NATIONAL ASSOCIATION OF BOND LAWYERS
Voice from the Past
Chapter 17
Seldom do a personality and an epoch so mingle in memory as
do my recollections of
the late Joseph L. Refsnes and the invested sinking fund.
As the president of Refsnes, Ely, Beck of Phoenix, Arizona,
"Young Joe" (his father,
Joseph E. Refsnes, was "Old Joe") was very knowledgeable about
and active in making use
of available arbitrage techniques for the benefit of issuers that
his firm often represented as
financial advisor. This was in the early 1970's, when the yield
restriction on investments
made with the proceeds of advance refunding bonds applied to only
a "major portion" (85%)
of those proceeds. Young Joe was particularly adept at making
optimum use of this largesse,
and could easily turn it into a profitable reason for an issuer
to refund some outstanding
bonds. He did so often.
Joe was a very inventive investment banker who did not only
create arbitrage
investment opportunities. As to one of his inventions, it was
necessary, in the opinion of bond
counsel, to obtain a ruling from the Internal Revenue Service
before an issue that Joe was
working on could be approved as bearing tax exempt interest. Joe
was well satisfied with the
logic of his case, and was outraged when the ruling request was
denied. The matter had gone
all the way up to the Assistant Secretary of the Treasury for Tax
Policy. Joe insisted on
making a trip to Washington, D.C., to argue his case in person.
This official, Joe later
reported, did not argue with the logic, but simply said that no
such ruling would be made.
As the Assistant Secretary had been a personal friend of mine
for many years ("Your
friend" as Joe referred to him), Joe gave me the impression that
I was partly to blame, though
I'd known nothing about the situation. However, he told me of
this while he was taking me
quail hunting in the desert, and didn't shoot me, so I guess he
forgave whatever guilt he may
have thought I bore. He felt better after he got two or three
quail and I didn't get any.
Red-haired and with a temper to match, Joe decided on his
revenge. Under the law of
Arizona, like that of most States, an issuer of general
obligation bonds is required to collect
taxes and accumulate a sinking fund for the payment of principal
and interest when due. The
law did not prevent early accumulations, so a bond issue that,
under normal conditions would
be paid off in ten years could be made to mature 20 years from
date of issue; taxes to pay the
bonds would be levied and collected at the times appropriate for
a ten-year issue. The
sinking fund holding these collections would be invested in
government bonds bearing a
substantially higher interest rate than the municipal bonds; the
surplus earnings would be used
to pay some of the debt service, making the necessary tax levies
less than if the bonds
matured currently. Referring to the Assistant Secretary, Joe
said, "If he wants arbitrage I'll
give him arbitrage!" The first time Joe used this scheme for the
benefit of a municipality, the
cost to the issuer was what it would have been if the bonds bore
interest a negative rate.
Not surprisingly, many issues of bonds using this technique were
promptly
forthcoming in Arizona. Refsnes, Ely, Beck was the fiscal
advisor or lead manager of most
of the underwritings, and the IRS did not immediately learn that
it was the victim of this
revenge. In time a larger issue came to market, and Fred Weisner
from the Denver office of
a major New York dealer was invited into the syndicate. Fred
immediately realized the
significance of the technique, and a few months later applied it
very successfully to an issue
of a Tennessee political subdivision. From there on, the
practice spread like chicken pox in
kindergarten. It took two or three years for Congress and the
IRS to put the genie back in
the bottle.
Emulators in other parts of the country missed a major part of
Joe's cleverness. In
proving the effectiveness of invested sinking funds to
prospective issuers, they assumed that
identified government bonds of appropriate maturities and
interest rates would be available at
specified times and at prices the issuers would then have the
money to pay. This made it
necessary for issuers to enter into agreements called "forward
supply contracts" with dealers
in government bonds. The inflated prices these dealers required
diminished the benefits to the
issuers of the higher yields on the investments.
Joe's practice was to require the levy of pretty much the full
amount of taxes that
would normally be required for the first year's principal to be
deposited in the sinking fund;
in subsequent years the levies for principal would be reduced by
the amount of interest
previously received on the government bonds in the sinking fund,
or, if the levies were not
reduced, they were stopped entirely when the sinking fund
contained sufficient securities to
set up an escrow that would defease the bonds. As a practical
matter the issuer would
always, or nearly always, find suitable government bonds on the
open market in which to
profitably invest each year's tax collections. With the very
high interest rates on government
bonds in the late 70's and early 80's most of the Arizona
sinking funds were invested in
CATS ant TIGRS (bearing compounded yields) which stopped the
required deposits years
before their final scheduled deposit dates. An expert at running
the numbers on bond issues,
Joe would demonstrate that, in any likely situation, a very
substantial amount of money would
be saved for the issuer, although no one could tell exactly how
much. In the very unlikely
situation that the required government bonds would be unavailable
at the contemplated prices,
Joe had the answer. This would happen only if interest rates on
government bonds fell beyond
anyone's reasonable expectation. In such a case, interest on
municipal bonds would also fall,
and an issuer would be able to pay its bonds via an ordinary,
non-advance, refunding with
new bonds bearing a very low interest rate; or it could merely
use the collected but
uninvested tax revenues to call in the longest outstanding bonds.
He also saw that, if
government bond yields fell, the portfolio in the sinking fund
would grow in value because it
would then have yields well above the current government market.
To take advantage of these
considerations, Arizona invested sinking fund bonds were issued
with early call dates. Some
investors who did not look closely at the offering statements
covering the bonds they were
buying were irate to find that they did not have the customary
10-year call protection, but that
was their problem. I never heard of any municipality exercising
this early redemption right.
The very unlikely situation did not happen.
Manly W. Mumford with assistance from Fred Rosenfeld