County Will Reap Profits from Arbitrage : Innovative Product Has Guaranteed Return
He’s not taking a page from the how-to book by Ivan Boesky--whose wheelings and dealings made arbitrage part of the lexicon and ultimately gave takeover “arbs” a black eye in financial circles.
But Orange County Treasurer Robert Citron, the colorful, outspoken keeper of several billion dollars of taxpayers’ hard-earned money, has joined ranks with some major players in the money market to push municipal financing to new frontiers.
Using a loophole in the section of the 1986 federal tax law that effectively bars local and state governments from making a profit by investing the proceeds of tax-free municipal securities, Citron and officials at First Interstate Public Finance Co. and Merrill Lynch Money Markets Inc. have created a new investment procedure the county treasurer calls a Taxable Arbitrage Investment Portfolio (TAIP).
It will earn the county a guaranteed return of at least $1.3 million in the next year, Citron said, and will not involve investing county tax revenues.
“The beauty is that I’m not using my (county) money,” he said. “It’s somebody else’s!”
The arbitrage will occur as Citron uses the proceeds from the sale of as much as $600 million in federally taxable notes to invest in money market securities--such as commercial paper and certificates of deposit--which have similar maturities but pay higher interest than the county will pay on its own notes.
(The classic definition of arbitrage is the simultaneous purchase of goods in one market and their sale in another market at a higher price.)
Indications Favorable
It is uncertain how attractive the procedure will prove to be to investors, but early signals indicate that quite a few are lining up.
Municipal bond market observer Ralph Norton, editor of the Muni Bond Report newsletter, said the arbitrage factor may increase yield to investors, who will expect slightly higher interest rates than paid by municipalities that are not investing the proceeds from their notes.
Additionally, while interest from the county’s notes will be subject to federal income taxes, California residents will not have to pay state income taxes, Citron said.
Jeffrey Leifer, senior vice president and chief operating officer of First Interstate Public Finance--an arm of First Interstate Bank--said he foresees no trouble with the private placement of $200 million of the county’s paper.
Citron and Leifer said Los Angeles County has taken the new procedure to heart and plans a $1-billion issue for Oct. 1--just a month after Orange County launches its TAIP on the market with the first installment of what could be a $600-million issue.
Merrill Lynch Money Markets, which is handling up to $400 million of the Orange County issue, is one of seven underwriters that Los Angeles County is using, Leifer said.
Guaranteed Profit
Citron, whose investment techniques repeatedly earn him a spot at the top of the heap when municipal money managers’ successes are compared, obtained permission from county supervisors Tuesday to issue the taxable notes. Unlike tax-free bonds, they are backed not by the county’s revenues but simply by its credit rating. In effect, they are IOUs.
The key element of the new procedure, Citron said, is that he will be able to earn a guaranteed profit for the county during the next year without using any county money. Instead, he’ll be investing funds “borrowed” from institutional investors who buy the interest-paying taxable notes.
First Interstate is guaranteeing a minimum “spread” or profit of 25 basis points, while Merrill Lynch is guaranteeing a minimum of 20 basis points. One hundred basis points equals one percentage point.
Norton, the Muni Bond Report editor, said he expects that the market will greet the new investment vehicle with enthusiasm:
“There have been a lot of taxable muni deals that have definitely excited the market in the past year. I think this one would, too. . . . Taxable munis are a secure issue.”
Unlike a corporate note, which can drop in value overnight on rumors of a takeover attempt or a leveraged buyout, taxable municipal notes are backed by the credit of a government agency.
Solid Credit Rating
“Orange County’s credit rating is one of the best in the nation,” Leifer said.
The relative safety of taxable municipal notes enables the county to offer its notes at a relatively low interest rate. Leifer said he is talking “near” the London Interbank Offered Rate, which was 6.65% Tuesday morning.
“That is more like the rate for an overnight transaction, not 15 months,” the maturity of the placement Leifer is negotiating.
“The litmus test for market acceptance is my buyer’s (low) interest rate,” Leifer said. “It shows how other institutions will do when Merrill Lynch issues” the public portion of the county’s note offering.
Merrill Lynch Money Markets will underwrite an initial $200-million offering of Orange County taxable notes beginning about Sept. 15, said K. Carter Harris, vice president of the New York-based financial markets operation. An additional offering will follow.
He said that while the strategy of reinvesting proceeds from a taxable municipal note offering is new for counties and cities, “the underlying program is straightforward.”
Merrill Lynch Money Markets brought its offer of a guaranteed minimum profit in a taxable arbitrage deal to Citron because it has been dealing with him for five years and because California law enables counties to take the lead in looking at new investment programs, Harris said.
