IRB academy

What an industrial revenue bond is

A state or local issuer — usually a development authority — sells tax-exempt bonds and lends the proceeds to a company for a qualifying project. The company repays the loan; bondholders rely on the company’s credit, collateral and any bank support, not on the issuer’s taxing power.

Because most buyers pay no federal income tax on the interest, they accept a lower yield than on a taxable loan to the same company. That difference — often well over a percentage point — is the reason to use bonds.

Key points

• The issuer lends its tax-exempt status, not its credit.
• The company signs a loan agreement; the bonds are secured by its payments.
• A trustee collects payments and pays bondholders.

Who qualifies

Manufacturers use the qualified small issue: up to $1 million per issue, or $10 million when the issuer makes the capital expenditure election — provided capital spending at the facility and related sites over the six-year test period stays within $20 million (IRC §144(a)). Exempt facilities — solid waste disposal, water and sewage, qualified residential rental housing, local energy, airports and docks — qualify without the $10 million limit (IRC §142).

Retail, office, hotel and restaurant projects do not qualify, and a warehouse on its own is not manufacturing. Nonprofits use a separate route, qualified 501(c)(3) bonds.

Key points

• Manufacturing: $10M per issue; $20M six-year capital spending limit.
• Exempt facilities: no size limit, but specific use tests.
• A borrower may have no more than $40M of small-issue bonds outstanding.

The federal tests

At least 95% of net proceeds must finance the qualifying facility; no more than 25% may buy land; buying an existing building requires rehabilitation of at least 15% of the bond-financed cost; average maturity may not exceed 120% of the assets’ economic life; and only 2% of proceeds may pay costs of issuance (IRC §147).

Bond counsel confirms these in the tax certificate at closing. Breaching them later — for example by leasing the plant to a non-qualifying user — can make interest taxable, so they shape how the project is run as well as how it is financed.

Key points

• 95% to the facility; 25% land cap; 2% issuance-cost cap.
• Maturity tied to the economic life of the assets.
• Bond counsel’s opinion rests on these tests.

Volume cap

Most private activity bonds need part of the state’s annual volume cap (IRC §146). The IRS sets a per-resident amount with a minimum for small states, and each state allocates its cap by statute or through an agency — in application rounds, by category set-asides or first come first served.

Cap is often the critical path: apply early, with an inducement resolution in hand. Unused cap can be carried forward for up to three years for a stated purpose. Governmentally owned airports and docks and 501(c)(3) bonds do not need cap.

Key points

• Allocated by each state; calendars differ.
• Apply with an inducement and a complete application.
• Carryforward lasts up to three years.

Steps and timing

1. The issuer adopts an inducement resolution, so costs paid from then on can be reimbursed. 2. Volume cap application. 3. Public notice at least seven days ahead and a TEFRA hearing, then approval by an elected official. 4. Documentation and buyer diligence. 5. Marketing, pricing and closing.

Workstreams overlap; plan on three to six months, longer if a cap round is missed.

Key points

• Inducement first — it protects your reimbursement.
• TEFRA notice: at least seven days before the hearing.
• Three to six months is typical.

What it costs

One-time costs include bond counsel, issuer’s and borrower’s counsel, the issuer’s fee, the trustee, and the underwriting or placement fee — usually the largest single item, often 1–2% of par for small placements. Only 2% of proceeds may pay these costs; the company funds the rest.

Against those fixed costs, the lower tax-exempt rate applies every year for the life of the bonds. Below a few million dollars the fixed costs often outweigh the saving; the cost calculator finds the break-even for your numbers.

Key points

• Ask for an underwriting or placement fee quote early.
• Compare all-in cost, not just the coupon.
• Smaller deals favour bank direct purchase.

How the bonds are sold

A bank can buy the whole issue (direct purchase); a bank letter of credit can back variable-rate bonds sold to money market funds; established companies with audited statements can sell unrated bonds to high-yield funds and other sophisticated buyers; larger credits can be rated and sold broadly.

The right route depends on size, operating history, financial statements and banking relationships — and it drives both the rate and the documents.

Key points

• Direct purchase: cheapest and fastest, with tender risk.
• Letter of credit: bank credit replaces yours; annual fee.
• Unrated placement: fixed rate to maturity, higher yield.

After closing

Spend the money on the approved project and keep records by category; keep the facility in qualified use; report audited statements and covenant certificates to the trustee and holders; give notice of material events; and track investment earnings for arbitrage rebate, computed at least every five years.

Keep records for the life of the bonds plus three years. Talk to bond counsel before any sale, lease or change of use of the facility.

Key points

• Annual reporting to holders and the trustee.
• Arbitrage rebate at least every five years.
• Records for the life of the bonds plus three years.

Credit enhancement and variable-rate bonds

A bank letter of credit puts the bank’s promise behind the bonds: with a direct-pay letter of credit the trustee draws on the bank for every payment and the company reimburses the bank. Buyers then rely on the bank’s rating, which opens the money market fund buyer base. A confirming letter of credit from a larger bank can stand behind a local bank’s.

Variable-rate demand bonds reset daily or weekly and holders can tender them at par on short notice. A remarketing agent resells tendered bonds; if it cannot, the bank’s facility buys them as “bank bonds” at a higher rate. When the letter of credit expires or the bonds convert to a fixed rate, holders face a mandatory tender.

Key points

• Direct-pay letter of credit: the bank pays, the company reimburses.
• Weekly bonds: tender on seven days’ notice.
• Renew or replace the letter of credit before it expires.

Keeping the bonds tax-exempt

After closing, the borrower must keep meeting the rules. Small-issue borrowers track capital spending at the facility against the $20 million limit for three years after the issue, and each principal user’s outstanding tax-exempt facility bonds against the $40 million limit (IRC §144(a)(4), (a)(10)). Spending exceptions to arbitrage rebate have dated milestones at 6, 12, 18 and 24 months (Treas. Reg. §1.148-7).

If the rules are broken, interest can become taxable to holders and the documents usually force a redemption. Change of use, off-project spending and missed rebate payments are the common causes. Written procedures, a named responsible officer and an annual review are the defence, and bond counsel should see any sale, lease or expansion first.

Key points

• Form 8038 is filed after closing (IRC §149(e)).
• Rebate is computed at least every five years (Treas. Reg. §1.148-3).
• Ask bond counsel before any change of use.

Reading a term sheet

The term sheet fixes the deal before documents are drafted: issuer, borrower and guarantors, par amount, purpose, tax status, security, any credit enhancement, rate and mode, maturity and sinking fund, denominations, optional and extraordinary redemption, covenants, reserve fund, reporting, parties and the timetable.

Read three things closely. Call protection: a long non-call period lowers the rate but limits refinancing. Covenants: a coverage test the business misses in a bad year is a default even if payments are current. Extraordinary redemption: a determination of taxability usually forces redemption, sometimes at a premium.

Key points

• The term sheet is the deal; the documents follow it.
• Average maturity is tied to the assets’ life (IRC §147(b)).
• Negotiate covenants you can meet in a bad year.

CERTIFICATE OF COMPLETION

completed the Securitief IRB academy: industrial revenue bond basics