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DBC Finance - Arbitrage Regulations in DBC Finance
DISCLAIMER
This page is provided for information purposes only and should not, under any circumstances,
be relied upon for rendering any types of opinions related to the issuance of bonds. This information is furnished for use as an explanation of the features
of DBC Finance and DBC FinLite.
Proceed at your own risk.
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§1.148-1(b)
De minimis amount means --
(1) In reference to original issue discount (as defined in section
1273(a)(1)) or premium on an obligation--
(i) An amount that does not exceed 2 percent multiplied by the stated
redemption price at maturity; plus
(ii) Any original issue premium that is attributable exclusively to reasonable
underwriters' compensation; and
(2) In reference to market discount (as defined in section 1278(a)(2)(A)) or
premium on an obligation, an amount that does not exceed 2 percent multiplied
by the stated redemption price at maturity.
Plain par bond means a qualified tender or a bond--
(1) Issued with not more than a
de minimis
amount of original issue discount
or premium;
(2) Issued for a price that does not include accrued interest other than
pre-issuance accrued interest;
(3) That bears interest from the issue date at a single, stated fixed rate or
that is a variable rate debt instrument under section 1275, in each case with
interest unconditionally payable at least annually; and
(4) That has a lowest stated redemption price that is not less than its
outstanding stated principal amount.
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Any bond originally priced at less than 98 or
more than 102 (except if the premium is purely for underwriters' compensation)
is not a plain par bond and must be valued at its present value, not at its
stated par amount. This is important in determining the principal amount for
transferred proceeds purposes and for determining the principal amount used
for comparisons between refunded and refunding bonds
to make sure there is no overissuance of refunding bonds as required in
some states and localities.
DBC Finance automatically computes the value of bonds whenever required.
DBC Finance also has the Debt Service
Calculator that allows one to compute the value of bonds for any
subset of bonds on any date and produces a report that shows
these values individually as well as collectively.
§1.148-4(e)
Value of bonds --
(1) Plain par bonds.
Except as otherwise provided, the value of a
plain par bond
is its outstanding stated principal amount, plus accrued unpaid interest.
The value of a plain par bond that is actually redeemed is its stated
redemption price on the redemption date, plus accrued, unpaid interest.
(2) Other bonds.
The value of a bond other than a plain par bond is its
present value on that date. The
present value
of a bond is computed under the
economic accrual method taking into account all the unconditionally payable
payments of principal, interest, and fees for a qualified guarantee to be paid
on or after that date and using the yield on the bond as the discount rate,
except that for purposes of §1.148-6(b)(2) (relating to the universal cap),
these values may be determined by consistently using the yield on the issue of
which the bonds are a part. To determine yield on fixed yield bonds, see
paragraph (b)(1) of this section. The rules contained in paragraphs (b)(2)
and (b)(3) of this section apply for this purpose. In the case of bonds
described in paragraph (b)(2)(ii) of this section, the present value of those
bonds on any date is computed using the yield to the final maturity of those
bonds as the discount rate. In determining the present value of a variable
yield bond under this paragraph (e)(2), the initial interest rate on the bond
established by the interest index or other interest rate setting mechanism is
used to determine the interest payments on that bond.
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Arbitrage yield is automatically calculated in DBC Finance in most cases.
In the normal case, the arbitrage yield is the rate at which the regular debt
service of all bonds to maturity plus any LOC fee or other ongoing credit
enhancement fee when present valued to the delivery date equals the par amount
of the bonds adjusted by any premium or OID and increased by
the amount of the accrued interest and bond insurance, if any.
The arbitrage yield is required to be computed to at least four decimal
places after the decimal point. DBC Finance keeps as many decimal places
as the computer can handle and reports 7 decimal places on regular reports.
Notes on controlling arbitrage yield calculation in DBC Finance:
- Any expenses including bond insurance and LOC fees that should be
accounted for in the arbitrage yield calculation should have its "Include in
arbitrage yield" prompt set to "Yes" on the Expense Description screen.
- A taxable bond component can be excluded from the arbitrage yield
calculation by setting the "Include in arbitrage yield" prompt to "No" on the
Bond Component Information - Advanced Options auxiliary screen.
- Any unusual arbitrage yield adjustments can be entered on the General -
Arbitrage Yield Adjustments auxiliary screen.
- An aggregate arbitrage yield over more than one bond series can be
computed by using Project Finance or by using CalcAgent.
§1.148-4(b)
Computing yield on a fixed yield issue -- (1) In general --
(i) Yield on an issue.
The yield on a fixed yield issue is the
discount rate that, when used in computing the present value as of the issue
date of all unconditionally payable payments of principal, interest, and fees
for qualified guarantees on the issue and amounts reasonably expected to be
paid as fees for qualified guarantees on the issue, produces an amount equal
to the present value, using the same discount rate, of the aggregate issue
price of bonds of the issue as of the issue date. Further, payments include
certain amounts properly allocable to a qualified hedge. Yield on a fixed
yield issue is computed as of the issue date and is not affected by subsequent
unexpected events, except to the extent provided in paragraphs (b)(4) and
(h)(3) of this section.
(ii) Yield on a bond.
Yield on a fixed yield bond is computed in the same manner as yield on a fixed
yield issue.
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Any term bond whose issue price is less than:
100 - 0.25 * weighted average life
(the above will be referred to as the average life test) must value its
sinking fund principal payments not at face value,
but at the present value of its potential future cash flows at the yield to
final maturity of the term bond. The yield to final maturity of the term
bond must take into account any bond insurance or other credit enhancement
used in the bond issue.
In DBC Finance, the average life test and sinking fund adjustment calculations
are performed automatically as long as the
delivery date is 8/16/1993 or after, and if there is bond insurance, the
allocation of the insurance to the term is the application of the entire
formula to the term bond separately (e.g., "0.5% of total adjusted Debt Service" is
fine, but "1000000" is not). If there is bond insurance and the formula
cannot be applied separately to the term, then the prompt "Arbitrage Expense
Allocation Method" on the General Bond Information - Advanced Options screen
must be set properly to one of the "Proportional by ..." options in order for
the calculation to take into account the insurance properly.
If a term bond
fails the average life test and its sinking funds must be valued at their
present values,
then an additional column, "Sinking Fund Adjustments", as well as the
individual yields and insurance amounts applied for each such term bond,
will appear on the Proof of Arbitrage Yield report.
Other notes:
- If the user wishes to override the yield computed by DBC Finance for a
term bond, he can enter a value for the "Arb yield override for term bond"
prompt on the
Bond Component Information - Advanced Options auxiliary screen.
- If a term bond is spread over more than one series of bonds and is aggregated
together in Project Finance, DBC Finance will know to treat the whole thing as
one term bond as long as the short ID name for the separate pieces are
identical. If the term bond is spread over more than one series and the
F5-Aggregate Reports feature is used to combine the series into one aggregate
set of reports, the sinking fund adjustment will not be correct unless all
pieces of the term pass the average life test or all of them fail the average
life test.
- When computing the sinking fund adjustments, the yield to be used is the
arbitrage yield as computed on the term bond -- not the stated yield from
the Official Statement. These values will generally differ beginning with
the third or fourth decimal place due to rounding.
Example of Sinking fund Adjustment Calculation in DBC Finance.
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§1.148-4(b)(2)(ii)
Substantially identical bonds subject to mandatory early
redemption.
If substantially identical bonds of an issue are subject to specified
mandatory redemptions prior to final maturity
(e.g., a mandatory sinking fund redemption requirement), yield on
that issue is computed by treating those bonds as redeemed in
accordance with the redemption schedule for an amount equal to
their value. Generally, bonds are substantially identical if the
stated interest rate, maturity, and payment dates are the same.
In computing the yield on an issue containing bonds described in
this paragraph (b)(2)(ii), each of those bonds must be treated
as redeemed at its
present value,
unless the stated redemption price
at maturity of the bond does not exceed the issue price of the bond
by more than one-fourth of one percent multiplied by the product of the
stated redemption price at maturity and the number of years to the
weighted average maturity date of the substantially identical bonds, in
which case each of those bonds must be treated as redeemed at its outstanding
stated principal amount, plus accrued, unpaid interest. Weighted average
maturity is determined by taking into account the mandatory redemption
schedule.
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Certain premium bonds subject to early optional redemption require the
cash flow used to compute the arbitrage yield to be computed to the
optional call date that produces the
lowest aggregate arbitrage yield.
Testing all possible permutations of optional call and maturity dates
for a nontrivial set of maturities can be an extremely tedious undertaking,
especially if one has to set up each scenario manually.
Fortunately, DBC Finance automatically computes
the proper optional call or maturity dates
such that the lowest aggregate arbitrage yield on the issue will be
achieved.
Simply input a call table under the Calls section and assign it
to the bond component containing the bonds in question.
Whenever a solution is performed,
DBC Finance will apply the three tests specified in
paragraph 1.148-4(b)(3) below to decide if the bonds are subject to this regulation,
and if so, all potential call dates will be tested and the optimal
ones selected for the arbitrage yield calculation. The actual call
dates and prices used can be found on the Proof of Arbitrage Yield report.
When using this feature, note the following:
- If a bond has an optional call within 5 years of issuance, we
assume that it must be tested at all of its call dates. The
Internal Revenue Code allows for a 0.125% safe harbor which
is tested by DBC Finance (but not by DBC FinLite).
- The optimal call dates can change if the bond solution calculations
changes the bond par amounts. If so, the arbitrage yield will
not be correct after the solution. DBC Finance will detect this
condition and will produce a warning that requests that the
solution be repeated in order to converge onto the proper
arbitrage yield.
- If there is ever a need to compute the arbitrage yield using
a call date different from the one DBC Finance computes, there is
an advanced options tab named "Assumed Call Dates" where these
dates can be hard-coded and protected.
§1.148-4(b)(3)
Yield on certain fixed yield bonds subject to optional early redemption --
(i) In general.
If a fixed yield bond is subject to optional early
redemption and is described in paragraph (b)(3)(ii) of this section, the yield
on the issue containing the bond is computed by treating the bond as
redeemed at its stated redemption price on the optional redemption
date that would produce the lowest yield on the issue.
(ii) Fixed yield bonds subject to special yield calculation rule.
A fixed yield bond is described in this paragraph (b)(3)(ii) only if it--
(A) Is subject to optional redemption within five years of the issue date, but
only if the yield on the issue computed by assuming all bonds in the issue
subject to redemption within 5 years of the issue date are redeemed at
maturity is more than one-eighth of one percentage point higher than the yield
on that issue computed by assuming all bonds subject to optional redemption
within 5 years of the issue date are redeemed at the earliest date for their
redemption;
(B) Is issued at an issue price that exceeds the stated redemption price at
maturity by more than one-fourth of one percent multiplied by the product of
the stated redemption price at maturity and the number of complete years to
the first optional redemption date for the bond; or
(C) Bears interest at increasing interest rates (i.e., a stepped coupon bond).
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In a tax-exempt bond issue, any assets (e.g., escrows, reserve funds,
construction funds, etc.) that were originally funded by bond proceeds
are restricted from generating earnings at a yield greater than the
arbitrage yield of the bonds. For a new money issue, it is clear which
assets are funded by bond proceeds of the issue. However, in favorable
interest rate environments, it is possible to structure a refunding that
effectively closes down all the bonds of a previous bond issue while
keeping some or all of its assets outstanding, and then replaces those
bonds with a new bond issue that have an arbitrage
yield substantially lower than that of the previous bond issue. What
remains after the transaction would be assets that potentially have
earnings at a yield greater
that the arbitrage yield of the bonds outstanding. To prevent this
abuse, the Treasury instituted
the Transferred Proceeds rules. In the example above, the assets
of the bond issue that was refunded would in effect be "transferred" to
the new bond issue as a result of the refunding, forcing those assets'
earnings to be restricted to
the new lower arbitrage yield. The actual Transferred Proceeds
calculation computes a single dollar amount that represents the
adjustment (a.k.a. penalty or benefit) neccessary
to the new escrow (or asset) yield computation that would account for the
change in yield restriction of those assets being transferred.
In a refunding, whenever the portion of the new escrow that is funded by
new bond proceeds is used to pay off principal on the old bonds, and there
are assets
remaining that was originally funded by the
bond proceeds of that old issue, part of those assets must be transferred
to the new bond issue.
Any date on which this occurs is called a Transfer Date. On any
Transfer Date, the Transfer Factor is determined by the following formula:
principal retired by escrow / total principal outstanding
A regular asset to be transferred can be fully described by entering its
future cash flows and it yield to maturity.
To calculate the penalty or
benefit attributed to a single asset on a single Transfer Date,
compute the present value (PV) of the untransferred portion of the asset's
future cash flows both at the new bond yield and at the asset's own yield to
maturity, then take the difference of these two values, multiply by the
transfer factor, and compute the PV of this result to the delivery date
of the new bonds at the arbitrage yield of the new bonds. The total
transferred proceeds penalty or benefit is the sum of all the penalties and
benefits computed for all assets to be transferred for all Transfer
Dates.
- All escrows and other assets to be transferred should be entered within
the old bond series on the Data - Miscellaneous - Refund Escrows screens.
Regular assets require the input of its yield and its future receipts.
There is an entry for cost, but that does not affect the Transferred
Proceeds calculations -- it is for record keeping purposes only.
- In a refunding of a refunding of yet a third refunding issue, there
may be cascading transfer assets that go into the Transferred Proceeds
calculations. A cascading transfer asset can be fully described by entering
its future cash cash flows, its transfer factors as reported in the
verification report of the previous refunding, and the yield restriction of
the previous bond issue.
Cascading transfer assets
should also be entered in the old bond series in the Data - Miscellaneous -
Refund Escrows area.
The calculation of the penalty or benefit of a
cascading transfer asset is the same as that for a regular asset except that
the computation of the untransferred portion of the cascading asset's cash
flows becomes a major accounting headache. The details will be omitted here,
but fortunately, DBC Finance has been programmed to do this calculation
automatically. Also, cascading Transferred Proceeds are now rare because of
a rule in the Tax Reform Act of 1986 that states that bonds issued after
1985 may be advanced refunded only once.
- In a refunding of an old issue that has a Debt Service Reserve Fund (DSRF)
outstanding that is liquidated and used to fund part of the new escrow
in a ratable or proportional basis, since the old DSRF was funded by bond
proceeds of the old issue, the part of the escrow funded by the liquidated
funds are subject to Transferred Proceeds calculations. Since this portion
of the escrow is unknown until the refunding solution is run, this asset
cannot be described by the user without an iterative process. DBC Finance
version 2.306 and later solves this problem by automatically transferring
any new escrows funded by funds on hand. A column on the Prior Debt - Escrows
auxiliary screen, "Calculate TP", allows the user to override the automatic
Transferred Proceeds calculations on these assets.
- In addition to entering all the old assets into the correct
input screens, in order to compute Transfer Proceeds, the user must go to
the Calculate - Enter Solution Assumptions screen and set the "Compute
Transferred Proceeds?" prompt to "Yes". Otherwise, TP will never be
calculated. The prompts that follow the "Compute Transferred Proceeds?"
prompt should almost always be left at their default values. In particular,
the "Apply transfer cap?" prompt should be left at "No" because DBC Finance
does not preform the Universal Cap calculations correctly.
- DBC Finance allows overriding of its calculations in several places. In the
unusual case that the user wishes to compute his own Transfer Factors, the
user can override part or all of the DBC computed factors by choosing the
appropriate setting for the "Source of transfer factors" prompt near the
bottom of the Prior Debt Description screen. If the user wishes to avoid
all TP calculations and enter his own penalty or benefit, he must set the
"Compute Transferred Proceeds?" prompt mentioned above to "No", then set
the "Additional escrow yield adjustment" prompt on the Prior Debt
Description screen to the benefit or penalty amount. A benefit is entered
as a positive number, a penalty as a negative number, and the amount is
entered in thousands.
- If any of the old bonds to be refunded were originally priced below 98
or above 102, those prices must be entered in the old bond series and the
dated, delivery, and first interest dates of those bonds must be the original
dates -- not the previous payment date.
- If the new issue is a partial refunding, DBC Finance will automatically
split up the old bond issue into its refunded and unrefunded portions and only
the refunded portion of old escrows will be subject to Transferred Proceeds
calculations. It is important in this situation that all the bonds in the
old issue are entered into Debt/Size -- not just the ones to be refunded.
This way, DBC Finance can compute the percentage of the issue that will be
refunded and split up the escrow properly. The Transferred Escrows report
will print the percentage used for allocating the refunded portion as a
footnote.
- If the old bond issue was previously partially refunded, the old series
of bonds effectively became two separate bond issues at the time the previous
refunding was done. Consequently, The inputs
in Debt/Size for the old bond series in the new refunding
should not include any of the bonds
that were refunded previously. Also, any assets that are
required to be transferred
should be reduced by a percentage equal to the proportion of the bonds
that were refunded at the time of the previous refunding.
- Each Prior Debt in Refund has at most one set of Transfer Factors. This
means that in a refunding of multiple prior issues of bonds, each issue that
has Transferred Proceeds should be put into its own Prior Debt. Otherwise,
the assets of the bond issues may be incorrectly transferred on an aggregate
basis.
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§1.148-9(b) Transferred proceeds allocation rule--
(1) In general.
When proceeds of a refunding issue discharge any of the
outstanding principal amount of the prior issue, proceeds of the
prior issue become transferred proceeds of the refunding issue and
cease to be proceeds of the prior issue. The amount of proceeds of
the prior issue that becomes transferred proceeds of the refunding
issue is an amount equal to the proceeds of the prior issue on the
date of that discharge multiples by a fraction--
(i) The numerator
of which is the principal amount of the prior issue discharged with
proceeds of the refunding issue on the date of that discharge; and
(ii) The denominator of which is the total outstanding principal
amount of the prior issue on the date immediately before the date
of that discharge.
(2) Special definition of principal amount.
For purposes of this section, principal amount means, in reference to a
plain par bond,
its stated principal amount, and in reference to any other bond, its
present value.
(3) Relation of transferred proceeds rule to universal cap rule-- (i)
In general. Paragraphs (b)(1) and (c) of this section apply to
allocation transferred proceeds and corresponding investments to a refunding
issue on any date required by those paragraphs before the application of the
universal cap rule of §1.148-6(b)(2) to reallocate any of those amounts. To
the extent nonpurpose investments allocable to proceeds of a refunding issue
exceed the universal cap for the issue on the date that amounts become
transferred proceeds of the refunding issue, those transferred proceeds and
corresponding investments are reallocated back to the issue from which they
transferred on that same date to the extent of the unused universal cap on
that prior issue.
(4) Limitation on multi-generational transfers.
This paragraph (b)(4) contains limitations on the manner in which proceeds of
a first generation issue that is refunded by a refunding issue (a second
generation issue) becomes transferred proceeds of a refunding issue (a third
generation issue) that refunds the second generation issue. Proceeds of the
first generation issue that become transferred proceeds of the third
generation issue are treated as having a yield equal to the yield on the
refunding escrow allocated to the second generation issue (i.e., as determined
under §1.148-5(b)(2)(iv)). The determination of the transferred proceeds of
the third generation issue does not affect compliance with the requirements of
section 148, including the determination of the amount of arbitrage rebate
with respect to or the yield on the refunding escrow, of the second generation
issue.
§1.148-9(c)(2) Allocation of mixed escrows to expenditures for
principal, interest, and redemption prices on a prior issue--
(i) In general. Except for amounts required or permitted to
be accounted for under paragraph (c)(2)(ii) of this section, proceeds of a
refunding issue and other amounts that are not proceeds of a refunding issue
that are deposited in a refunding escrow (a mixed escrow) must be accounted
for under this paragraph (c)(2)(i). Those proceeds and other amounts must be
allocated to expenditures for principal, interest, or stated redemption prices
on the prior issue so that the expenditures of those proceeds do not occur
faster than ratably with expenditures of the other amounts in the mixed
escrow. During the period that the prior issue has unspent proceeds, however,
these allocations must be ratable (with reasonable adjustments for rounding)
both between sources for expenditures (i.e., proceeds and other amounts) and
between uses (i.e., principal, interest, and stated redemption prices on the
prior issue).
(ii) Exceptions --
(A) Mandatory allocation of certain non-proceeds to earliest
expenditures.
If amounts other than proceeds of the refunding issue are deposited in a mixed
escrow, but before the issue date of the refunding issue whose amounts had
been held in a bona fide debt service fund or a fund to carry out the
government purpose of the prior issue (e.g., a construction fund), those
amounts must be allocated to the earliest maturing investments in the mixed
escrow.
(B) Permissive allocation of non-proceeds to earliest
expenditures.
Excluding amounts covered by §1.148-9(c)(2)(ii)(A) and subject to any required
earlier expenditure of those amounts, any amounts in a mixed escrow that are
not proceeds of a refunding issue may be allocated to the earliest maturing
investments in the mixed escrow, provided that those investments mature and
the gross proceeds thereof are expended before the date of any expenditure
from the mixed escrow to pay any principal of the prior issue.
§1.148-9(h)(5)(i) Operating rules for separation of prior issue into
refunded and unrefunded portions--
(1) In general.
For purposes of paragraph (h)(3)(i) of this section, the separate purposes of
a prior issue include the refunded and unrefunded portions of the prior issue.
Thus, the refunded and unrefunded portions are treated as separate issues
under paragraph (h)(1) of this section. Those separate issues must satisfy
the requirements of paragraphs (h) and (i) of this section. The refunded
portion of the bonds of a prior issue is based on a fraction the numerator of
which is the
principal amount
of the prior issue to be paid with proceeds of
the refunding issue and the denominator of which is the outstanding
principal amount
of the bonds of the prior issue, each determined as of the issue date
of the refunding.
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- Ballard, Frederic L. ABCs of Arbitrage. American Bar
Association, 1994.
- Arbitrage Regulations. Section §1.148.
Internal Revenue Code.
April, 1998.
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