, etc.) need to be considered separately Issuers have the opportunity to enter into short-term lease arrangements with commercial banks on a tax-exempt basis The economic benefit to the bank is the transfer of the depreciation expense to them, as beneficial owner of the assets The utility has the beneficial use of the assets for their entire useful life “Bank-Qualified” considerations- Under existing Tax Law, an issuer can pass on their depreciation tax benefits ONLY if they do not issue in excess of $10 million in tax-exempt debt in the year that they enter into the lease arrangement

Variable Rate Debt In the pursuit of the lowest cost of debt, many issuers will consider issuing variable rate debt Generally, this is debt that is remarketed by a Remarketing Agent, with the rate reset weekly The operable index for the weekly reset of the debt is the Bond Market Association’s index of approximately 650 active issues of Variable Rate Demand Obligations (VRDOs), known as the “BMA” Currently, the BMA is at 2.49%, and the 52 week moving average is 2.07% VRDO programs can produce significant debt service savings to issuers

HISTORY OF THE BOND MARKET ASSOCIATION’S MUNICIPAL SWAP INDEX (“BMA”

Credit Enhancement Requirements for Issuing Variable Rate Debt VRDO Bondholders need to be protected against an issuer’s default on their required debt service payments Depending upon the issuer’s underlying credit ratings, two separate structures must be considered, as follows: A direct-pay Letter of Credit facility with a highly-rated commercial bank, which will pay the ongoing debt service requirements on the VRDOs on the issuer’s behalf each month. This will cost more than… A Liquidity Facility, where a commercial bank will “stand behind” an issuer’s payment obligations, guaranteeing payment in the event of a default on the part of the issuer.

The Remarketing Agent A major investment bank or commercial bank will have a desk specializing in the weekly remarketing of an issuer’s VRDOs to short-term investors These services can be provided for an annual fee in a range of 10 to 25 basis points of the size of the VRDO issue, in the current market environment Some major issuers have negotiated fees as low as 6 basis points for these efforts These activities should be judged on an ongoing basis versus actual BMA. An aggressive firm will consistently remarket the VRDOs at or below prevailing BMA

How Much Variable Rate Debt Can Any Issuer Have? Since variable rate debt creates interest rate risk, the Rating Agencies have developed an unwritten “comfort level” for any issuer of no more than 25% of the total debt portfolio Greer Commission of Public Works, in its formal Hedging Policy, has adopted this 25% limit for variable rate exposure, whether debt issued as VRDOs or some other synthetic exposure, such as fixed to floating rate interest rate swaps

Derivative Products A growing number of issuers are entering into derivative structures as a debt management tool, such as interest rate swaps Greer CPW maximized its available 25% variable rate exposure potential in December 2002 by entering into a $15 million notional amount fixed to floating interest rate swap with Bear Stearns Capital Markets as counterparty in the swap This was awarded to Bear Stearns as the most aggressive bidder under a three-way competitive process CPW receives 5.11% on the swap, which is the weighted average coupon rate on their fixed rate debt outstanding, and pays BMA plus 224 basis points As of September 1, 2005, CPW had realized nearly $600,000 in net benefit from this swap

Rating Agency Relationships Even relatively small or infrequent issuers of tax-exempt debt should take to time to develop relationships with each of the three major credit rating agencies (Moody’s, Standard & Poor’s, Fitch) Issuers who access the market NR (not rated) will pay dearly in terms of the interest cost on the debt Even transactions which carry municipal bond insurance enhancement, but without underlying ratings on the issuer, will pay more Maintaining these relationships also forces the issuer to explore, document and present their operating successes and elements of credit-worthiness

The Primary Market-Competitive Versus Negotiated Sale Under certain governing law, many issuers are forced to borrow only on a competitive, sealed-bid basis Negotiated sale is a considerably more cost-effective method of accessing the tax-exempt market, for a variety of reasons, including the ability to time or reschedule market entry as market conditions change, as well as an ability to structure features on the particular offering to meet the particular needs of the investors Some issuers, such as the Los Angeles Department of Water and Power, campaigned vigorously to change State Law so that they could reap the benefits of using negotiated sale for their financings

Wrap Up To repeat, Debt is Good Define your real needs, and issue debt to meet those needs Hire good, qualified Financial Advisors, as this will pay you many, many times over