Publications: Bureau of Public Debt Publishes Final SLGS Regulations

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On June 30, 2005, the Bureau of Public Debt of the U.S. Treasury published final regulations on U.S. Treasury securities of the State and Local Government Series (“SLGS”), issued under 31 Code of Federal Regulations (“CFR”) Section 344. The final regulations take effect for all SLGS subscriptions initially filed on or after August 15, 2005 (the “effective date”). The major negative impact of the new rules is to eliminate bond issuers’ ability to increase investment yield through early cancellations or redemptions, combined with new subscriptions on more favorable terms. On the positive side, the differential between maximum SLGS rates and current Treasury borrowing rates is reduced from 5 basis points below the Treasury rates to 1 basis point; all subscriptions and redemption notices will have to be filed automatically using SLGSafe, a web-based service that has been available on an optional basis since 2000.

What are “SLGS”? SLGS securities are a special series of U.S. Treasury obligations that the Bureau of Public Debt of the U.S.Treasury offers only to State or local government units, or other issuers of tax-exempt obligations, to assist in compliance with the federal “arbitrage” rules governing the investment of tax-exempt bond proceeds. The interest rate on SLGS securities is set by the purchaser in the subscription for the SLGS securities, up to maximums that are determined on a daily basis by the Treasury. The maximum rates for the various maturities are announced each day by the Treasury at 10:00 a.m. and are effective for subscriptions filed through 10 p.m. that day.

Negative Arbitrage Recovery. The final regulations will prevent a variety of practices that used SLGS securities to reduce negative arbitrage. In general, these practices relied on the fact that unlike market rates that fluctuate continually during the course of a trading day, the maximum SLGS rates, which determine the prices at which SLGS securities can be purchased or redeemed, do not change after they are published each morning. In fact, the prices can be predicted using market rates at the close of business the previous day and subtracting the 5 basis point differential. Issuers have been able to use the static nature of SLGS rates to move funds into and out of SLGS investments in ways that allowed incremental gains in the overall yield. The final regulations are intended to eliminate this opportunity.

Reinvestment Yield Restrictions. Thus, beginning on August 15th of this year, bond issuers must now certify that the yield on SLGS securities purchased with proceeds of the redemption of other SLGS securities or the sale of market securities will not exceed the yield at which the bond issuer redeemed or sold the other SLGS securities or market securities. The final regulations contain an example indicating that it is permissible to redeem SLGS securities prior to maturity, reinvest in short-term SLGS securities at a lower yield, and then purchase higher yielding market securities with the proceeds of the short-term SLGS securities at their maturity. The key to this example is that the “SLGS to SLGS” redemption moves to a lower yield, while the reinvestment of the proceeds of the short-term SLGS securities occurs at their maturity rather than at redemption prior to maturity.

Cancellations. The new regulations prohibit any cancellation of a subscription, except for cases in which the bond issuer establishes, to the satisfaction of the Treasury, that the cancellation is required for reasons unrelated to the use of the SLGS program to create a “cost-free option.” The final regulations also retain the penalty contained in the current regulations for the failure to settle on a subscription, which renders an issuer ineligible to subscribe for SLGS securities for a six-month period. The final regulations continue to provide the Treasury with the option to waive the penalty if the issuer settles after the proposed issue date and pays a late payment assessment generally equal to the interest that would have accrued on the SLGS security from the proposed issue date to the actual date of settlement plus an administrative fee.

Many industry groups objected strongly to the proposed restrictions on the flexibility of the program, arguing that it would be far less “user friendly” as a result. (Mr. Ritter is the original author of the SLGS program in 1972, chaired the NABL Task Force on the proposed changes). Only time and experience will determine whether the positive changes will outweigh these negatives.