November-December 2011

How to Save Substantial Interest Expense

As we know, virtually all MSW operating expenses should be paid from current revenues, but long-lived capital assets are a different story. If several future generations of customers will use a new waste-to-energy plant, or a set of new transfer stations, the cost of these facilities should not fall only on today’s ratepayers. The answer is to borrow, using long-term debt. But this is expensive and has the rub that, during perhaps several years of construction, current customers pay high debt service costs for something they cannot yet use. In addition, the money borrowed at high long-term rates waiting to be spent on the project usually languishes in the bank earning very low short-term yields. (It should be mentioned that an alternative to long-term borrowing is to just save up the required funds first, then build. While this is very conservative, it is even more generationally inequitable. However, if a community follows this path over many years, paying cash for the next generation’s capital assets at the time of construction, things would even out over time, but this implies considerable trust from one age group to the next.)

Fortunately, especially for public entities, there is a straightforward way to save considerable interest expense in the construction years. It is based on this reality that short-term rates are normally lower than long-term ones. These days (early autumn of 2010), this “yield curve” is astonishingly steep (see Figure 1).

To take advantage of this situation one can use “Bond Anticipation Notes” (BANs). These are short-term obligations that investors will buy if there is a formally approved program to eventually issue long-term debt once the specific construction projects are completed. These IOUs, usually one year in length, can normally be renewed several times, and in addition this is often coupled with completely deferring (i.e., capitalizing) the interest payments involved. In this approach over a perhaps three-year construction period, zero debt service would be paid by the solid waste authority undertaking the capital project(s)—neither principal nor interest. Of course, in this option the interest deferred each year is added to the principal on the forthcoming long-term debt, but at the currently very low short-term rates this buildup of principal would be modest.

A middle ground is simply to pay each year the short-term interest-only cost involved, leaving the initial principal constant until the project is finished and long-term amortizing debt is arranged.

Even if interest deferral is not elected, borrowing at say 0.50% during the construction period is much less costly than starting immediately with long-term bonds at 4.25%. Of course, the risk is that once several years of the short-term notes are completed long-term bond rates might have crept up.

This BAN arrangement has been utilized in many areas of municipal governments, certainly not limited to solid waste operations. Over the last few years, for example, King County, in which Seattle is located, has used this short-term approach to finance several major capital investments:

Courthouse seismic refit—$85 million

Regional emergency center—$35 million

Jail improvement projects—$40 million

Forthcoming accounting system conversion—$90 million

An Example

Suppose that a major new transfer station is required, at a cost of perhaps $30 million. Normally, at 4.25% interest for a traditional 20-year municipal bond the annual debt service (including both principal and interest) would be as shown in the third row of the table below. But under a three-year BAN program, paying current interest only, the short-term costs would be much lower, as in row four—until the start of 2014, when long-term debt would be created. For simplicity, we assume that long rates remain at 4.25%, at least until the bonds are issued at the start of 2014 (Figure 2).

For an “immediate” savings of over $6 million, it might be worth the risk that, starting in 2014, long-term rates could be up a bit, while also allowing that they might likewise go down.

Of course, accurately predicting interest rates seems to be impossible. Therefore, many large organizations try to act independent of what rates might do in the future. If several million dollars in savings appear to be achievable over the next, say, three years via borrowing on a BAN program, it is often decided to capture these savings, without undue worry that long-term rates might be higher at the start of year four—or at least higher enough to offset the short-term savings from the BAN approach.

Of course, with such a program the savings in the start of the project will be partly offset by a longer payback period, since the 20-year fixed obligation would not start until 2014, rather than 2011. But, the “extra” fixed payments are many years in the future, are set now in dollar terms, are likely to be diminished by inflation, and are certainly much reduced in terms of present value today, assuming a 5% discount rate (Figure 3).

To prevent this “overhang” at the far end, the fixed rate bonds issued in 2014 in the above example could have a maturity of 17 years at perhaps a slightly lower interest rate and a slightly higher annual payment.

It should be emphasized that such an initial short term borrowing arrangement has virtually nothing to do with “derivatives,” about we have heard so much lately. A BAN program is more akin to a construction loan, followed by a long-term mortgage. It is potentially available to solid borrowers undertaking a substantial capital project, or series of projects, which will with virtual certainty be paid for via a long-term loan immediately after physical completion of the project.