When a borrower purchases a letter of credit, a
bank with better credit agrees to make all of the principal and
interest payments on the bonds and be reimbursed by the organization.
Bondholders generally feel more comfortable with this situation; a bank
has guaranteed they will be getting their money, and because of this
guarantee they are willing to accept a lower interest rate for
purchasing the bonds. This complex network of relationships is depicted
graphically below.
The cost of a letter of credit is largely
driven by the perceived credit risk of the borrower and typically
includes a one-time fee along with an annual service charge. Letters of
credit usually are issued for three- to five-year terms and can be
renewed or substituted throughout the life of the bonds.
Key Benefits and Considerations
A
letter of credit-enhanced bond offering gives the borrower the ability
to tailor its debt structure to reduce the organization’s exposure to
changing interest rates. Most letter of credit bonds use short-term or
variable interest rates. The interest rate is closely associated with
the SIFMA (formerly the Bond Market Association) index, which has
averaged 2.82 percent over the last 15 years.
Flexibility is a
major benefit of a letter of credit. The debt can be paid off whenever
the borrower desires without penalty. In addition, it is relatively easy
to negotiate changes with a letter of credit bank; most changes do not
require the authorization of the bondholders. It may be possible to
leverage existing bank relationships to issue supplemental or additional
debt.
The process for obtaining a letter of credit, shown in the
flowchart at the top of the page, is also generally shorter than that
of other enhancement options. Obtaining a letter of credit-enhanced bond
structure typically takes about 12 weeks and occurs in three phases:
internal financing, external financing analysis, and closing.
Phase I: Gathering and Analyzing Internal Information
The
organization’s need for funds must be accurately determined before any
action is taken. It is less expensive to issue bonds once to cover all
needs than to borrow too little and be forced to look for additional
financing. The organization and its underwriter or financial adviser
should compare the letter of credit option to other financial structures
during this initial phase.
The organization’s finances must be
evaluated to identify qualitative and quantitative credit strengths and
weaknesses and the ability of the borrower to repay the planned debt.
Creditors want to be sure the loan will be repaid, and that the
borrowing organization is not taking on more debt than it can handle.
The higher they perceive the credit risk of the borrower, the higher the
letter of credit fee will be.
Requesting the Enhancement
If
the letter of credit route is chosen, these detailed credit strength
elements become part of a “Credit Enhancement Request Package,” an
application to a bank or banks for a letter of credit. The goal is to
outline the organization’s financial strengths, both qualitatively and
quantitatively, which in turn should reduce the risk associated with it.
Less risk translates to lower fees and less stringent covenants --
financial targets the organization must hit consistently or risk
default.
The credit enhancement request package should include
what is being requested from the bank, how the funds from the bonds will
be used, collateral offered, and the organization’s financial
statements. It is important to describe the details of the bonds being
issued as well as the benefits the organization will receive by issuing
them.
A good credit enhancement request package should highlight
strengths and explain any potential issues. Collateral needs to be
specified, and any other potential business opportunities for the bank
that may arise as part of the transaction. After the package is
submitted, banks usually will respond within two weeks.
Phase II: Analysis of Bank Responses
Each
bank can offer different terms, fees and collateral than originally
offered. Fees are easily compared, but covenants and collateral must
also be carefully considered. These can include maintaining ratios or
other financial guarantees, pledges not to take on additional debt, or
maintenance covenants. All terms need to be negotiated and finalized
once a bank’s proposal is chosen.
Phase III: Document Revision and Bond Issuance
During
the final phase of the letter of credit-enhanced bond issuing process,
all documents may go through several rounds of revision. These documents
include:
- Trust or master trust indenture:
Drafted by bond counsel, this provides the terms of the bonds and
specifies the mechanics of how they are paid. Rights, duties, and
remedies are included in the indenture, as well as the necessary funds
and accounts created as part of the financing.
- Loan agreement (sublease): This specifies prepayment provisions, provisions required by state law, and may also include business covenants.
- Reimbursement agreement:
This contains many of the specifics of when and what the borrower will
repay to the letter of credit bank, including all fees, and it contains
the primary business covenants for the borrower while the bonds are
outstanding. It also may contain any extension provisions and any other
guarantees. The reimbursement agreement, created by the bank’s counsel,
is the most important document to review from the perspective of the
borrower.
- Tax compliance documents: These deal
with any tax issues connected with the issuance of the bonds, including
possible limitations on the cost of issuance and reimbursement issues.
All tax-exempt bond issues require this document.
- Bond purchase agreement:
Drafted by the underwriters counsel, it sets out all the terms and
conditions under which the underwriter will buy the bonds from the
borrower, including the provision of a letter of credit by a highly
rated bank. The borrower and bank are a party to this document.
- Remarketing Agreement:
Document between the borrower and the firm serving as the remarketing
agent, usually the underwriter, outlining the duties of the remarketing
agent for setting the periodic interest rates on the bonds while
outstanding and remarketing any bonds subsequently to the initial sale.
- Preliminary & official statement or offering circular:
Prepared by both the bond and underwriter’s counsel, it summarizes all
of the documents, terms of the financing, and use of proceeds. It is the
document used to solicit orders from investors, much like a red herring
for public stock sales.
A trustee is chosen at this point, and
will act as a hub for future debt service payments. Ratings must be
acquired from a ratings agency, such as S&P, to ensure t the bond
rating will receive the current letter of credit bank’s rating. The
bonds are registered, then issued, and funds are transferred. All future
debt service payments are made by the trustee to investors, with
reimbursement by the borrower.
While the enhancement is complex, a
letter of credit can usually help a borrower access the capital markets
at better interest rates than other financing structures. It is one of
several tools available to weaker credits, and due consideration should
be given to all financial options.
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