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Chapter 3 - Debt Financing

Some transportation projects or programs of projects are so large that their costs exceed available current grant funding and tax receipts, or would consume so much of these current funding sources as to delay many other planned projects. For this reason, when states and local agencies consider ways to pay for these large projects, they often look to financing the projects through borrowing. The most common method of borrowing is to issue municipal bonds. The bond issuance yields an immediate influx of cash in the form of bond proceeds. The state or local agency then retires its obligation by making principal and interest payments to the investors over time.

Although bond financing imposes interest and other debt-related costs, bringing a project to construction more quickly than otherwise possible can sometimes offset these costs. Delaying projects can impose costs that derive from a variety of sources: inflation, lost driver time, freight delays, wasted fuel, and forgone or deferred economic development. Any analysis of the financial costs and benefits of debt financing weighs the costs of borrowing against the economic, safety, and mobility benefits of completing the project sooner than would be possible with pay-as-you-go funding. In recent years, Federal policy makers have examined strategies under which Federal-aid funds can better support states that elect to accelerate projects through borrowing.

Repayment of bond financing necessitates a stream of future revenues, which can come from a variety of sources. A few examples of traditional options have included general state and local taxes, fuel taxes or vehicle-related fees, and toll receipts. In recent years, Federal law has expanded states' ability to tap Federal-aid highway funds as another potential repayment source: apportioned Federal-aid highway funds. In this variation of a grant anticipation note, states can pledge a share of future Federal highway funding toward payment of debt service on a long-term bond issue. Bonds repaid with future Federal funds are commonly referred to as GARVEEs, or Grant Anticipation Revenue Vehicles. The remainder of this chapter discusses pledges of future Federal-aid highway funds under the GARVEE financing mechanism.

3.1  Grant Anticipation Revenue Vehicles (GARVEEs)

GARVEEs permit states to pay debt service and other bond-related expenses with future Federal-aid highway apportionments.

What's New

While some debt service payments have been eligible for reimbursement from Federal-aid highway funds since the beginning of the modern Federal-Aid Highway Program in 1956, this opportunity was of limited practical use. For example, prior to 1995, states could use their apportioned Federal-aid highway funds to repay only the principal component of debt service on certain categories of projects, and interest costs were eligible for reimbursement only for some Interstate projects.

The NHS Act, which amended Section 122 of Title 23 to expand FHWA's bond reimbursement provisions, effected two significant changes:

• The NHS Act expanded the types of debt-related costs eligible for Federal-aid reimbursement to include interest expense for all projects, debt issuance costs, and the cost of purchasing commercial bond insurance.
• The NHS Act eliminated provisions that restricted the amount and timing of advance construction authorizations. The limitation was replaced with a requirement that advance construction projects be on the approved STIP, enabling FHWA to approve an advance construction project at any time.

The change to the advance construction provisions is explained in greater detail in the preceding chapter concerning the management of Federal funds.

The ability to convert advance construction in a future authorization period is critical to the GARVEE process. Under the former rules, it would have been necessary to obligate the Federal share of debt service payments within the bounds of available obligation authority. Under the new rules, it is possible to obligate Federal funds for debt service expenses over a longer period.

Candidate Projects and Key Requirements

Candidates for GARVEE financing are typically larger projects (or programs of projects) that have the following characteristics:

• They are large enough to merit borrowing rather than pay-as-you-go grant funding, with the costs of delay outweighing the costs of financing;
• They do not have access to a revenue stream (such as local taxes or tolls) and other forms of repayment (such as state appropriations) are not feasible; and
• The sponsors (generally state DOTs) are willing to reserve a portion of future year Federal-aid highway funds to satisfy debt service requirements.

GARVEEs Steps in the Process

State seeks approval for advance construction of GARVEE project(s). State makes election to receive reimbursements for construction or debt service. FHWA approves project as debt-financed project and executes project agreement(s). State issues bonds and uses proceeds for construction. State requests partial conversion of AC project(s) for semi-annual/annual debt service payments. FHWA obligates Federal funds for requested debt service payment. State claims reimbursement for Federal share of bond debt service and funds are paid to state account. State uses Federal-aid reimbursement for debt service on bonds.

In addition, candidate projects must be eligible for Federal-aid highway funding under one or more program funding categories for which advance construction is available. (Section 115 of Title 23 specifies these categories, and they are also listed in Section 2.1 of this primer.) The projects must also appear on the STIP.

In general, projects financed with the proceeds of a GARVEE debt instrument are administered in the same manner and are subject to the same requirements as other Title 23 projects. As discussed below, the primary difference relates to the reimbursement process.

Costs Eligible for Reimbursement

One of the important changes effected by the NHS Act was to broaden the types of debt-related costs eligible for reimbursement. Costs eligible for reimbursement now include the following:

• Interest payments and retirement of principal (including any capitalized interest) under an eligible debt financing instrument;
• Issuance costs (including but not limited to underwriters' discounts, rating agency fees, fees paid to financial advisors and bond counsel, and printing costs) and credit enhancement fees (such as bond insurance premiums); and
• Any other related incidental costs as determined by the Secretary (including ongoing trustee fee and audit costs).

Under certain conditions, capitalization from bond proceeds of a required reserve account or contingency fund may also be eligible for Federal-aid reimbursement.

Matching Requirements

Reimbursements on GARVEE-financed projects are subject to the same matching share requirements that attach to any other project funded from the same program category.

One of the more fundamental decisions for states structuring a GARVEE transaction is whether to match the Federal reimbursement of debt service up front (by, for example, reducing the borrowing requirements through a direct pay-as-you-go contribution toward project costs) or on a payment-by-payment basis. In the former case, it is acceptable for the state match to be provided as an in-kind match (under the flexible match provisions) or with toll credits. In the latter case, the state would provide its matching contribution on a nominal, current-year basis, with each debt service payment matched at the proper pro rata share.

As noted in a previous chapter, states cannot use tapered match on GARVEE-financed projects.

Eligible Issuers and Debt Instruments

By law, GARVEEs must be issued by a state, a political subdivision of a state, or a public authority. These categories include State Infrastructure Banks (SIBs) and 63-20 corporations¹ as eligible issuers. In cases where a SIB issues GARVEE bonds, reimbursement of debt service expense incurred by the SIB would not be viewed as SIB capitalization grants. Eligible financing instruments include bonds, notes, certificates, mortgages, leases, or other debt financing techniques.

Terms of the Transaction

The issuer of a GARVEE bond has significant flexibility in structuring the terms of the transaction. Coverage ratios, interest rates, the term of the obligation, the level of debt service reserves, and the use of bond insurance are all matters determined by the issuer and the credit markets. An additional consideration for any state contemplating a GARVEE issuance is the extent to which the state is willing to place claims on future Federal funding, as a GARVEE today means debt service tomorrow - and commitment of Federal monies that would otherwise be available to fund pay-as-you-go projects. Some states may need enabling legislation to issue GARVEEs; in some states, legislation includes clauses that place limits on the volume of GARVEE debt that can be issued.

Another key decision left to the state's discretion is how to structure the revenue pledge, leading to two major types of GARVEEs: non-recourse GARVEEs and back-stopped GARVEEs, each of which is described below.

• Non-Recourse GARVEEs - States may elect to pledge their obligations of future Federal-aid funds as the only security backing the Federal share of the obligation to investors. Because of the additional risk associated with any non-recourse financing, and in the absence of bond insurance, these issues may carry higher interest rates and therefore be a bit more expensive than recourse financings.

The market may also perceive risk when the pledge of future Federal-aid funds spans authorization periods. This is because there is no guarantee that the Federal highway program will be reauthorized at the end of the authorization period (such as TEA-21 which expires in 2003). Moreover, Section 122 makes it clear that a debt financing instrument's eligibility for reimbursement with future Federal-aid highway funding does not constitute a commitment, guarantee, or other obligation by the United States, nor does it create any right of a third party (such as an investor) against the Federal government for payment.

• Back-stopped GARVEEs - States may elect to pledge other sources of revenue as a back-stop for the future Federal-aid funds. In these cases, states have pledged a secondary source of revenues, such as state fuel tax revenues or local property taxes, to payment of debt service in the event that future Federal-aid highway funds are not available. This will generally result in lower interest costs on the bonds. The offsetting disadvantage of this structure, of course, is that it requires another source of revenue to be available for the back-stop pledge.

GARVEEs in Practice

When a project or a program of projects is selected for GARVEE financing, it must first be approved as a Federal-aid debt financed project(s). Discussions with bond counsel are always advisable during the process of identifying GARVEE candidate projects. FHWA approves only the project or program of projects to be debt financed, not the bond issue; the bond issue itself is under state authority.

FHWA approval must be received to designate the project(s) for advance construction under the appropriate funding categories, and the project(s) must appear on the STIP. At this time, FHWA also approves the project(s) for the GARVEE financing mechanism, and can provide advice on the finer points of the interaction between the GARVEE instrument and the Federal-Aid Highway Program. A method is then selected for matching the Federal contribution, either through an up-front non-Federal contribution or a payment-by-payment match. It is also possible for states to issue a separate series of bonds to satisfy the non-Federal matching requirement.

As illustrated in Figure 3.1, debt is issued by the state or its designated financing agent, and construction proceeds on the project(s) using proceeds of the GARVEE issue to fund eligible costs. Funds are obligated as debt service comes due, generally through the use of partial conversion of advance construction. PCAC is an especially appropriate technique, since debt service payments will spread out over a number of years and states will find it advantageous to consume only the necessary amount of obligation authority each year. Debt service payments can be sent to either a state-designated account or a trustee.

Figure 3.1 - GARVEE Bonds