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CDFA Spotlight:
Bank Pricing of Non-Qualified Bonds
By Stan Provus |
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This article presents material from the Banker's Guide of the St. Louis County Economic Council prepared by Rick Palank, Vice President and a CDFA board member. The focus of this article is some guidance on how banks that purchase Small Issue bonds (and others that are not bank qualified) directly might go about pricing such bonds, recognizing that Small Issue bonds are not bank qualified. This means the bank's that purchase them can not take the so-called 80% carrying charge deduction—they can not expense or deduct 80% of the interest paid on funds borrowed to purchase Small Issues or other non-bank qualified bonds.
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This month we present material from the Banker's Guide of the St. Louis County Economic Council prepared by Rick Palank, Vice President and a CDFA board member. The focus of this article is some guidance on how banks that purchase Small Issue bonds (and others that are not bank qualified) directly might go about pricing such bonds, recognizing that Small Issue bonds are not bank qualified. This means the bank's that purchase them can not take the so-called 80% carrying charge deduction—they can not expense or deduct 80% of the interest paid on funds borrowed to purchase Small Issues or other non-bank qualified bonds. If you would like to contribute an article to the Learning Corner, please contact me at (501) 760-6000 or provus@hsnp.com Stan Provus
Bond Pricing of Non-Bank Qualified Bonds
Before a bank decides on pricing a tax-free issue, it must determine its taxable equivalent tax-exempt lending rate, which is dependent on its own tax rate, its cost of funds, and the non-tax deductibility factor of its cost of funds.
The following formula and table is provided as a bond-pricing tool. To determine the equivalent tax-free lending rate where the bank wants to equalize the after tax rate earned on its taxable loans.
- Equivalent Tax-free Lending Rate = (TLR – COF) – ((TLR – COF) x TR) + COF
- Tax Rate (TR) = the bank's combined federal and state tax rate (including effect of alternative minimum tax if applicable).
- Cost of Funds (COF) = the bank's costs of funds.
- Taxable Lending Rate (TLR) = rate the bank would charge borrower as if the loan was taxable.
Formula assumes 100% of interest paid on costs of funds is non-deductible as applicable for a manufacturing issue of industrial development bonds.
The following table can be used to determine the tax-free lending rate when the bank's combined federal and state tax rate is 40%.
Industrial Development Bonds – Manufacturer
Equivalent Tax Free Lending Rate
| | Average Cost of Funds | | |
Taxable Lending Rate | 2.0% | 2.5% | 3.0%3.5%4.0%4.5%5.0% |
0.05 | 0.038 | 0.04 | 4.2%4.4%4.6%---- |
0.055 | 0.041 | 0.043 | 4.5%4.7%4.9%---- |
0.06 | 0.044 | 0.046 | 4.8%5.0%5.2%5.4%5.6% |
0.065 | 0.047 | 0.049 | 5.1%5.3%5.5%5.7%5.9% |
0.07 | -- | -- | 5.4%5.6%5.8%6.0%6.2% |
0.075 | -- | -- | 5.7%5.9%6.1%6.3%6.5% |
0.08 | -- | -- | ----6.4%6.6%6.8% |
0.085 | -- | -- | ----6.7%6.9%7.1% |
Footnotes
While the interest rate on the bonds is an integral component of the borrowing cost, a more complete measure of the total financing costs is the All Inclusive Cost (AIC), which takes into account principal and interest payments, letter of credit fees, costs of issuance and associated ongoing fees.
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.
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