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13 CHAPTER TWO FINANCING MECHANISMS--AIRPORT PRACTICES AND INNOVATIONS This chapter gives a high-level review of capital financing Interest Costs mechanisms used by airport operators. Although certain of these mechanisms may be commonplace at one airport, they The interest paid by airport operators to attract investors rel- may be innovative at another. Specifically, the following are ative to what other municipal enterprises pay is a measure discussed in this chapter: of the attractiveness of airport debt in the capital markets. Airport interest costs also reflect whether interest on the Airport access to credit, bonds is taxable for federal income tax purposes, is subject Types of airport bonds, and to the alternative minimum tax (AMT), or is tax-exempt (see Other forms of airport financing. Ways of Addressing Alternative Minimum Tax Issues). AIRPORT ACCESS TO CREDIT Insurability The cost to airport operators to access the capital markets is a The affordability of purchasing bond insurance to improve function of several key factors that determine airport invest- credit ratings and reduce interest costs is a third factor relat- ment quality: ing to the cost of airports accessing the capital markets. Bond insurance is an important means by which airports can reduce Bond ratings, their interest costs. That airport operators of all size cate- Interest costs, gories can afford insurance is a signal of creditworthiness in Insurability, and the capital markets. Although airport operators do not always Defaults. buy bond insurance, especially those with strong ratings, the overwhelming majority of the bonds issued since 9-11 have Airport operators are major and regular participants in the been insured. municipal bond markets. Figure 7 shows the value of state and local transportation-related financing transactions for 2000 Defaults through 2004. In addition to the value of financings transacted by airport operators, it shows the value of transactions by oper- The frequency with which airport operators have defaulted on ators of toll roads and highways, mass transit, and other modes bond issues is the fourth measure of the competitiveness of of transportation such as seaports, bridges, tunnels, and parking airports in the capital markets. By this measure, the compet- facilities. Airport financings are a significant share of the total, itiveness of airports is particularly strong. The airport industry second to transactions carried out by operators of toll roads and never experienced a single default. There have been several highways and, in some years, mass transit operators. instances of airline special facility debt defaults. Airport Bond Ratings TYPES OF AIRPORT BONDS Major investor services use rating systems to grade bonds Airport sponsors and operators issue various forms of bonds according to investment quality to inform potential investors to finance generally large-scale capital projects with long-term about the creditworthiness of specific types of bonds at specific debt. This section discusses the following types of bonds: airports. Figure 8 shows the distribution of bond credit ratings for airports of all hub sizes as of August 2006, for two types General obligation (GO) bonds of debt: (1) GARBs and (2) stand-alone PFC bonds. Despite GARBS the financial challenges airports have faced since September Bonds backed by PFCs 11, 2001 (9-11), airports remain financially sound. The three Bonds backed by customer facility charges (CFCs) major credit rating agencies--Moody's Investors Service, Bonds to be paid with future grants Fitch Ratings, and Standard & Poor's--have concluded that, Ways of addressing AMT issues on the whole, the airport system has performed well under Potential new tax credit bonds (TCBs) for baggage difficult circumstances. screening infrastructure.

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14 FIGURE 7 State and local transportation--Related financings. [(a) includes seaports, bridges, tunnels, parking facilities, and other transportation.] Source: Government Accountability Office, Federal Tax Policy, Information on Selected Capital Facilities Related to the Essential Governmental Function Test. General Obligation Bonds the bonds being issued, and so constitute a larger per- centage of the GARB for small airports issuing smaller GO bonds may be issued to finance airport capital improve- numbers of bonds. This makes GO bonds more attrac- ments, backed by general tax revenues of the city, county, or tive the smaller the bond issue is, and because smaller state that owns and operates the airport. Specifically, local gen- airports typically have smaller capital needs, GO debt eral tax revenues such as sales, income, or property taxes may is typically more attractive for them. be pledged as a source of repayment for GO bonds, although No coverage requirement--Airport operators are typi- the airport operator may actually pay debt service from airport cally required to maintain coverage of 1.25x or 1.35x; that sources, or, in rarer instances, general local taxes may directly is, the ratio of net revenues after paying operating costs to pay debt service on proceeds used to fund airport projects. annual debt service must be at least 125% or 135% to give investors comfort that their debt will be repaid. Because Some large airports such as Honolulu International Airport of the strength of GO bond credits, coverage is not pay debt service on outstanding GO bonds issued on their required, which can also save airport operators money. behalf by their airport sponsor (in this case, by the state of Hawaii); however, the bonds were generally issued decades ago and the outstanding balances are relatively small. GO General Airport Revenue Bonds bonds are currently a key financing tool for many small air- GARBs are traditionally the most commonly issued bonds for ports for several important reasons: airport infrastructure. Their credit rating is based on revenues Stronger credit with lower interest rates--GO bonds are generated at the airport from airline rates and charges, park- a stronger credit than GARBs, which are discussed later. ing, rental car operations, terminal concessions, other leases, GO bonds therefore result in lower interest costs for the interest, and any other revenues of the airport. Following the airport because the bonds are backed by the full faith economic downturn in 2000 and the terrorist attacks of 9-11, and credit of a city, county, or state that (1) has a much GARB credit ratings for several airports were downgraded, and larger and diverse tax revenue base than an airport's 19 of the 31 large-hubs carried negative outlooks (Aviation revenue base, and (2) can typically adjust tax rates often Infrastructure Innovative Financing 2002). The financial out- more readily than an airport operator can adjust airport look and accompanying credit ratings for airports have sub- rates and charges. However, in certain states voters must sequently steadily improved as airport operators have taken approve tax rate adjustments and/or issuance of bonds, many steps to manage their financial results, and as traffic which may make GO debt less attractive than GARBs. levels have returned to pre-9-11 levels. Lower issuance costs--GO bonds do not have the upfront costs of developing a separate indenture/ordinance, The remainder of this chapter discusses other types of getting bond ratings and insurance, and preparing fea- bonds that reflect innovations by airport operators and the sibility studies that GARBs have. These upfront GARB financial markets. Even within the category of GARBs various costs do not generally vary significantly with the size of innovations can be seen.

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15 a b FIGURE 8 Bond credit rating for all hub sizes as of August 2006: (a) General airport revenue bonds; (b) stand-alone PFC bonds. Use of sureties in lieu of funded reserves--Airport oper- and/or free cash held in a reserve to be used for any allow- ators historically funded required debt service reserves able airport purpose (allowable uses may need to be deter- from either available retained earnings (cash) or from mined by the airport operator's bond counsel, depending bond proceeds. Sureties can be obtained from the finan- on the provisions of its bond indenture or ordinance). cial markets either at the time of, or any time, after bond Use of intermediate and subordinate liens--It is increas- issuance, to be used in lieu of a funded reserve. Sureties ingly common for airport operators to issue bonds with a are recognized by the rating agencies, bond insurers, and lower pledge of airport revenues than its senior debt. Issu- investors as equivalent security to providing a funded ing intermediate and subordinate debt can reduce cover- reserve. The airport operator pays a fee at issuance, usu- age requirements and annual airline rates and charges. ally a percentage of the new or outstanding principal, The downside is that such liens typically require new and in the event that it is needed to pay debt service, the bond indentures or ordinances, which can add time and surety is drawn on. Use of sureties can reduce the size of costs to the issuance process (see, for example, Figure 9). a bond issue and therefore annual debt service by elimi- Interest rate swaps--Airports increasingly enter into nating the need to fund a debt service reserve account "over-the-counter" contracts with investment banks to

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16 FIGURE 10 ManchesterBoston Regional Airport. Revenue bonds under a swap agreement. Advance refunding (synthetic fixed)--Examples include operators of the airports in Atlanta and Man- chester, New Hampshire. Swaption for refunding--A swaption is a financial instrument granting the owner an option to enter an interest rate swap pursuant to certain agreed upon terms. Examples include the operators of airports serving Philadelphia, Portland (Oregon), Chicago funds to further manage coverage. (Midway), and Albany. FIGURE 9 SeattleTacoma International Airport. Use Forward hedge for new money--Examples include of subordinate liens to reduce debt service coverage and the Indianapolis Airport Authority and the Metropol- airline payments. itan Washington Airports Authority. Synthetic variable--Have been used by the operators "swap" or exchange a stream of interest payments for of airports serving Boston, Las Vegas, and Orlando. another party's stream. Each swap is a unique contract Basis swap--Also known as "floating to floating" between the parties and cannot be bought and sold like swaps, have been used by the operators of airports in securities or futures contracts. Interest rate swaps are nor- Cleveland, Las Vegas, and New Orleans. mally "fixed against floating," where an airport operator exchanges fixed-rate obligations for floating rate obliga- Passenger Facility Charge Bonds tions, or "floating to fixed," where the reverse happens. The principal amounts are not exchanged, and are referred Airport operators have increasingly issued bonds that either to as the notional principal (with the exception of basis include a pledge of PFC revenues and/or are to be repaid in swaps). Swaps are often used to hedge certain risks, for part or in full from PFC revenues. Approaches to leveraging instance interest rate risk (see, for example, Figure 10). PFC revenues include: By swapping interest rates, an airport operator is able to synthetically alter its interest rate exposures and bring Combined flow of funds--These bonds are a form of them in line with management's appetite for interest rate GARB, where the bonds are secured by an underlying risk. Forms of interest rate swaps include (Market Update pledge of airport revenues. Under this structure, PFC and Interest Rate Swaps Presentation, Oct. 18, 2005): revenues, or certain PFC revenues, are defined as air- Forward current refunding (synthetic fixed)--A fairly port revenues in the bond indenture. Combined airport common type of swap transacted by operators of revenues are then used to pay GARB debt service. airports such as Charlotte/Douglas International, This bond structure is used by the airports serving Jacksonville International, MiamiDade International, Albuquerque, Guam, and Orlando, among others. Sacramento International, Salt Lake City Interna- Advantages--it is relatively easy to incorporate into tional, and Wayne County (Detroit). an existing revenue bond indenture, and debt service

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17 coverage requirements can be lower relative to stand- Disadvantages--(1) PFC revenues are completely alone PFC bonds (i.e., 1.25x1.35x instead of 1.5x dependent on passenger volumes; (2) the bonds entail for stand-alone PFC-backed bonds). development of a new indenture or ordinance; (3) they Disadvantages--bonds issued under this approach require FAA termination protection and approval of the reduce the airport sponsor's GARB capacity, and bond indenture; (4) they require more rigorous tests and sometimes more importantly, may require airline sensitivity analysis; (5) they have higher required debt majority-in-interest approval. service coverage levels, typically 1.5x; and (6) they are Direct debt service offset--These bonds are another form not applicable to airports where the definition of airport of GARB secured by airport revenues. PFC revenues "Revenues" includes PFC revenues, or that pledges are used to pay all or a part of the GARB debt service, them elsewhere. but they do not secure the bonds. Debt service may be Convertible lien PFC bonds--Another concept is to included in the airline rate base if projected PFC rev- issue bonds initially secured solely by PFC revenues enues are not realized under this structure. This bond that subsequently convert to GARBs. To date, the only structure is used by the airports serving Albany, Austin, airport to issue such bonds is Broward County, which Cleveland, Denver, El Paso, Grand Rapids, and Provi- operates Fort LauderdaleHollywood International Air- dence, among others. port (see Figure 11). Advantages--they result in higher demonstrated debt service coverage relative to the combined flow of Bonds Backed by Customer Facility Charges funds structure, as PFC revenues directly offset debt service (the denominator in the coverage calcula- As discussed in chapter three, CFCs are collected by rental tion). Also, debt service coverage requirements can car companies from their customers at certain airports to pay be lower relative to stand-alone PFC bonds. operating expenses and debt service for consolidated rental Disadvantages--(1) they do not preserve GARB car facilities. As with PFC revenues, CFC revenues can be capacity, (2) they are not applicable to airports where structured in many of the same ways as the various forms of the definition of airport "Revenues" includes PFC PFC bonds. revenues, or that pledges airport revenues elsewhere, and/or (3) they may require airline majority-in-interest Combined flow of funds--These bonds have the same approval. characteristics, advantages, and disadvantages as PFC Back-up pledge of subordinate airport revenues--These bonds structured as a combined flow of funds. Exam- bonds are secured by PFC revenues with a back-up ples include the bonds issued for the consolidated rental pledge of airport revenue that is subordinate to a more car facility at Fort LauderdaleHollywood International senior lien on airport revenue. This bond structure is used Airport. by the airports serving Baltimore, Las Vegas, Nashville, Direct debt service offset--These bonds have the same and Sacramento, among others. characteristics, advantages, and disadvantages as PFC Advantages--(1) it enhances the creditworthiness of bonds structured with a debt service offset. No specific the bonds versus stand-alone PFC bonds, (2) it keeps examples of this type of CFC bond have been identi- the costs out of the airline rate base, (3) debt service fied; however, they could be implemented by interested coverage requirements can be lower relative to stand- airports. alone PFC bonds (i.e., 1.25x1.35x), (4) it preserves Back-up pledge of subordinate airport revenues--These the senior lien GARB capacity, and (5) it maximizes bonds have the same characteristics, advantages, and airport management control over airport financing disadvantages as PFC bonds structured as CFC bonds decisions. with a back-up pledge of subordinate airport revenues. Disadvantages--they are not applicable to airports No specific examples of this type of CFC bond have where the definition of airport "Revenues" includes been identified; however, they could be implemented PFC revenues or that pledges them elsewhere. by interested airports. Stand-alone PFC bonds--Issuance of bonds backed Stand-alone CFC bonds--These bonds have the same solely by PFC revenues has evolved since they were first characteristics, advantages, and disadvantages as stand- issued in 1994. Stand-alone PFC bonds have been issued alone PFC bonds. Examples include the bonds issued by the airports serving Boston, Chicago, Fort Lauderdale, for the consolidated rental car facility at Dallas/Fort Lee County (Fort Myers, Florida), Little Rock, New Worth International Airport. Orleans, Palm Springs, Portland (Oregon), Richmond, and Seattle. Single-Tenant Special Facility Bonds Advantages--(1) they preserve GARB capacity, (2) keep costs out of the airline rate base, and (3) max- Special facility bonds issued by a single tenant are used to imize airport management control over airport financ- finance unit passenger terminals or portions of terminals, ing decisions because they do not require airline hangar and maintenance facilities, cargo buildings, and ground majority-in-interest approval. equipment support facilities for the exclusive use of an airline.

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18 FIGURE 11 Fort LauderdaleHollywood International Airport. Passenger facility charge convertible lien bonds for airport expansion. The bonds are backed solely by an airline corporate pledge to Ways of Addressing Alternative Minimum repay the debt. According to a study by the FAA Office of Pol- Tax Issues icy and Plans, however, this form of financing has come under significant scrutiny as a result of recent airline bankruptcies and Under current tax rules, interest on private-activity bonds, defaults (Aviation Infrastructure Innovative Financing 2002). including most airport debt, is subject to the AMT, which was introduced in 1969 to ensure that top income earners paid For example, one airline rejected payment of its special their share of income taxes. Despite the public nature of most airport facilities and the public benefit derived from their use, facility bond obligations and discontinued use of its mainte- more than 60% of airport bonds currently can only be sold as nance facility at an airport. Another airline closed its mainte- private-activity bonds rather than as tax-exempt governmental nance facility that had been funded with special facility bonds. purpose bonds. Historically, the interest rate penalty for inter- est on bonds for which interest earnings are subject to the AMT Multi-Tenant Special Facility Bonds ranges from 16 basis points (0.16%) to 49 basis points (0.49%), depending on the status of tax reform proposals that would Special facility bonds have been issued to fund multi-tenant affect the AMT ("Airline Agreement Paves Way for Non-AMT terminals, fuel storage and distribution facilities, and consol- O'Hare Bonds" 2005) (see Figure 12). Another key problem idated rental car facilities, as discussed in chapter four. These with AMT debt is that under current law, governmental pur- bonds have greater credit strengths than single-tenant special pose bonds may be advance-refunded once and only once, at facility bonds because of the more diverse revenue base from any time 10 years after issuance, but airport private-activity multiple tenants and users. bonds are prohibited from being advance refunded. This elim-

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19 nal projects that are still considered not open to the pub- lic and therefore are to remain AMT funded. Many airports carried out multipurpose allocations to refund the portions of prior bonds associated with air- field projects that could be changed to non-AMT debt with lower interest rates. Denver International Airport is an example. However, some operators at airports with residual airline agreements were unable to get bond counsel concurrence because net revenues go back to signatory airlines, and the airports have differential rates for signatory and nonsignatory airlines. The city of Chicago addressed this problem by changing its airline agreement, as described in Figure 12. Reform of the federal tax treatment of airport bonds-- Airport operators have, for some time, discussed the need to reclassify airport private activity bonds that directly benefit the general public as governmental pur- pose bonds, similar to the way GO debt is treated under the tax code. The change in status would eliminate the AMT penalty that increases interest rates on the bonds FIGURE 12 Chicago O'Hare International Airport. Interest and allow advance refundings of airport bonds. savings using non-alternative minimum tax bonds. inates the ability of airport operators to realize interest savings Potential New Tax Credit Bonds for Baggage by refunding AMT debt when interest rates are lower. Screening Infrastructure Two key developments relating to AMT restrictions and A recent Baggage Screening Investment Study conducted on associated interest rate penalties are: behalf of TSA resulted in the recommendation that Congress adopt new legislation authorizing the use of a federal tax Multi-purpose allocation refundings--Historically, it has credit bond program for the capital costs of a baggage han- been possible for airport operators to issue "non-AMT" dling system and related infrastructure. (i.e., tax-exempt) debt with lower interest rates for park- ing facilities (as long as the airport's bond counsel con- Tax credit bonds (TCBs) involve the issuance of taxable curs), because such facilities are used by the public and debt by state and local governments or other non-federal enti- not private companies. A ruling by the Internal Revenue ties for designated capital purposes. As shown on Figure 13, Service a number of years ago clarified that airfield proj- bondholders receive annual tax credits that can be applied ects could be financed on a non-AMT (tax-exempt) basis, against their federal income tax liability instead of cash inter- which triggered multipurpose allocations to allocate prior est payments. The tax credit itself represents taxable income bond proceeds between airfield projects (to be refunded to the bondholder. Principal is repayable by the issuer from with non-AMT debt with lower interest rates) and termi- nonfederal sources. The bonds are generally structured as FIGURE 13 Tax credit bond mechanisms--Investor perspective (TSA).

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20 FIGURE 14 Tax credit bond mechanics--Airport issuer perspective (TSA). "bullet" term bonds, where the principal is repaid in a lump The TCBs could be on parity with an airport's traditional sum at bond maturity. TCBs are generally structured as bullet revenue bond indebtedness or issued on a subordinate or term bonds to maximize the value of the tax credit, and the stand-alone basis. Possible pledged revenue streams include issuer makes periodic deposits to a sinking fund to provide one or more of the following: for principal retirement at maturity. General airport revenues from airline rents and fees Figure 14 shows the issuer perspective. Unlike other fed- and nonairline sources, as is the case for traditional eral tax credit programs oriented to equity capital (such as tax GARBs. credits for investments in low-income housing), TCBs do not PFC revenues, as is the case for stand-alone PFC-backed require the project sponsor to be the "consumer" of the tax bonds and double-barrel bonds backed by PFC revenues credit. Instead, this form of tax subsidy encourages private and general airport revenues. investment in desired infrastructure through lower-cost debt General local governmental resources such as sales capital for the issuer. and property taxes, as is the case for general obligation As shown on Figure 15, TCBs provide a substantial sub- municipal bonds issued to fund airport projects (more sidy to the issuer, as the interest expense can represent common for small- and non-hub airports than large- and 50% to 80% of the effective cost of long-term borrowing. medium-hub airports) The extent of the subsidy depends on the term (maturity) of the bonds and the interest (credit) rates. The longer the Airport participation in the TCB program would be entirely term and the higher the interest rates the greater the sub- voluntary. It is anticipated that large- and medium-hub air- sidy level. ports, which frequently access the capital markets to raise FIGURE 15 Tax credit bond mechanics--Airport sinking fund (TSA).