Under Section 148 of the Internal Revenue Code of 1986, as amended (“Code” – it’s been almost a year since we started this blog, and our devotion to defined terms remains unswerving), the gross proceeds of a tax-exempt bond issue cannot be invested at a yield that is materially higher than the yield of bond issue, unless the investment occurs during a “temporary period” exception to the application of yield restriction. Section 148 of the Code further provides that even if the gross proceeds of a tax-exempt bond issue are permissibly invested at a yield that exceeds the yield of the bond issue (either by being invested at a yield that is immaterially in excess of the bond yield or by being invested at a materially higher yield during a temporary period from yield restriction), all positive arbitrage obtained from that investment must be rebated to the Federal Treasury, unless an exception to rebate applies.
Public finance tax lawyers used to discuss things like whether the rebate requirement renders yield restriction superfluous, or, conversely, whether the existence of yield restriction makes the rebate requirement unnecessary. This topic, like all others that relate to compliance with the limitations on positive arbitrage from the investment of the gross proceeds of tax-exempt bonds, has been moot since at least 2008, when historically low interest rates have reigned supreme and the thought of earning positive arbitrage has been as illusory as the prospect of a Cleveland Browns Super Bowl. Bereft of a large part of what sustains us, public finance tax lawyers have for the last many years wandered aimlessly around the office muttering about private business use, TEFRA requirements, multipurpose issue allocations and other minutia to the point that even Carrie Brownstein, who generally finds tax lawyers alluring, has moved on.
Happily, the prevailing low-yield environment has not prevented all moderately interesting discussions about arbitrage. As you might have heard, the Federal Reserve has signaled its desire to raise the Federal Funds rate in the near future. This would, in all likelihood, trigger an eventual increase in virtually all other market-based interest rates and raise the prospect that positive arbitrage on the investment of tax-exempt bond gross proceeds could be more than a theoretical construct. In light of this, an issuer of new money tax-exempt bonds, which normally enjoy a three-year temporary period from yield restriction, might consider waiving this temporary period and leaving the bonds subject to yield restriction.
While the temporary period from yield restriction is in place, bond-financed investments of the project fund are treated as a separate class of investments for purposes of determining the investment yield from those project fund investments that are made after the temporary period expires. This is because the investments during the temporary period are not subject to yield restriction while the post-temporary investments are subject to yield restriction. This means that any negative arbitrage that accrues on investments made during the temporary period cannot be used in determining the yield of bond-financed investments of the project fund after the temporary period expires. If investment yields have risen above the yield of the bond issue by the time the temporary period expires, the issuer must make yield reduction payments (which are calculated in the same manner, and made at the same time, as rebate payments) based solely on the post-temporary period investment yield to comply with yield restriction (or make actual yield restriction of its bond-financed investments in accordance with this post-temporary period investment yield in the rare circumstance that yield reduction payments are not permitted to determine compliance with yield restriction). This obviously would prevent the issuer from obtaining any benefit from the post-temporary period positive arbitrage.
If, instead, on or before the issue date of the bonds, the issuer waives this temporary period, all of the bond-financed investments in the project fund will be treated as a single class of investments for purposes of determining their yield, because they will all be subject to yield restriction. The issuer can therefore benefit from the negative arbitrage that accrues during what otherwise would have been the temporary period. Even with the waiver of the temporary period for the investment of the new money bond proceeds, the issuer can still avail itself of yield reduction payments to determine compliance with yield restriction. Yield reduction payments will not, however, be necessary until such time that any positive arbitrage on the investment of the bond-financed project fund has offset the initial negative arbitrage to the point that the investment yield materially exceeds the yield of the tax-exempt bond issue (a materially higher investment yield in this instance is one that exceeds the yield on the bonds issue by more than 1/8th of a percentage point). Put another way, for as long as the initial negative arbitrage on the investment of the bond proceeds remains to be absorbed, the issuer can retain the benefit of any subsequent positive arbitrage on the investment of the project fund – something that might not be possible where the temporary period is in place.
This effect can be amplified where a reserve fund secures the new money bonds. A reasonably required reserve fund is not subject to yield restriction, but, on or before the issue date of the bonds, the issuer can waive the exception to yield restriction for this reserve fund. If the reserve fund and project fund are both subject to yield restriction, the investment of these funds will be treated as a single class of investments for purposes of determining the investment yield. As noted above, yield reduction payments remain available for determining compliance with yield restriction where the three-year temporary period from yield restriction is waived. Similarly, yield reduction payments can be made to determine the yield on the investment of a reasonably required reserve fund where the exception to yield restriction for that reserve fund has been waived. Thus, where the project fund and reserve fund are both subject to yield restriction, negative arbitrage that initially accrues on the project fund and reserve fund can be taken into account in determining the single investment yield of the bond-financed investments held in these funds, and use of yield reduction payments to maintain compliance with yield restriction will not be necessary until such time that subsequent positive arbitrage on these investments has offset the negative arbitrage, allowing the issuer to retain the benefit of the positive arbitrage until the initial negative arbitrage has been absorbed.
In sum, systemic negative arbitrage not only results in diminished intellectual stimulation for public finance tax lawyers, it results in a real cost to issuers. To the extent that permissible investment earnings are not available to help pay the cost of a bond-financed project, an issuer must make up this difference from other sources, which can easily lead to strains in other areas of the issuer’s budget. With interest rates likely to rise in the future (can they really get any lower?), and positive arbitrage a potential result of an increase in interest rates, an issuer might be able to derive some benefit from current negative arbitrage by foregoing otherwise available exceptions to yield restriction. Even if positive arbitrage does not obtain for quite some time, an issuer is no worse off by incurring negative arbitrage when the exceptions to yield restriction are waived than incurring negative arbitrage with these exceptions in place.
 A reserve fund that isn’t vital and necessary to market the bonds to the general public or that exceeds the size limitations for a reasonably required reserve fund is not excepted from yield restriction.
 Yield reduction payments are also available for a reserve fund that would otherwise be a reasonably required reserve fund except for failure to observe the size limitation for such funds, so long as (i) the value of the investments in the fund do not exceed 15% of the stated principal amount or issue price, as applicable, of the issue and (ii) the amounts (other than investment earnings) in the reserve fund are not reasonably expected to be used to pay debt service on the bond issue, other than in connection with reductions in the amounts required to be held in the reserve.