The federal debt limit, which has been suspended since February 2014, will be reinstated Sunday, March 15. At that time, the debt limit will be equal to the amount of debt then outstanding – in other words, there will be no room for additional debt. If Congress does nothing to change this (which seems likely), the window where borrowers of tax-advantaged obligations can submit new subscriptions to purchase SLGS (i.e., U.S. Treasury – State and Local Government Series) will likely close sometime late the preceding week. The anticipation of this closing raises a number of questions for bond practitioners:
- What happens if an issuer submits a subscription for SLGS and the window closes before the delivery date of the SLGS?
- How should escrow securities be purchased while SLGS are not available – do escrow securities need to be bid in this low-investment yield market?
- How long is the SLGS window likely to be closed?
Each of these questions is answered below after a bit of history.
A Little History
Since the closing in 1995, the SLGS window has closed nine times. The closings have come in waves – apparently when Congress and the President have gotten especially testy with each other. From 2002 to 2007, the window was closed five times, and then every year from 2011 to 2014 (looks like the streak will stay alive!). In this 20-year period, the shortest closing was one day – in 2007 – and the longest was more than five months – in 1995. With this bit of fascinating history, let’s turn to the questions that really matter.
What Happens to Pending SLGS Subscriptions?
Treasury is not legally required to deliver SLGS for which a subscription is pending when the window closes but historically it has delivered those SLGS. In explaining SLGS, the TreasuryDirect website includes the following FAQ:
What happens to subscriptions already in SLGSafe when the window closes?
Although not mandated, Treasury’s past practice has been to honor all SLGS subscriptions submitted by the specified time and date of the SLGS suspension, as announced in the respective Treasury press release.
This leaves lawyers and consultants in an awkward position – it’s a very good bet that pending subscriptions will be honored, but issuers will not be impressed by how good the bet was if for whatever reason Treasury changes its historic pattern and denies SLGS deliveries. As a result, if an issuer decides to subscribe for SLGS despite the impending window closure, some contingency planning may be in order. At a minimum, a bidding agent should be lined up and waiting in the wings if necessary to avoid the disaster of having no escrow securities upon closing. This might also require, before the sale, lengthening the time from sale to closing to allow time to complete the bidding. And potentially most difficult, thought should be given to a source of additional funding in the event interest rates have fallen since the sale of the bonds and only lower yielding open market securities are available. In that case additional funding will be required for a “sufficient” escrow. Of course, all of this talk of contingency planning with the issuer may lead to the more certain course of buying open market securities from the outset.
If SLGS Are Not Available, How Should Escrow Securities Be Purchased?
The easy answer to this question could be to bid all escrow securities in satisfaction of the Regulations’ safe harbor. And this is probably the right answer for advance refundings. But is this necessary for current refundings, where the escrow securities are not subject to yield restriction? Here are some considerations.
Will the refunding issue be subject to rebate? Consider whether it will qualify for either the small issuer rebate exception or the 6-month spending exception (the only spending exception potentially applicable to refunding issues). As to the latter, of course the escrow will by definition be used to pay off the current refunded bonds in less than 6 months. However, it is also necessary to ensure that any proceeds used to pay issuance costs and funded interest are also spent within 6 months. Since the escrow investments will not be yield-restricted, if the issue is also exempt from rebate, it may be unnecessary to bid the escrow securities. But first consider the following.
Even if the escrow securities qualify for a rebate exception, if there are other gross proceeds of the issue that are subject to rebate, the escrow securities may provide a valuable means of averaging down present or future positive arbitrage. If the escrow securities are not bid, it may be difficult to convince the IRS on audit that the securities were priced at fair market value. Two of the most common sources of gross proceeds subject to rebate in a current refunding issue that satisfies the 6-month spending exception are reserve funds and transferred proceeds.
Finally, it must be remembered why escrow securities are required under the tax safe harbor to be bid – because it is otherwise hard to confirm fair market pricing. Thus, even if not necessary for tax reasons, an issuer may choose to bid escrow securities to ensure a fair market price. And even if an issuer is confident it can purchase the securities at a fair market price without bidding, it may be a good idea to bid the securities just to avoid any “political” (non-tax) issues of having to prove fair market pricing in the future.
How long is the SLGS window likely to be closed?
This is probably the toughest question to answer. It depends on when Congress and the President raise or suspend (again) the debt limit, and this depends on when Treasury will otherwise run out of money. While the Country will be right at its debt limit on March 15 (given how the debt limit suspension works), it will be some number of months before Treasury has to issue debt to keep the government running. First, Treasury has shown an ability to make room under the debt limit by taking so-called “extraordinary measures” to delay the necessity of raising the debt limit, the one near and dear to our hearts being the closing of the SLGS window. While this doesn’t reduce the amount of debt outstanding, the combination of steps like this to reduce new debt together with other measures that reduce debt, as well as the annual cash inflows resulting from the upcoming tax deadlines, will postpone Treasury’s need for additional borrowing. Economists have projected that these factors will enable the government to continue operating at least through this spring and maybe as long as sometime into the fourth quarter of this calendar year. The result – we may be in for a record-breaking SLGS window closure!