Debt service reserves are cash assets set aside by a borrower to ensure that bondholders are paid in whole and on time. Debt Service Reserve Funds (DSRF) have been utilized to fund debt issues by private firms and government bodies for many years.
The reserve funds add to the security of a bond indenture, lowering the risk premium, or the amount of interest sought by investors.
The greater repayment security given by the reserve fund will be reflected in a higher rating, which correlates with a lower risk of default, if the bond is assessed by an independent agency.
Grantees’ out-of-pocket debt issuance expenses may be reduced as a result of the reserve fund’s improved bond rating.
How Debt Service Reserves Work
An agency must first issue bonds before establishing a debt service fund. The debt service reserve fund can be funded using proceeds from bond issuance or with a deposit from the issuer. The average reserve fund is equivalent to around one year’s worth of debt service payments. After funding the reserve, the agency can apply to FTA for reimbursement of up to 80%.
The Debt Service Reserve Program
The section 5307 DSRF pilot program was repealed under section 5323(d)(4) with the passage of the Moving Ahead for Progress in the Twenty-First Century Act (MAP-21) legislations on October 1, 2012. However, MAP-21 keeps section 5309 funds available for DSRFs, but it eliminates the Bus and Bus Facilities and Fixed Guideway Modernization categories and replaces them with a new Fixed Guideway Capital Investment Grant Program that funds New Starts, Small Starts, and Core Capacity Improvement projects. Section 5309 funding directed to these types of projects can now be utilized to pay a public transit operator for constructing a DSRF, starting on October 1, 2012.
FTA submitted a report to Congress in September 2008 detailing the agency’s implementation of the Debt Service Reserve Pilot Program.
The report can be seen on the FTA website’s Reports to Congress page.
How does a debt service reserve account work?
The Debt Service Reserve Account is a cash reserve that serves as an extra security precaution for the lender by ensuring that the borrower has funds available for the next x months of debt service. It’s usually a deposit equal to a number of months’ worth of predicted debt service obligations. The aim for the Debt Service Reserve Account is usually six or twelve months of debt service.
A DSRA is used to offer a cash buffer when the cash available for debt service (CFADS) is less than the planned payments. This buffer provides some breathing room for operational concerns to be remedied and/or the debt to be restructured in more extreme scenarios before the borrower defaults.
Operation and funding of debt service reserve account
In most cases, the DSRA is funded up to a dynamic goal balance. The interest and principal payback amounts are included in the DSRA’s goal balance. It might be three (3), six (6), nine (9) or twelve (12) months, or even a preset amount.
The term sheet normally specifies the funding strategy for the establishment of the DSRA (initial funding of the DSRA), which could be one of the following:
- Partially funded on the last day of construction, then funded from the project’s cash flow; or, partially funded on the last day of construction, then funded from the project’s cash flow.
DSRA Target
The target balance is calculated using bank terminology and is based on projected debt service. By comparing the target balance to the DSRA Opening Balance, target deposits / (withdrawals) are computed.
Modelling DSRA in project finance model
Linking the formula inside various components of the project’s cash flows and the DSRA itself is required when modeling the mechanics of a DSRA. Essentially, cash inflows and withdrawals are used to represent the DSRA, as seen below:
- Cash flow funding: This is funding that comes from the project’s cash flow (using cash on hand to fund the DSRA) to get the DSRA up to the desired balance.
- Release to cash flow (distress): This is the cash flow released from the DSRA’s available balance to cover the CFADS shortage.
- Release to cash flow (extra cash released): This is the amount of money released by the DSRA to bring the balance down to the target level, which includes the release on ultimate maturity.
Interest is often earned on the DSRA’s opening balance and recognized in the same way that interest on cash balances is in the cash flow waterfall.
Position of DSRA in the financial statements
The cash available to finance DSRA is ranked after debt servicing in the cash flow waterfall, but it takes precedence over any payments to equity, providing additional security for the lenders. The cash inflows and outflows from DSRA are linked to the cash flow waterfall, and the DSRA’s closing balance is included in the balance sheet’s current assets.
Tips to keep in mind when modelling DSRA
- The amount of money used to top up the DSRA/c from the project’s cash flow should not exceed the amount of money available to support the DSRA.
- Aside from the initial funding and final release, all other DSRA movements should be modest in the base case.
- At the end of the loan term, the DSRA balance should be zero, and it should steadily decrease in the months preceding up to that point.
- During a period of distress, release from the DSRA should only be adequate to maintain a DSCR of 1.00x.
What is debt reserve current account?
- When the cash flow available to service debt is insufficient, the Debt Service Reserve Account (DSRA) is used to make debt repayments.
- The DSRA is a safety net that offers borrowers time to deal with a shortage of cash flow to service debt and keeps them from defaulting.
- In project finance, the DSRA target and funding mechanism are critical, and information can be found in the project term sheet and credit agreement.
Is Dsra a restricted cash?
If you’re seeking for project funding, you’ll almost certainly need a Debt Service Reserve Account (DSRA).
A debt service reserve account (DSRA) is a restricted bank account into which money are deposited to cover periods of low cash flow and ensure that your debt service (interest + principal) is paid without going into default owing to temporary liquidity concerns. The commercial details of each contract are negotiated individually, but as a rule of thumb, the target balance is normally six months’ worth of debt service in the future.
Excess returns (above projected) will please equity holders; however, lending banks are less concerned. The fundamental concern of the banks is whether the borrowed funds can be returned. They do not share in any extra profit that belongs to equity investors; instead, they are concerned with their own return, which is frequently fixed.
As lenders, banks must now ensure that they receive a return on their investment. This is the same situation as with equity holders. The banks, on the other hand, are paid a predetermined rate of return, while equity holders, broadly speaking, are paid any extra return.
The fundamental reason why a DSRA would not be attractive to everyone (especially equity investors) is that money is locked up. Cash is not free; it has a cost, and while keeping cash on your balance sheet earns you interest, the interest rate is often lower than the project’s equity rate of return. The same is true for a funded DSRA: if the project firm borrows money to fund the DSRA, the lending rate is often substantially higher than the DSRA’s interest earning rate.
As a result, the equity IRR suffers, which is why settling the DSRA usually necessitates lengthy talks. As a result, equity holders will want to keep the amount as low as feasible, whilst banks will want it as large as they believe is required to provide payment certainty.
The opening balance, cash inflows, cash outflows, and closing balance of a DSRA are often modelled as a control account. At Commercial Operations Date, the project company establishes it (COD).
One row releases funds from the DSRA when they are needed to pay off senior debt, and one row tops up the account when it falls below its goal level, or releases funds if the account is overfunded.
What is a debt service escrow?
The Escrow is intended to provide the Borrower with a reserve to cover debt service payments on the Loan, as well as additional Project obligations specified in writing by HUD, as needed to ensure the Project’s financial viability. Lender will hold the Escrow in line with the Program Obligations.
What is difference between current and savings account?
A savings account is one in which you deposit money and receive interest on it, whereas a current account is one in which you deposit money to conduct business operations.
What is a good current account balance?
- The balance of payments’ current account comprises a country’s main activities, such as capital markets and services.
- Because the current account balance should theoretically be zero, which is impossible, it will reveal whether a country is in surplus or deficit in actuality.
- A surplus indicates that a country’s economy is net creditor to the rest of the globe. A budget deficit indicates that the government and economy are net debtors to the rest of the world.
- Goods, services, income, and current transfers are the four key components of a current account.
What is the difference between current account and capital account?
A country’s balance of payments is divided into two parts: current and capital accounts. The current account shows a country’s net revenue over time, whereas the capital account shows the net change in assets and liabilities during a given year.
In economic terminology, the current account is concerned with cash receipts and payments as well as non-capital items, whereas the capital account is concerned with capital sources and usage. In the balance of payments, the sum of the current and capital accounts will always be zero. Any current account surplus or deficit is matched and cancelled out by an equal current account surplus or deficit in the capital account.
What are gearing ratios used for?
- Gearing ratios are a set of financial indicators that relate shareholders’ equity to business debt in a variety of ways in order to analyze the company’s leverage and financial stability.
- Gearing is a measure of how much of a company’s activities are funded with debt as opposed to stock from shareholders.
- When compared to the gearing ratios of other companies in the same industry, gearing ratios become more meaningful.
Where is debt service financial statements?
DSCR Income Statement (Example 1) In this case, it is $600 million. Because the entity must pay interest and principal, the debt service will often be lower than the operational income. It is the amount paid for a security or bond at the time of purchase, excluding any interest earned.
Can Dsra be part of project cost?
The funding of the debt service reserve account upon construction completion is included in the project’s CAPEX as part of the financing costs, although it is normally not included in the project’s fixed assets.
