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