Concept and Issues. Issue bonds in advance of an event in order to obtain future interest rate or marketing benefits.
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1 Concept and Issues Issue bonds in advance of an event in order to obtain future interest rate or marketing benefits. Pre-event bonding should be considered in light of the Fund s overall financing plan and goals. Pre-event bonding merits analysis because of the size and complexity of the Fund s overall financing plan. Florida Hurricane Catastrophe Fund 1
2 Concept and Issues If an event were to occur, the Fund would have to raise over $8 billion, using a variety of financing mechanisms. The amount of money raised is directly related to future interest rate conditions. This represents an extremely large financing. The State s economy might be in disarray when the financing has to occur. Property and Casualty Insurers, usually a significant player in the taxexempt bond market, might be net sellers when the Fund needs to issue its bonds. Without some form of pre-event bonding, the post-event financing would be the Fund s first time in the market. Florida Hurricane Catastrophe Fund 2
3 Florida Hurricane Catastrophe Fund 3 Sep-69 Sep-70 Sep-71 Sep-72 Sep-73 Sep-74 Sep-75 Sep-76 Sep-77 Sep-78 Sep-79 Sep-80 Sep-81 Sep-82 Sep-83 Sep-84 Sep-85 Sep-86 Sep-87 Sep-88 Sep-89 Sep-90 Sep-91 Sep-92 Sep-93 Sep-94 Sep-95 Sep-96 Sep Yield (%) 6 8 Average Over 30 Year Period: 7.03% Long Municipal to Treasury Bond Yield Ratio Interest Rate Risk Sep-98
4 Market Supply & Demand Characteristics 105% Long Municipal to Treasury Bond Yield Ratio 100% 95% Northridge Earthquake 90% Hurricane Andrew 85% 80% Florida Hurricane Catastrophe Fund 4 Jan-90 Jul-90 Jan-91 Jul-91 Jan-92 Jul-92 Jan-93 Jul-93 Jan-94 Jul-94 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Ratio Jul-98 Jan-99 Jul Bond Buyer 20 Yields (%)
5 Background Since pre-event bonding must be done on a taxable basis, the Fund could experience negative arbitrage Negative arbitrage is the difference between the Fund s cost of funds (long-term borrowing) and its investment rate (short-term investments). The Fund has considered pre-event bonding in the past. Since then, however, the Fund has obtained its Private Letter Ruling allowing it to issue tax-exempt debt on a post-event basis. One of the Fund s underwriters has submitted a proposal that provides a new twist on pre-event bonding - a Cinderella Bond whose interest rate drops after an event to recognize the Fund s ability to utilize taxexempt debt. Florida Hurricane Catastrophe Fund 5
6 Benefits Locks in a portion of the money the Fund may need to raise. Reduces the size of the potential post-event financing. Reduces the amount of money the Fund may need to raise in poor market conditions. - Florida economy distressed - Property & Casualty Insurers liquidating their portfolios Introduces the bond market to the Fund and vice versa. Removes the First time issuer stigma. Florida Hurricane Catastrophe Fund 6
7 Costs and Considerations The direct monetary costs (Negative Arbitrage) may be substantial. Rates may be lower when the post-event financing occurs. Reduces financial flexibility. A post-event financing may never be needed. Buyers of taxable bonds (pre-event) are usually different from buyers of tax-exempt bonds (post-event), negating the benefit of exposing the bond market to the Fund. Greater funds on hand may attract the attention of the Legislature. Only involves 1st 10-years, greatest Interest Rate Risk in later years Florida Hurricane Catastrophe Fund 7
8 Evaluation Any pre-event bonding proposal cannot be adequately evaluated without making two major assumptions: - The timeframe of a triggering catastrophic event - Interest rates at the time of the post-event financing Pre-event Taxable Borrowing Rate Post-event Borrowing Rate Investment Rate Catastrophic Event Timing?? Florida Hurricane Catastrophe Fund 8 Post-event Tax-Exempt Rate
9 Evaluation Known at the time of the pre-event issuance Pre-event Taxable Borrowing Rate May be known at the time of the pre-event issuance, as with Cinderella Bonds Post-event Borrowing Rate Investment Rate Investment Rate depends on the term and the credit quality of the investments. Must balance liquidity and yield. Post-event Tax-Exempt Rate Will not be known at the time of the pre-event issuance Florida Hurricane Catastrophe Fund 9
10 Cinderella Bonds Pre-fund with a taxable instrument (bonds or swaps) that converts to a pre-determined lower rate upon an event. The bond-based structure would convert to a pre-determined fixed-rate tax-exempt bond. The swap-based structure would decrease by a pre-determined percentage of LIBOR, a variable rate. Evaluation is dependent on the same two issues: negative arbitrage and post-event interest rates. Florida Hurricane Catastrophe Fund 10
11 Cinderella Bonds Negative Arbitrage - Unless the yield curve is flat or inverted, since both the borrowing and the investment would be on a taxable basis, the Fund would have to reduce the credit quality of its investments in order to eliminate negative arbitrage and maintain adequate liquidity to fund claims if there were an event. Interest Rate Comparison - For a bond-based structure, the proposal quoted a post-event tax-exempt interest rate that would be 50 basis points over current tax-exempt rates. - For a swap-based structure, the proposal quoted a drop in rates after an event equal to 20% of LIBOR. - There is no guarantee that traditional tax-exempt interest rates will be higher or lower than these levels after an event. Florida Hurricane Catastrophe Fund 11
12 Current Market Conditions: Cinderella Bonds 10 Year Treasury Rate 5.72% 5 Year AA Tax-Exempt Rate 4.90% 5 Year Fully Flexible A GIC Rate 6.27% Proposal Assumptions: Pre-event Taxable Borrowing Rate = 10 Year Treasury basis points = 6.77% Post-event Tax-exempt Borrowing Rate = Current rate + 50 basis points= 5.40% Example Assumptions: $2 Billion Pre-event Issue and Catastrophic Event Occurs in Five Years Example Results: 6.77% Pre-event Borrowing Rate % GIC Rate = 50 basis points negative arbitrage 50 basis points of negative arbitrage for five years = 0.50% X $2 Billion X 5 = $50 Million Florida Hurricane Catastrophe Fund 12
13 Other Options Monitor Yield Curve Monitor Taxable/Tax-exempt Spread Relationships Continue to Evaluate New Products Florida Hurricane Catastrophe Fund 13
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