Refunding Valuation Analysis (ReVal)
An Issuer’s Decision Tool
by Kerry Rudy
Issuers looking to advance refund tax-exempt fixed rate bonds for savings may benefit from a new tool developed by PNC Capital Markets LLC (PNCCM). Refunding valuation analysis (ReVal) can be useful to a wide range of issuers, including governmental entities and their agencies and 501(c)3 not-for-profit corporations that issue fixed rate tax-exempt bonds in the public markets.
Fixed rate tax-exempt bonds are typically issued with 10-year no call protection for investors. Advance refundings involve investing tax-exempt bond proceeds in U.S. Treasury securities to be held in escrow until the tax-exempt bonds to be refunded can be redeemed on their call date. In cases where tax-exempt proceeds cannot be invested at a yield at least equal to the yield on the refunding bonds, negative arbitrage is generated resulting in a less than 100% efficient refunding.
ReVal enables issuers to evaluate the efficiency of advance refunding opportunities utilizing market based yield curves for both tax-exempt bonds and U.S. Treasury securities that are invested in the escrow. ReVal computes present value savings against Peak Present Value Savings (“PPVS”), essential information to assist with with a “go/no-go” refunding decision.
How ReVal Works
Calculates “Peak Value.” The ReVal analysis defines Peak Present Value Savings (“PPVS”) as the highest savings of any possible future refunding period (stated in today’s dollars).
It takes into account the “efficiency” of refunding savings generated today versus the risks of waiting.
The analysis also defines the time period for PPVS, so risk is better understood (i.e., an increase in interest rates, tax law changes, market access or increased credit spreads).
Issuer-based. Savings are calculated and assessed using issuer-based methodologies. Issuer-specific refunding criteria and thresholds can be incorporated.
Complements Qualitative Decision Making. ReVal results can act as a companion to other decision factors. The analysis helps quantify the relative impact of negative arbitrage for advance refundings.
Grounded in Fact. ReVal employs historical interest rate movements to project future tax-exempt and taxable escrow (SLGS) yield curves along forecasted interest rate paths. Default settings are calibrated to gravitate towards historical averages.
LONG-TERM TREASURY YIELD CURVE
This graph illustrates the historical evolution of the full US Treasury yield curve – historical rate movements for all tenors in the yield curve are sampled to project future rate environments. ReVal uses actual data from 1977 to present for yield curve simulations and 1964 to present for model calibration.
What Makes ReVal A More Practical Tool
ReVal was designed and built from the ground up to reflect the option value to an issuer. No liquid market exists for issuers to detach and sell their option, leading to a lack of “transparency” in value.
Simulating a series of refunding transactions is a way to assess and capture the option value from an issuer’s perspective. This is what ReVal was built to do.
ReVal inputs are not based upon derivatives markets (i.e., forward curves, implied volatility).
LONG-TERM HISTORICAL RATE MOVEMENTS
ReVal relies on repeated sampling of actual historical rate movements over long periods to derive the most unbiased expectation of future rates.
In PNCCM’s view, standard option valuation models rely on theoretical “risk-neutral” or “arbitrage-free” relative pricing approaches which can create unrealistic projections of future rate environments and can yield distorted results in the tax-exempt market.
Many borrowers prefer historically-based approaches for projecting future interest rate environments.
ReVal projects tax-exempt and U.S. Treasury (escrow yield) interest rate paths together using corresponding historical data from both markets, a key driver of savings for advance refunding scenarios.
ReVal delivers customized solutions by allowing its inputs to include an issuer’s unique refunding savings criteria.
Simulated future refundings failing to meet a given issuer’s criteria for savings are assigned a zero value, reflecting the issuer’s decision to wait for a better refunding result.
Calculating Refunding Savings Across Future Interest Rate Paths
ReVal utilizes its forecasting engine to evolve today’s SLGS and tax-exempt yield curves to each future “calculation date” (quarterly intervals until bond maturity); this is repeated at least 10,000 times resulting in as many potential future interest rate paths.
For every individual path, a matched-maturity refunding analysis of the bond is simulated using the forecasted yield curves along that path at each calculation date.
This results in at least 10,000 unique potential PV savings at each calculation date (subject to an issuer’s given refunding criteria). These are then averaged across all simulated interest rate paths to yield an “expected” PV savings from refunding, every quarter over the bond’s life.
Lastly, PPVS is determined by identifying the quarter with the highest expected savings (in today’s dollars); this is our theoretical option value– the discounted expected payoff from optimally exercising a refunding option.
REVAL YIELD CURVE EVOLUTION — UST 3-YEAR HORIZON (SAMPLING OF 100 CURVES)
PEAK PV SAVINGS (BASED UPON HISTORICAL & MMD PRICING)
For Each Valuation Date, Present Value Savings are Calculated for at Least 10,000 Interest Rate Simulations.
OPTIMAL PV SAVINGS
Example: 5% Coupon Bond With March 2026 Maturity - Callable Sept. 2021 at Par
While current PV savings in this example are approximately 6.6%, potential savings (PPVS) exceed 10%.
Exercising the refunding option today may be viewed as “inefficient” since it only captures 60% of the potential value of the refunding option.
Peak savings occur just prior to the first call date in 2021.
Consequently, an issuer must choose between certain savings today and the risk of waiting up to 5 years before the peak savings are projected to occur.
Time value is an important measure of risk, as much can change with tax law, credit ratings, market access and an issuer’s outlook.
An issuer must balance the known benefit of refunding savings today versus the potential for future risks to increase or decrease refunding savings in making the "go vs. no-go decision.”
Ready to Help
Using ReVal, issuers will be able to utilize a realistic methodology of present value savings today versus peak present value savings. Please feel free to call Kerry Rudy at 312-338-5270 if you would like PNC Capital Markets LLC to evaluate the efficiency of advance refunding fixed rate tax-exempt bonds.
Important Legal Disclosures & Information
- UST (1964 to present) / Delphis Hanover (1964 to 2012) and MMA Median Index (2012 to present)
PNC Capital Markets LLC ("PNCCM"), member FINRA and SIPC, is a wholly owned subsidiary of The PNC Financial Services Group, Inc. (“PNC”) and affiliate of PNC Bank, National Association (“PNC Bank”). PNCCM is not a bank or thrift, but rather, it is a separate and distinct corporate entity from its bank affiliate.
This document is for informational purposes only. No part of this document may be reproduced in any manner without the prior written permission of PNCCM. Under no circumstances should it be used or considered as an offer to sell, or a solicitation of an offer to buy, any of the securities or other instruments mentioned in it. The information contained herein is based on information PNCCM believes to be reliable and accurate, however, no representation is being made that this document is accurate or complete and it should not be relied upon as such. Neither PNCCM nor its affiliates make any guaranty or warranty as to the accuracy or completeness of the data set forth herein.
PNC Capital Markets is the marketing name used for investment banking and capital markets activities conducted by PNC through its subsidiaries PNC Bank and PNCCM. Securities underwriting, sales and trading services are provided by PNCCM.
Municipal Advisor Disclosure
PNC Capital Markets LLC (“PNCCM”) is providing the information contained in this document for discussion purposes only in anticipation of serving as an underwriter to the person to whom this document is addressed. The information provided herein is not intended to be and should not be construed as “advice” within the meaning of Section 15B of the Securities Exchange Act of 1934, as amended (“Exchange Act”), unless such information is provided (i) within the scope of an underwriting of an issuance of municipal securities for which PNCCM is acting or seeking to act as underwriter, (ii) to a person that is separately advised by an independent registered municipal advisor, pursuant to the requirements of Exchange Act Rule 15Ba1-1(d)(3)(vi), or (iii) in response to a written or oral request for proposals or qualifications. PNCCM is not acting as a municipal advisor, and is not subject to the fiduciary duty established in Section 15B(c)(1) of the Exchange Act, with respect to this communication or any related municipal financial product or issuance of municipal securities. PNCCM is not recommending any action to any municipal entity or obligated person and such entity should discuss any information and material contained in this communication with any and all internal or external advisors and experts that the municipal entity or obligated person deems appropriate before acting on this information or material.
MSRB Rule G-17 Disclosure
The following disclosures are required by Municipal Securities Rulemaking Board (“MSRB”) Rule G-17, as PNCCM proposes to serve as an underwriter, and not as a financial advisor, municipal advisor or fiduciary to any person or entity, in connection with the issuance and sale of securities for the person to whom this is addressed:
- MSRB Rule G-17 requires an underwriter to deal fairly at all times with all persons, including both municipal issuers and investors.
- An underwriter’s primary role is to purchase securities with a view to distribution in an arm’s-length commercial transaction with an issuer; and an underwriter has financial and other interests that differ from those of such an issuer.
- Unlike a municipal advisor, an underwriter does not have a fiduciary duty to an issuer under the federal securities laws and is, therefore, not required by federal law to act in the best interests of that issuer without regard to its own financial or other interests.
- An underwriter has a duty to purchase securities from an issuer at a fair and reasonable price, but must balance that duty with its duty to sell those securities to investors at prices that are fair and reasonable.
- An underwriter will review the official statement, if any, for those securities in accordance with, and as part of, its responsibilities to investors under the federal securities laws, as applied to the facts and circumstances of the transaction.