CDFA Spotlight: Letter of Credit Interest Coverage By Stan Provus

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This article addressed how to size the Letter of Credit (LOC) interest coverage.

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This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel.

Types of municipal bonds backed by LOCs include bonds and notes bearing interest at either fixed or variable (floating) interest rates and commercial paper. LOC-backed qualified small issues for manufacturers are very common. To substitute completely the credit of the bank providing the LOC for that of the issuer or obligor in a conduit financing, the LOC must be structured to ensure the bank will provide complete and timely payment of amounts payable to bondholders. When rating a LOC-backed issue, the rating agencies evaluate the payment structure, the enforceability of the LOC, the possibility of payment delay, and the adequacy of coverage. This article focuses primarily on the adequacy of interest coverage.

A LOC provides a specific amount of coverage of principal and interest under all circumstances contemplated by the financing documents. The LOC must cover all changes in interest rate and length of interest rate periods contemplated by the indenture. Floating interest rates must be capped at a rate not to exceed the rate covered by the LOC. Typically, this is a rather high interest rate such as 12%. This not to exceed rate or maximum permissible rate in a floating rate transaction is generally set high enough so bonds can be remarketed or clear the market even if there is a significant increase in rates over time.

The required size of the interest component of the LOC varies by transaction because the variables needed to calculate it are derived from the financing documents of a particular issue. However, the interest component calculation method contains several standard sizing components that must be considered in order to assure full credit substitution support. The LOC must cover all changes in interest rate. As noted above, floating rates must be capped at a rate not to exceed the rate covered by the LOC. The number of days of interest required under the LOC is calculated by adding the days required to cover. These include:

The longest interest payment period. The longest period of time during which interest can accrue between interest payment dates is the foundation for the interest size. This must account for the possibility of the payment date’s occurring over a holiday weekend. It must also account for interest accrual between the bond closing and the first scheduled interest payment date. This long first coupon may be reduced after the first payment date.

The interest reinstatement period. The interest reinstatement period is the amount of time after the LOC bank has funded an interest draw (direct pay LOC) before its funds are reinstated or reimbursed by the obligor. Reimbursement by the issuer/obligor may or may not occur during this period. Interest, however, will continue to accrue. If the bank elects not to reinstate interest on the last day of this period, interest will continued to accrue in that period. This accrual is the second component to size the interest component of the LOC.

Remedy period or time to take out bondholders if interest is not reinstated. This is the length of time, described in the governing bond document, between the trustee’s receiving notice from the bank that it will not reinstate the interest component and the date set for payment by the trustee of principal and accrued interest to bondholders. The payment is typically made by acceleration, redemption, or a mandatory tender of the bonds, and interest should accrue until the final payment date. This remedy period is the final consideration in sizing the interest component of an LOC.

In summary, the day’s interest component of the LOC is based on the following formula:

Days Interest Component = Interest Period + LOC Reinstatement Period + Post Default Accrual + Other (Weekend).

For example:

Variables

Interest payment date is the first business day of the month.
Reinstatement period for interest is five calendar days.
Remedy period is five calendar days.

Calculation:

Maximum interest accrual: 31 days
Reinstatement period: 5 days
Remedy period: 5 days
Total 41 days

The day’s interest, in this floating or variable rate example of 41 days, would be multiplied by the maximum permitted interest rate to arrive at a dollar amount for the interest component of the LOC. For example, assuming a $2,000,000 bond issue, 41 days interest x 12% (maximum interest rate) per annum equals: $26,959. The daily interest amount is based on a 365-day year in floating rate deals in contrast to a 360-day year for fixed rate issues. Therefore, the LOC amount in this example would be: $2,000,000 + $26,959 = $2,027,000 (rounded to nearest thousand).

There are two articles on LOCs published by Moody’s Investor Service, Global Credit Research. These are: (1) “Approach to Rating LOC-Supported Industrial Development Bonds and Municipal Bonds”, and an updated version, “Moody’s Approach to Rating Bonds backed by Letters of Credit.” Both articles were written by Joseph Staffa, Esq. at Moody’s, who has been an instructor at CDFA’s Municipal and Industrial Development Bond course for the past few years.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.