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The Pot of Gold and the Reserve Fund

One investment that is often overlooked, or possibly invested in a risky manner, is the debt service reserve fund (DSRF) of your revenue bonds. More than half the public entities I’ve worked with have paid more than they should for the municipal bonds they’ve issued. This doesn’t necessarily mean that these public entities should refinance the muni-bond — what it does mean is that the DSRF is accumulating negative arbitrage (refer to the preceding section).

In the foot-thick municipal bond documents that contain the indenture (the official statement), you get 10 to 15 pages of very valuable information that can save you quite a bit of money. In some DSRFs, you have no options and can’t save a penny, but in most cases, you can see savings of $10,000 to more than $100,000.

Investors often miss these potentially valuable 10 to 15 pages, which is really unfortunate. A professional advisor can sometimes find lucrative investment potential by digging into the details listed on these 10 to 15 pages of the official statement, arbitrage statement, and a few other documents in the stack of “bond documents.” The bottom line is that you have more money in your budget — and that makes you look like a hero for saving money.

Beware Negative Arbitrage

Negative arbitrage is when you borrow money at one interest rate and reinvest it at a much lower interest rate. If you are paying 6 percent on your bond and your reserve account is invested at 3 percent, you have a negative arbitrage, and that’s money unnecessarily going out the door. You’re much better off achieving positive arbitrage, which is essentially the opposite situation — you’re earning more on your reserve fund investments than you’re paying to borrow. If you’ve had your reserve fund invested lower than the rate at which you’re borrowing for a lengthy period of time, you can show quite a bit of negative arbitrage, and that can offset any future positive arbitrage.

Suppose that you have issued a bond for $25 million and the coupon rate — the rate you’re paying the investor — is 5 percent. Now say that you’re required to maintain a 10 percent debt-service reserve fund — the portion of that $25 million that you hang onto for safety. That’s $2.5 million. You’re basically borrowing that money at a 5 percent rate, and if you invest it at only 3 percent, the yearly negative arbitrage is $50,000. It’s costing you money, making your bond cost more like 5.2 percent instead of 5 percent, because your reserve fund is under water. That’s reason enough to work a bit harder for a better return.

You should consider the investment objectives, risks, charges and expenses associated with municipal fund securities before investing. Carefully read the official statement before investing and for more information about municipal fund securities.”