Former Federal Reserve Chairman Ben Bernanke recently advised that the Fed should maintain “constructive ambiguity” about the possibility of taking the Federal funds rate below 0% in an effort to simulate the U.S. economy during the next recession. Given that current short-term interest rates in the United States are at near-historic lows, many believe that it is inevitable that U.S. monetary policy will replicate the negative interest rates employed in Japan and Europe when the next recession hits. One economist suggests that negative interest rates and negative bond yields (more on that below) are the inexorable conclusion of a trend that began in the late 1400s. We are on notice.
If the Fed experiments with a Bret Easton Ellis-inspired monetary policy and takes the Federal funds rate to less than zero, what are the potential consequences for issuers of tax-exempt bonds? For some speculation (and to see the text of the first footnote), hit the jump.
Should the Fed adopt negative short-term interest rates, longer-term government bond yields in the United States could also fall below 0%, as they have in Japan and Europe. A negative Federal funds rate will cause banks to charge their depositors for the privilege of maintaining those deposits, rather than paying those depositors interest in exchange for the use of the depositors’ funds. This will incent (and also incense) the depositors to withdraw their cash and invest it in more productive assets, and perhaps in a manner that stimulates aggregate demand.
Government bonds find favor in a negative short-term interest rate environment, because these obligations are secure and provide a regular stream of interest and principal payments. The demand for tax-exempt bonds has increased since the enactment of the Tax Cuts and Jobs Act, because tax-exempt bonds are one of the few remaining sources of tax-exempt income. Their appeal would likely be further enhanced by negative short-term interest rates. Increased demand for tax-exempt bonds would bid up their prices, which would reduce their yields. A sufficient spike in demand for tax-exempt bonds would push the yields of these bonds below 0%.
There are at least two likely consequences for issuers of tax-exempt bonds if the United States experiences negative short-term interest rates.
- The Product of Two Negative Factors is Positive.
Issuers of tax-exempt bonds will in all likelihood have positive arbitrage on the investment of the proceeds of negative-yield tax-exempt bonds. The nonpurpose investments acquired with these proceeds will most likely have a positive yield, which will result in positive arbitrage for the issuer of the negative-yield tax-exempt bonds. Issuers and their advisors will need to reacquaint themselves with concepts like yield restriction, temporary periods, yield reduction payments, and arbitrage rebate (and the exceptions thereto). Moreover, given that yield reduction payments generally are not available in the case of an advance refunding escrow, the issuance of tax-exempt bonds to advance refund taxable bonds (that are not also tax-advantaged bonds) could, at a minimum, become quite complicated.
- Lots of Premium.
The increased demand and bidding up of prices for tax-exempt bonds will likely cause issuers to receive even more premium on the issuance of tax-exempt bonds than these issuers are obtaining in the current environment of historically low interest rates. This premium will constitute sale proceeds of the bonds. The issuer will need to ensure that it can spend at least 85% of the proceeds of the bond issue within three years after the issuance date to ensure that the issue is not comprised of taxable hedge bonds under Section 149 of the Internal Revenue Code or taxable arbitrage bonds under Treasury Regulation 1.148-10. This could prove difficult if governing law limits the use of bond premium to the payment of issuance costs and interest on the bond issue, and the issuance costs and interest on the issue that accrues within three years after the issuance date is insufficient to absorb the premium.
If negative short-term interest rates are, like Thanos in Avengers: Infinity War, inevitable, such rates will not cause half the population to vanish simultaneously. Negative short-term interest rates will, however, be an unprecedented circumstance in the United States, and they will very likely cause complications for issuers of tax-exempt bonds. Issuers of tax-exempt bonds, and their counsel, need to be ready.
 The “protagonists” of Less Than Zero also experimented, but it was with cocaine and heroin. This experimentation was copious and disastrous. With any luck, any experimentation with negative short-term interest rates will be limited and beneficial.
 Although it seems perverse that one would invest in a bond that has a negative yield, there are some incentives to do so. Even though the investor will lose money if the investor holds a negative-yield taxable bond to maturity, a tax-exempt bond with a nominal negative yield might have a positive yield, or at least a less negative one, after accounting for the present value of the tax savings that obtains over the term of the bond. Also, if negative short-term interest rates persist, or the economy falls into deflation, the price of the negative-yield bond should rise, and the holder can then sell it at a gain.
 If you haven’t yet seen Avengers: Infinity War, which was released in December 2018, I do not apologize for withholding a spoiler alert.