Economic gains are possible when investors with different strengths and preferences are combined in a single financing. It’s happening at the WIFIA loan program.
By John Ryan
The WIFIA loan program makes long-term loans for qualified projects at the U.S. Treasury’s interest rate. Since debt capital markets start with this rate as a minimum baseline and add a spread for credit risk, liquidity premia and equity return, in theory, a WIFIA loan should always be a cheaper alternative than the market equivalent, right?
In practice, things are not so straightforward.
The vast majority of WIFIA’s borrowers are highly-rated public water agencies that can access the tax-exempt municipal bond market. As in any other part of the debt capital markets, muni rates start with the Treasury curve and add in all the spread components that cold-eyed bond buyers require. But unlike the other market segments, muni investors can also subtract something – the value of the tax-exempt status of the overall yield. In a competitive market, the subtracted value of the tax-exemption can exceed the positive spread, resulting in rates that are lower than the Treasury curve. This depends on a lot of variable factors, but it’s typically the case for highly-rated borrowers and maturities within about 20 years.
In effect, WIFIA’s highly rated public agency customer base can frequently choose between two good, federally supported alternatives. It can look like a simple binary choice, at least with respect to minimizing the cost of debt service. When expected muni rates are low relative to the Treasury curve, stick with a 100 percent bond issue. When they’re not – as is currently the case – substitute bonds for the maximum amount of a WIFIA loan, 49 percent of the project’s capitalized cost. Isn’t that still straightforward?
Except, an even better outcome is possible.
The choice doesn’t need to be binary. Instead of simple pro-rata substitution based on lowest rates, muni bonds and a WIFIA loan can be combined synergistically in ways that will further reduce cost and may expand structural options.
As in many capital structures, the synergies in this case arise from very different preferences and strengths between the two debt sources, and how those are reflected along their complete yield curves.
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The muni bond market is dominated by high income U.S. individual investors (direct or through bond funds) because they have a unique ability to monetize the tax-exemption. Muni market clearing prices will reflect this but also their preferences as individual investors. Their investment horizon is centered around natural lifespans, they’ll want liquidity for unexpected events and many face future uncertainties in income or tax rate. It’s a human-scale picture, and the muni yield curve reflects this: very competitive in the shorter maturities (often significantly below Treasury rates) but rising relatively steeply towards the long end and increasingly unpredictable beyond market-quoted maturities of 30 years.
In contrast, the U.S. Treasury market is dominated by worldwide institutional investors and a federal infrastructure loan program like WIFIA can be the ultimate institutional lender. Investment horizons are very long, objectives involve large-scale outcomes and illiquidity is not a problem. The Treasury curve is usually less steep than its muni equivalent. More importantly, beyond 30-year maturities rates are assumed to remain ‘flat forward’ indefinitely – and this assumption is made actual in WIFIA’s rate setting.
For financing a large-scale, long-lived infrastructure project for 40 or 50 years, these two very different investors make a good match. The WIFIA program allows customized non-pro-rata amortization (which they call “sculpting”) so each investor can play to their strengths. The 51 percent muni tranche can be paid down first, all within the predictable 30-year market. That way, the series bonds will reflect the most competitive monetization of the tax-exemption value as well as the overall term and liquidity preferences of the individual investors – they really like infrastructure, just not for too long.
The 49 percent WIFIA loan tranche can begin repayment after the muni bonds are paid off, ideally around year 30. The WIFIA loan’s interest rate will be primarily determined in the flat-forward part of the Treasury curve, which is the lowest possible rate for such long-term debt. Since things can change a lot over such a time frame, it’s worth noting that WIFIA loans are pre-payable at par anytime.
Combining muni bonds and a WIFIA loan in this example can improve the cost savings on debt service for financing a long-lived project by 30 to 40 percent, compared to a pro-rata amortization. A big number, but an intuitive result based on the very different profiles of the two lenders. There are likely many additional synergies between the two, including those that are less quantifiable or situation specific.
Given the scale of long-lived infrastructure projects that need financing in the coming decades, synergies between the muni bond market and the WIFIA loan program should be actively developed by potential borrowers – and by the lenders themselves. Why not? It’s a classic win-win, straight out of Econ 101.
John Ryan is principal of InRecap LLC. InRecap is focused on debt alternatives for the recapitalization of basic public infrastructure. Ryan has an extensive background in structured and project finance. He recently served as an expert consultant to the U.S. Environmental Protection Agency. Views expressed in this article are solely those of the author.
