New Fiduciary Instruments

The municipal bond market traditionally has been supported by large institutional investors, such as fire and casualty insurance companies. In the late 1970s, however, faced with reduced profit margins, many of these institutions curtailed their municipal bond buying, forcing tax-exempt bond yields to unprecedented highs. Interest costs increased significantly as bond issuers were forced to make yields more attractive to buyers. Investors were unwilling to lock into fixed returns, feeling uncertain about inflation, tax liabilities, and yield curves. Governments still needed to borrow, however, and investors still needed to earn returns. As a consequence, a number of new fiduciary and fiscal instruments have been devised to meet these respective needs.

Stepped Coupon Bonds

In traditional serial bonds, each maturity has a single coupon rate payable over the life of the bond. Stepped coupon bonds, on the other hand, use a serial maturity schedule, with coupon rates that start at lower levels and progressively increase to higher levels, even though all the bonds in the issue are sold at par. Stepped coupon bonds are particularly applicable to the financing of projects requiring that interest payments be made from project revenue.

The substantial increase in coupon payments each year is intended to provide the investors with a hedge against inflation and thus make the bonds more marketable. The assumption is that, as the purchasing power of paper money goes down each year, stepped coupons give bondholders more paper money to keep pace with inflation.

From the perspective of the issuing government, because of the lower coupon rates, more bonds may be scheduled to mature in early years, thereby lowering the average life of the issue. For example, if the repayment schedule for the principal on the $1.3 million bond issue shown in Exhibit 8 were reversed, so that the initial payment were for $210,000, the second year payment for $190,000, and so forth, the Jefferson County Council could save $83,548 in interest costs and the average coupon rate would be lowered to 4.02%.

Zero Coupon Bonds

Zero coupon bonds (also called "zeros") were introduced into the tax-exempt bond market in the late seventies and quickly became a "hot item" in public finance. As a form of original investment discount bonds, they are especially favored by individual bond buyers. Zero coupon bonds may be issued as either general obligation bonds or as revenue bonds.

Zero coupon bonds sell at substantial discounts from the customary face, or par, value of $1,000 because they pay no interest. By paying par upon maturity, however, they offer capital gains that may be as much as 25 times the original investment, depending on the length of the issue and the equivalent rate of return on the original investment. For example, single-family mortgage revenue bonds, issued in 1982 by the Virginia Housing Development Authority, were priced at $250 per $1,000 maturity amount, for an annualized yield of 11.83 percent at maturity in 1994. The Virginia issue also included bonds priced at $100 yielding 12.45 percent in 2001, as well as some priced at $20 yielding 12.58 percent in 2014.

Federal tax laws entitle bondholders who forego tax free income over the life of their investment to receive tax-exempt capital gains upon maturity. The result is a sort of tax-free income, accrued annually from the time the bonds are first issued. Held to maturity, for example, a fifteen-year zero coupon bond purchased for $315 will provide a tax-free capital gain of $685; or, according to the IRS, $45.67 in tax-exempt income each year ($685 divided by 15). These earnings are the equivalent of an 8 percent compound interest on the original investment.

Zero coupon bonds may be attractive to investors who are interested in investing for a future need, such as college for their children or retirement. Since the interest on a zero coupon bond in essence is automatically reinvested in the bond, this type of bond may appeal to investors who expect future interest rates to decline or want the convenience of not having to deal with how to invest their returns. Governments are able to delay interest payments until the final maturity.

The proceeds of a zero coupon bond are less than its face value, it is necessary to issue a larger par value when using zero coupon bonds. From the municipality standpoint, issuing zero coupon bonds means that a much larger face value (value at maturity) must be issued. For example, if the objective were to obtain $20 million from 15-year zero coupon bonds sold at $315 per $1.,000 face value, the municipality would have to issue bonds which at maturity would be worth $63,492,063 (i.e., $20 million divided by $315 x $1000). Debt limits usually apply to the par value of bonds, and therefore, zero coupon bonds usually use the same level of debt capacity as a non-zero coupon bond for the same amount, yet result in less bond proceeds because they are sold at a discount. Since all interest is paid at maturity, the issuer must have substantial funds available for what is effectively a balloon payment.

Brokerage firms have bought traditional coupon-bearing, long-term issues and have stripped the coupons from the bonds. Each component is then sold separately. In effect, the bond becomes a zero coupon bond, with the guarantees of the issuing public agency. Without coupons, the value of what is called the corpus is much reduced. For example, a 14 percent corpus, maturing in the year 2011 could have been bought in the early 1980s for about $40 per $1,000 bond face amount, providing an annual yield to maturity of 11.5 percent compounded. In other words, over thirty years, each $40 invested would increase about 25 times to maturity in the year 2011.

Compound Interest Bonds

Compound interest bonds (also called capital appreciation bonds, accumulators, or municipal multiplier bonds) are sold at par. The interest component is held by the issuer and compounded at a stated rate so that the investor receives a lump sum, consisting of both the principal and interest, at the bonds' maturity. Unlike zero coupon bonds, which sell at a discount, these bonds sell at face value. However, an investor in compound interest bonds still pays much less for the bond than it would be worth at maturity. For example, a 10-year bond with a face value of $1,000, earning at a compound interest rate of 6%, would be worth $1790.85 at maturity, or worth $1,877.14 at maturity if earning at a compound interest rate of 6.5%.

The main advantages of these bonds over regular coupon bonds is that an investor knows exactly what the total return on his or her investment will be. With a traditional coupon bond, the bond holder must reinvest the semi-annual interest at the then prevailing rate, thus making the total return uncertain. Compound interest bonds guarantee the current rate of return for the duration of the issue--as much as fifteen to twenty years. This type of bond combines the investment multiplying power of compound interest with the income sheltering feature of traditional tax-exempt bonds.

As with zero coupon bonds, the interest on a capital appreciation bond is reinvested in the bond, making this type of bond particularly appealing to investors who expect future interest rates to decline. However, if interest rates are expected to increase, investors may be reluctant to invest in zero coupon bonds and compound interest bonds.

For an issuer, the greatest advantage of compound interest bonds relative to zero coupon bonds is a legal one. Since debt limits usually apply to the par value of bonds, capital appreciation bonds and zero coupon bonds with the same par value will utilize the same debt capacity. However, the compound interest bonds will result in more bond proceeds since zero coupon bonds are sold at a discount. Thus issuers who are approaching a debt limit may find compound interest bonds to be more desirable than zero coupon bonds. However, since all interest is paid at maturity, the issuer must have substantial funds available for what is effectively a balloon payment.

Payments to a sinking fund must be structured to earn a sufficient sum to cover the "appreciated capital," that is, the accumulated interest and principal costs. At some point during the life of the bond, the issuing jurisdiction may begin to make interest payments to the bond holders. The total annual payments are higher, however, because interest must now be paid on the interest that has accumulated as additional capital (principal). It has been estimated that a capital appreciation bond can cost the municipality 2.5 times as much in annual sinking fund payments when compared to a more conventional term bond where only the principal payments are deferred (and paid in a lump sum when the bonds mature).

The annual payments to a sinking fund (earning 4.5%) for a compound interest bond with an annual rate increase of 6% are shown in Exhibit 10. Note that these annual payments are $18,345 higher than the annual sinking fund payments required to service a zero coupon bond under the same assumptions (see Exhibit 9).

The often stated justification for the use of compound interest bonds is that the cost impact of the capital improvement is deferred until the more direct beneficiaries of the facility can participate in the payment of these costs (e.g., through increased tax revenues). The impact of the additional interest costs (the interest on the "appreciated capital") can be partially absorbed if the investments in the sinking fund are carefully managed. Misuse of this bonding strategy, however, can create a floating debt of significant proportions.

Flexible Interest Bonds

The idea of issuing tax-exempt bonds with a floating interest rate has been adapted from the Eurocurrency market. This approach provides stability for both the issuer and the bondholder throughout the life of the bonds, particularly during times of interest rate volatility. As the name implies, the yield (interest paid by the issuer) on a flexible interest bond changes over the life of the bond, based on some interest index printed on the bond itself. This feature stands in contrast to the traditional fixed-rate bond whose interest rate remains constant but whose market value may change when interest rates rise or fall.

Since flexible interest bonds have less risk of principal erosion, interest costs are lower than on long-term, conventional bonds. The savings in interest costs to the issuer can be very substantial; the difference between a traditional bond and a flexible interest bond is often as much as 3 to 3.5 percent.

The interest index most often used is the average weekly rate of Treasury bills or bonds issued during the preceding interest period. For example, the floating rate for a short-term bond might be pegged at 67 percent of the average weekly T-bill quote, while the rate for a longer term issue might be set at 75 percent of the average weekly quote on thirty-year Treasury bonds (see Exhibit 11).

An additional feature of flexible interest bonds is a swing limits--a pre-established range within which the interest (cost to the public agency) may vary. Bonds issued in the late 1980s, for example, had floating interest rate limits of 7 percent minimum to a maximum of 12.5 percent over the life of the bonds.

As with other municipal bonds, the maturities of flexible interest bonds vary. Such bonds usually have call and/or put features. These specify the earliest dates at which the bondholder can get his/her money back at par. Some recent flexible interest bonds have been structured so that they can be redeemed at the end of a given calendar quarter. Flexible rate certificates issued by the state of Washington, for example, pay interest each month, and bondholders may elect on the 15th day of each month in which the interest payments are due, either (1) to accept a new interest payment date at the same rate as the previous month, or (2) to tender the bonds for purchase by the state at par. Although they are basically bonds, floating rate bonds with short demand features are often called notes or certificates of indebtedness.

Since flexible interest bonds have less risk of principal erosion, interest costs are lower than on long-term, conventional bonds. The savings in interest costs to the issuer can be very substantial; the difference between a traditional bond and a flexible interest bond is often as much as 3 to 3.5 percent.

Variable Rate Demand Bonds

Variable rate debt first gained popularity during the 1970s as short-term, variable rate demand notes. However, long-term, variable rate demand bonds also have become popular in the last few years. The interest rate on these bonds is reset periodically (ranging from daily to annually) to market rates applicable at that time, based on a specified index. The bond contract states the method of resetting the rate, including the amount, timing, and limits. The demand feature allows the investors to require the issuer or a specified third party to purchase the bonds at specified times, such as when the interest rates are reset. In exchange for a lower yield, variable rate bonds provide investors protection against the possibility of price declines intrinsic in fixed rate long-term bonds. The bond issuer obtains a lower, short-term rate, while avoiding the problem of the bonds being put back under unfavorable circumstances.

The most common variable rate bond is the "lower floater" in which the interest rate is adjusted weekly relative to a specified index that reflects the current market. [2] Holders of lower floater bonds can require redemption of the bonds after seven-days notice. A put option that can be exercised in fewer than 30 days, such as the lower floater, is called a continuing put. Other debt structures allow different timetables for putting the bonds; these vary from monthly to multi-year demand obligations. Usually, the remarketing agent has the flexibility to set the interest rate within a range of the index in order to allow the bonds to trade at par. Variable rate bonds provide investors long-term instruments which will always sell around par, making them popular with tax-free money market accounts, as well as individual investors. In return for a security always worth about par, the investor accepts fluctuating income. In times of declining interest rates, the investor's income will decline (and this decline could be quite significant).

The structure of long-term, variable rate demand debt involves a rather complicated credit system. The issuer usually enters into an agreement with a credit facility, typically a commercial bank. The bank provides the debt issuer with a letter of credit. Should bondholders exercise the put option and redeem the bonds before maturity, the issuer enlists the services of a remarketing agent. The remarketing agent resets the interest rate and then tries to remarket the bonds. If after this process some bonds remain unsold, the issuer's remaining cash needs are met by the agreement with the credit facility, which either purchases the unsold bonds or makes a loan to the issuer. The issuer must pay the fees associated with the remarketing agent and the credit agreement. If the credit facility has to provide cash, the issuer also will incur interest on the funds which typically is tied to the bank prime rate or higher. [3]

Bond rating companies use a two-part bond rating approach for variable rate demand bonds. The first component of the rating, referred to as the credit rating, focuses on the creditworthiness of the issuer to meet debt service requirements over the life of the bonds. The second component, the liquidity rating, reflects the ability of the issuer to make timely payments under the demand feature. The latter is usually based on the rating of the bank that supplies the letter of credit.

Caps, Floors, and Collars

Issuers of variable rate demand bonds face the possibility that interest rates may increase in the future. To help mitigate the consequences of an increase in interest rates, a system of caps, floors, and collars has been developed. Caps, floors, and collars are derivative products that allow municipal bond issuers to avoid fluctuating interest rates on their variable rate debt. With these instruments, issuers can maintain their interest rate payments within set boundaries.

Under an interest rate cap (also called a ceiling), in exchange for a one-time premium from the bond issuer, a third party agrees to pay the issuer if a specified interest rate index rises above a certain percentage rate, known as the cap or strike rate. The premium depends on the bond maturity date and usually is in the form of basis points on the notation principal, the size of the contract upon which interests amounts are determined. The more distant the maturity date, the larger the principal, and the lower the strike level, the larger the up-front fee. If the floating interest rate remains below the strike rate for the duration of the contract, the cap purchaser receives no payments. In effect, the bond issuer is buying an insurance policy to protect against high interest rate payments on its variable rate bonds. [4]

Under a particular cap agreement, for instance, the issuer might buy a cap with a strike rate of 4 percent. If the applicable tax-exempt bond index, such as the Public Securities Association (PSA) index, stays at 3.5 percent, the issuer receives no payments, but if the index rises to 4.25 percent during the term of the agreement, the issuer would receive .25 percent from the counterparty.

In calculating the cost-effectiveness of purchasing a cap, the bond issuer must compare the required up-front fee to the expected present value payments to be received under the cap. A risk averse issuer, however, may value the security of a known limit on debt payments enough to warrant a purchase of a cap even though its premium may exceed expected payments under the cap. [5]

A floor is the mirror image of a ceiling. With a floor contract, the bond issuer receives an up-front fee from a third party. If the interest rate index falls below the floor or strike level, the issuer makes payments to the third party. Similar to a cap agreement, if the floating index rate does not fall below the strike level, the issuer pays nothing. [6]

Under the terms of a particular floor agreement, if an issuer sold a floor with a strike price of 3 percent and the J.J. Kenny Index dropped to 2.5 percent, the issuer would pay the counterparty an amount based on the 0.5 percent difference.

In entering into a floor agreement, an issuer compares the up-front premium it receives with the payments it must make if the floating interest rate falls below the strike level. The issuer may bet that it can keep a premium without making any payments. A counterparty buys a floor if it predicts that interest rates will fall, and it can recoup on the contract. [7]

A collar is the simultaneous purchase of a cap and sale of a floor by the issuer. Under this contract, the government entity trades any benefits from a potential fall in the interest rate index for protection against excessive interest rates. Under a collar agreement, the issuer defines a specific range for its interest rate payments, eliminating some of the uncertainty associated with issuing variable rate debt. The closer the cap and floor strike rates are set, the more the bonds will resemble fixed rate obligations.

The collar costs the issuer less than a cap, but still sets a limit on future debt service payments. An issuer may elect to enter into the floor provision of the collar with the goal of offsetting the cost of the cap part of the agreement. The cap and floor levels of the collar agreement can even be determined so that they perfectly offset each other.

The main advantage of caps and collars is the protection they offer against rising interest rates. They can provide an issuer the stability associated with fixed rate debt, while allowing the issuer to take advantage of the lower interest rates often associated with variable rate debt.

Four types of risk are associated with caps, floors, and collars:

o The issuer is exposed to the credit risk of the counterparty--it may default on payments owed. This kind of risk, of course, only materializes when the contract is "in-the-money," that is, when the interest rate index rises above the strike level.

o Rollover risk occurs when the term of the bond does not coincide with the term of the derivative agreement. Rollover risk refers to the possibility that the issuer is unable to enter into a satisfactory new contract when the original one expires.

o Basis risk takes place when the interest index tied to the derivative contract does not exactly match the interest rate on the underlying variable rate bonds. This risk sometimes develops when the issuer's credit rating is downgraded.

o Market risk refers to the possibility that the issuer's remarketing agent will not be able to locate a buyer for variable rate bonds. If the bond issuer has contracted for a cap or a collar to hedge variable rate risk, the issuer will be "over-hedged" if the bonds do not remain outstanding. [8]

In addition, the issuer and counterparty may incur risk if they make assumptions or predictions about interest rate levels or the steepness of the yield curve that prove wrong. Caps and collars become more valuable under times of interest rate volatility, the measure of the amount of change expected in the future. Also, as the yield curve steepens, caps become more valuable. [9]

According to a 1994 survey by the Government Finance Officers Association, only approximately 6 percent of the municipal issuers had used derivative products in connection with bond sales. More than one-third of those issuers being from California and Florida. About 17 percent of these derivative users had entered into caps, floors or collars, with 5.5 years as the average term of contract. Reasons for entering into derivative agreements cited by users include: lower borrowing costs, the need to lock-in current interest rates, the decrease in interest rate risk, and the reduction of debt service uncertainty. [10]

Callable Bonds

Bonds may be issued with the provision that they can be paid off--"called in" for payment--prior to their maturity date. Virtually all bonds are now issued with a "date of first call" provision, after which the issuer can choose to retire the bonds before the stated maturity date. In general, the date of first call for municipal bonds is 5 to 10 years after the date of issue. The call provision normally is exercised with appropriate notice only on interest payment dates. Callable bonds can afford greater flexibility in the jurisdiction's debt structure. Bonds may be recalled and refunded at more favorable terms if (1) the market or the jurisdiction's credit rating improves, (2) the initial retirement schedule proves too rapid, or (3) a period of declining revenue is encountered. The callable feature can be used to avoid overly rigid fiscal responsibilities, while at the same time permitting more rapid retirement if the project's revenue capacity expands. Terms of the call will dictate whether the issuer must pay a premium to investors. A premium for callable bonds may erode any resulting savings from refunding.

A variation on the callable bond has been used primarily in conjunction with mortgage revenue bonds used to finance low income housing. A bond holder may purchase such bonds with the expectation of holding them for 8 to 10 years. But as rental income from the housing units reaches pre-determined thresholds, the authority is required to call in some portion of the outstanding bonds for early payment at face value. The bonds are redeemed by lottery: the individual bondholder does not know when or if his/her bond will be called in for redemption.

Tender Option Bonds

A tender option bond, also known as a put bond, offers the investor the option of submitting the bond for redemption before maturity. Usually the investor may redeem or "put in" a bond five years after the date of issue or on any anniversary date thereafter. In return for this option, the investor accepts a lower yield. The issuer pays a lower rate of interest (usually about 1 percent less than for conventional bonds of the same maturity), and consequently, the jurisdiction's cost is lower. However, the bond returns more to the investor (about 0.75 percent) than conventional bonds that mature on the first prescribed put date.

Tender option bonds may also be issued with a simultaneous call date, on which the issuer can call in and pay off the bonds. Thus, the issuer and the bondholder have equal rights to cash in the bonds when market conditions and interest rates are favorable. If interest rates go down, a put bond will probably be called in by the issuing government. Conversely, if interest rates go up, the bondholder can "tender his option" to be paid at face value by the issuer.

A variation on the tender option bond approach has been used primarily in conjunction with mortgage revenue bonds used to finance low income housing. Instead of offering a "put" option, the issuer is required to call in the bonds for early payment at face value as sufficient funds become available. Thus, for example, a bond holder may have purchased such bonds with the expectation of holding them for 8 to 10 years. But as rental income from the housing units reaches pre-determined thresholds, the authority is required to call in some portion of the outstanding bonds. The bonds are redeemed by lottery: the individual bondholder does not know when or if his/her bond will be called in for redemption. When all the bonds to be called from this fund are lumped together, the maturity is referred to as a super-sinker.

Detachable Warrant Bonds

A warrant gives the holder the right, at some future date, to purchase more of the same securities to which the warrant is attached, at the same price and rate of return as the original bond. In exchange for that right, the issuer pays a lower rate of interest (about one-half percent less) than offered on otherwise comparable securities. The marketability of such bonds depends on the opinion of prospective buyers as to anticipated fluctuations in interest rates. If interest rates rise, the savings to the issuer become real because of the initial lower interest cost. If the rates fall, the opposite is true.

The Municipal Assistance Corporation of the City of New York issued the first public tax-exempt detachable warrant bonds in 1982. These bonds gave the holders warrants that could be exercised for two years. The expectation was that, even if interest rates declined during the two-year period, the savings from the lower interest payments over the life of the bond issue would amount to about $11 million. Since interest rates held relatively constant during this period, the long-term savings will likely be even greater.

Private Activity Bonds

A private activity bond is a municipal bond, used either entirely or partially for private purposes, which must meet the test of qualification outlined within federal tax law to obtain tax-exempt status. To qualify as a private activity, tax-exempt bond, the debt must fit into one of the seven categories outlined below, meet volume cap requirements, and satisfy several other requirements outlined in section 147 of the statutes.

Tax-exempt bonds offer private entities lower interest rates than they would otherwise be able to obtain. Private use may result from ownership or leasing of financed property, a loan of proceeds, or other actual or beneficial use of financed property under a management or incentive payment contract, output contract, or other arrangement. The private business use of allocated proceeds is determined according to the annual use of the facility beginning with the issue date or the date the facility was placed into service. A government can use private-activity bonds to give economic incentives to targeted activities or geographic areas. Some economists believe that the incentive given by tax-exempt status through private- activity bonds creates positive economic effects beyond the specific project or program that is being financed.

The purpose of private-activity bonds must be defined specifically and must be used according to the limitations of the state and federal statutes. The numerous and strict limitations on private activity bonds make them inflexible. Changes in their purpose may make them taxable. Volume caps limit the availability of private activity bonds. Each state's cap is determined by a formula computed as the greater of either $50 per capita or $150 million. In 1994, for example, the State of Texas had a volume cap of $902 million in private activity bonds. Texas had to turn down $863 million in requests, almost the same amount.

Under the Internal Revenue Code, as amended by the Tax Reform Act of 1986, municipal bonds are not tax-exempt if (1) more than 10 percent of the proceeds from such bonds are used in support of private business activities (private business use test); and (2) more than 10 percent of the bond principal or interest is secured by bond-financed property or the income it generates (private security or payment test). Bonds issued to finance property owned by an organization that is exempt under section (501)(c)(3) are tax-exempt provided that: (1) no more than five percent of the bond's net proceeds are used in private trade or business; and (2) no more than five percent of the bond's net proceeds are secured by facilities used in a private trade or business or by the income generated from such facilities (private loan financing test).

Federal law outlines the following categorical definitions for private activity bonds:

o Exempt facility bonds used to finance certain types of facilities, including government-owned airports, docks and wharves; mass commuting facilities; facilities for the furnishing of water, sewage treatment, or solid waste disposal; qualified residential rental projects; facilities for local furnishing of electric energy or gas; local district heating or cooling facilities; qualified hazardous waste facilities; and high-speed intercity rail- facilities.

o Qualified mortgage bonds used to finance multifamily and single-family housing;

o Qualified veterans mortgage bonds used to assist veterans in financing housing;

o Qualified small issue bonds, also called an Industrial Development Bond (IDB), used for manufacturing facilities with capital less than $10 million looking three years back or three years forward;

o Qualified student loan bonds used to finance student loan programs;

o Qualified redevelopment bonds issued for use in areas that the government designates as distressed areas or enterprise zones; and

o Qualified 501(c)(3) bonds used to finance facilities for non-profit corporations.

The 1986 Tax Reform Act placed substantial limitations on the use of private activity bonds. A unified volume cap was enacted which restricts the amount of private activity debt issued within a state to the greater of either $50 per capita or $150 million. The cap was put in place for all private activity bonds except for veterans mortgage bonds; qualified 501(c)(3) bonds; exempt facilities bonds for airports, docks and wharves; and 75 percent of high-speed intercity rail facilities.

In addition, bondholders must not be substantial users of the facility. Qualification also depends on the issue's average maturity not being longer than 120 percent of the economic life of the facility. A limit of 25 percent of a tax-exempt, private-activity bond issue may be used to purchase land for nonfarming purposes. The tax code places a similar set of restrictions and exceptions on the acquisition of existing property.

Inflation Protection Bonds

Every investment represents a balancing of acceptable risk and potential awards. Generally speaking, the longer the maturity, the lower the rate of return provided by bonds. While the interest rate for most bonds is guaranteed, an unanticipated rise in inflation means that the interest dollars earned will not buy as much as the investor had anticipated.

Treasury Inflation Protection (TIP) bonds, issued for the first time in January, 1997, trade one kind of risk for another. The tradeoff for buyers of these bonds is that they accept a lower stated rate of return in exchange for a guarantee that their buying power will not be diminished by inflation alone. Initially, the Treasury will sell 10-year notes, but other issues with as yet unspecified maturities will be added within a year. Some experts have suggested that the federal government eventually hopes to have 15 percent of its roughly $5 trillion debt in "inflation protection" bonds.

These new securities will be structured like those that Canada began issuing in December, 1991. The principal amount of these so-called "bullet" instruments will be adjusted for inflation, while the interest rate remains fixed. Inflation will be measured by the Consumer Price Index for urban areas CPI-U), without any adjustment for recurring seasonal variations. The CPI-U is published monthly by the Bureau of Labor Statistics and is a measure of the average change in consumer prices over time for a fixed market pasket of goods and services, including food, clothing, shelter, fuels, transportation, charges for doctors' and dentists' services, and drugs.

The bonds will be issued by auction on a quarterly basis in denominations as low as $1,000, appealing to 401(k) plans, IRAs, and other tax-deferred accounts. The bonds will be issued with a fixed rate of interest determined by the auction. The principal value then will be adjusted for inflation, with semi annual interest payments based on the fixed percentage of the inflation-adjusted value of principal. At maturity, the principal payment will not be less than the original par amount of the investment.

Assume, for example, that the interest rate established by the auction is 3.75%. The semi-annual interest payment on a $1,000 bond would be $18.85. If, at the time of the first payment, the principal has been adjusted by 2% to reflect the impact of inflation, then the interest payment would be $19.12. Another 2.% adjustment in the second 6 months would yield a second interest payment of $19.51. Assuming that the 2% semi-annual adjustment in the principal continued through the 10 year period, the interest earned on this bond would total $464.69 and the bond at maturity would have a redemption value of $1,485.95.

In Canada, Great Britain, and other countries that have offered such bonds, the adjustment has fluctuated between 3 and 5 percentage points over the rate of inflation. Since the adjustment for inflation in the principal is subject to capital gains, an investor could face adverse tax consequences should inflation surge. The break-even inflation rate for a taxpayer in the 28 percent bracket is 8.5 percent.

In the example, the $485.95 increase in the face value of the bond would be subject to capital gains, and at 28%, the tax would be $136.07. Therefore, the total return on this investment would be $464.69 plus ($485.95 - $136.07) = $814.57. In other words, to earn the same return on a traditional 10-year bond, the investor would have to secure an interest rate of 8.146%.

Lease-Purchase Financing

Lease-purchase financing can be a powerful and flexible tool for state and local government. The main players in a lease-purchase agreement are: (1) the lessee--a government unit; (2) the lessor--a private firm, vendor, or another governmental entity; and (3) investors. A government acquires an asset by agreeing to make a series of lease payments which are considered installments toward the purchase of the asset. The government may obtain title to the asset either at the beginning or at the end of the lease term. Lease-purchase payments are divided into two portions: principal and interest payments. After arranging an agreement, the lessor often will assign the rights to the lease payments to a number of investors. In 1980, lease-secured debt totaled less than $1 billion. By the end of the decade, however, that figure had grown to between $7 and $8 billion. [11]

A key characteristic of a lease-purchase agreement, which distinguishes it from general obligation tax-exempt debt, is the non-appropriation clause, which states that if the lessee government fails to make the specified lease payments, the agreement is terminated. As a result of the non-appropriation clause, a lease-purchase agreement represents a weaker pledge toward repayment than a general obligation bond.

The risk of non-appropriation prompts parties to a lease-purchase agreement frequently to insist that several provisions be included to strengthen the lessee's commitment toward repayment.

o A non-substitution clause states that, in the event of non-appropriation, the lessee cannot acquire or use, for some specified period of time, property similar to that described in the agreement.

o An essential purpose statement maintains that the asset serves a vital public function, thus implying that the government will likely make the necessary appropriation.

o A lease-purchase agreement related to the construction of a facility may require a lessee to maintain insurance against the risk of construction delay or failure of completion. Lessees may also need to maintain reserve funds to protect investors against the threat of non-appropriation.

o A "best effort" clause requires the government lessee to make its "best effort" to get the legislature to appropriate funds. In 1992, however, the Texas Supreme Court left standing a ruling that "good faith effort" clauses, which require a public entity to seek annual appropriation of lease payments, establish unconstitutional debt. [12]

o A security of interest provision ensures that if the lessee terminates the agreement, the lessor has the right to take possession of the leased property. In some states, municipalities are not permitted to grant such a security interest in municipal property. [13]

The most important benefit of lease purchases is the flexibility that they offer. Lease purchases can be entered into much more quickly than bonds, often within 60-90 days of initial authorization. [14] Expedited issuance can permit a government to save money by avoiding inflation in construction costs. Lease purchases enable a government both to avoid committing a large share of operating revenues to the cash purchase of an asset and to preserve its general obligation debt capacity. In addition, lease-purchase financing allows the government to avoid some of the substantial referendum costs associated with general obligation bond financing. Finally, lease purchases allow governments to acquire expensive equipment that costs too much to fund from one fiscal year's budget but is too small or has too short of a useful life to finance with bonds or other long-term debt. [15]

Lease-purchase financing is generally more expensive than general obligation bond financing. Because of the risk of non-appropriation, lease purchase bonds typically bear an interest rate of 10 to 100 basis points higher than general obligation bonds. [16] In addition, a lease purchase may involve additional issuance costs, such as payments to insure against the risk of construction delay and failure of completion.

Individual lease purchases can be consolidated into a master lease-purchase program in order to achieve lower interest rates, tighter controls, and lower administrative costs. Typically, a centralized governmental department issues tax-exempt debt to finance the purchase of vehicles, equipment, computers or other capital assessts on behalf of other governmental departments. The centralized department then enters into a standardized lease-purchase contract with each of the other departments. The lease-purchase payments received from these departments is used to repay the debt.

Master lease-purchase programs often are financed through the issuance of commercial paper that may be periodically rolled into a fixed rate bond with a five to seven year maturity. The use of commercial paper allows the government to issue additional debt on an as needed basis without incurring large incremental issuance costs.

A master lease-purchase program often can obtain significantly lower interest rates than would be available through vendor-financed lease purchases. The centralization and standardization of the lease-purchase contracts also can result in lower administrative costs and tighter controls over lease purchases. Centralizing financing procedures reduces the likelihood of vendor leases being entered into without the proper authorization. Some states and local governments, however, have encountered unwillingness by agencies to participate in a master lease-purchase program because of a perception that such programs reduce an agency's purchasing flexibility and autonomy.

Certificates of participation, commonly referred to as COPs, are a widely used type of lease-purchase financing mechanism. Individual investors purchase fractional interests in a particular lease, the payment of which is subject to annual appropriation by the issuer's governing body. Buyers of a COP do not have the protection and security provided by a bond, since if the annual appropriation is not made, the owner of the certificate probably will not be paid. COPs can be insured, however, providing protection from the bond insurance company.

Certificates are generally issued in $5,000 denominations and can receive investment ratings from a rating agency. COPs can be traded in the secondary market, making them more marketable. Therefore, issuers are able to obtain a lower interest rate on COPs than on other types of lease-purchase financing. The relatively small denominations of the COPs spreads the risk associated with lease-purchase transactions and facilitates an active secondary market. [17]

In a typical COPs transaction, the lessor assigns to a trustee the lease and lease payments along with its rights and obligations. The trustee, in turn, will issue certificates of participation through a competitive or negotiated sale to underwriters. The tax-exempt status will be passed through to owners of COPs who receive the distribution of the interest component. [18]

Tax-Exempt Leveraged Lease Financing

Over the last ten years, lease purchases have been used to finance the acquisition of equipment, such as computers and motor vehicles. Increasingly, however, costly, long-term projects, such as the acquisition of real property, have also been financed using lease- purchase agreements. [19]

Tax-exempt leveraged lease (or TELL) financing is one of the more creative approaches, which in today's investment market often more versatile and cost-effective than conventional borrowing. TELL financing can greatly reduce the cost of borrowing on capital projects of $5 million or more. In TELL financing, municipalities generate capital funds by selling public facilities. The sale is financed through tax-exempt revenue bonds. Once the buildings have been sold, the private investment is "leveraged" by the municipality leasing back the facility at subsidized rates. The results are sharply reduced financing costs, a new pool of unrestricted funds for capital projects, and greater financial flexibility for borrowers.

Four main participants in TELL financing are a public jurisdiction, a limited partnership, a financing authority, and the bondholders Any government unit or public agency authorized to issue special purpose revenue bonds or industrial development bonds may take advantage of leveraged lease financing. The public jurisdiction offers to sell a public facility to a private investor (using operating as a special purpose limited partnership) who buys the facility by making a down payment and, over a five-year period, contributing equity equal to 25 to 30 percent of the sales price. The jurisdiction then leases back the building on a long-term basis for continued use. The infusion of equity by the investor reduces rents significantly during the first five years.

The balance of the sales price is financed by tax-exempt revenue bonds issued on behalf of the partnership and loaned by a qualified financing authority (such as an industrial development authority). Underwriters arrange the tax-exempt bond financing and structure the sale/ leaseback transaction to meet the requirements of the bond market, the private investors, and the government. The lease serves as collateral for the loan which, in turn, secures the bond issue. The proceeds of the sale from individual bondholders then finance the intended capital improvement.

In purchasing the facility, the private investors obtain the tax benefits associated with ownership. The subsidized base payments during the initial five years are a reflection of the value of these benefits. Lease payments represent the cost of financing to the governmental unit. In reducing the magnitude of the lease payments, TELL successfully reduces the effective borrowing cost below the issuer's current tax-exempt rate.

Although investors own the building, the facility lease is carefully written to provide the government with maximum flexibility and control over the use and final disposition of the building. Typically, a jurisdiction leases back the building for a period of thirty years on a net-net basis, that is, the jurisdiction assumes the basic operating and maintenance costs. In so doing, the jurisdiction retains control over day-to-day management and operations. In addition, the lease usually provides the government with several renewal options and with rights to repurchase the facility. As a further protection, the public agency often retains ownership of the land, leasing it to the investors for a period of sixty-five years. At the end of the land lease, the land and improvements automatically revert to the government.

Under TELL financing, the repurchase price cannot be negotiated in advance of the sale. However, lease provisions can shield the jurisdiction from inflated real estate values at the time of repurchase. These safeguards include the land lease, the renewal options, and the method of appraisal that defines the repurchase price at the end of thirty years. The land lease, for example, serves to encumber the facility and to limit its future value in the open market.

Almost any capital project, from new construction to the refunding of outstanding debt, can be financed through leveraged leases. College dormitories, for example, have been successfully financed through TELL arrangements. In considering TELL financing, the managing underwriter should assist the government in developing a feasibility study, which should include an analysis of the impact of the project's proposed financing terms on the local budget, an estimated rental schedule, and an outline of legal and financial actions required of the government. Upon completion of this analysis, the managing underwriter, the bond counsel, and representatives of the equity partnership should draft necessary lease, purchase, and financing documents, followed by the submission of a firm purchase contract within sixty to ninety days.

A Note of Caution

In the dynamic and uncertain period of the 1980s, state and local governments have had to develop capital financing programs that are more responsive to their overall financial conditions and fiscal policies than traditional general obligation and revenue bonds.

The federal tax reform bill passed in August, 1986 has had a number of effects on the future supply of tax-exempt financing. The act eliminated significant tax breaks to banks, among the biggest bond buyers prior to the enactment of this act. The impact of the 1986 tax changes are still being felt today, as the market has continue to shift from institutional buyers to retail customers with smaller pocketbooks. Restrictions on the types of projects that can be financed by tax-exempt bonds, along with statewide caps on the volume of new issues, have resulted in a reduction in municipal bond issues. The reduction in the supply of new issues, in turn, has tended to increase the relative value of municipal bonds, particularly in states that have historically low municipal debt.

The second important effect of the tax bill is the lowering of the maximum federal tax bracket from 50 percent to 33 percent. Although the new, lower federal tax brackets have already been discounted, municipal bonds continue to be attractive relative to taxable alternatives for the vast majority of investors whose marginal tax rates are at the higher end of the new federal tax schedule. At the same time, since federal tax brackets have been lowered, the state portion of an individual's total effective tax bracket becomes larger. As a consequence, the exemption from state taxes offered by municipal bonds to residents of the state of issue becomes more important.

New financing techniques are not a panacea for meeting the needs of local government for expanded capital facilities. More conventional approaches should not be abandoned unless officials are satisfied that sufficient benefits will accrue compared to the risks. The development of more innovative approaches stems from the willingness and ability of state and local governments to accept and deal with the uncertainty of future markets for financing capital facilities. Practical concerns are also part of the equation, including the political acceptability of such approaches, the ability of government to structure and manage these creative financing mechanisms, and of course, the laws that govern capital financing. Interest payments are still the cost that governments must pay for the use of other people's money. Careful application of new financing techniques, however, may uncover some real opportunities or provide capital resources that otherwise would be unavailable.

Funding Capital Facilities as a Development Cost

The difficulties of obtaining public funds for capital improvements have induced many localities to look to the private sector for help. It was once common to rely on the private sector to design, construct, and finance major capital improvements, such as water systems, roads, or mass transit systems. While this practice has largely been abandoned in recent years, developers of new subdivisions and some commercial or industrial projects may be required to pay the infrastructure costs created by their developments.

This shift to private sector financing has been most pronounced in high-growth states and especially those faced with strict limitations on public bonding or taxes. It has been estimated, for example, that more than half of all state and local capital formation in California in the 1980's was financed by private developers, either by direct installation of capital facilities or by the payment of fees in lieu of facility dedication. The recent trend has been to require private developers to finance more and more of the "off-site" capital costs. Although each state has its own body of court rulings on these requirements, the courts generally have upheld off-site dedications that can be shown to be "reasonably related" to the public capital costs attributable to development.

In 1981, for example, the Suburban Sanitary Commission, which provides sewer and water services in northern Virginia, established a "system expansion offset charge" (SEOC), defined as an "equity charge" on new residential and commercial subscribers to fund new or expanded capital projects required to meet the increased service demands without making older system subscribers pay the cost. The SEOC is a lump sum, nondeferrable fee; it is in addition to water and sewer service connection charges. The legality of the fee differential of the SEOC, set at three times the fee paid by existing residents to finance new or expanded capital projects, was challenged. The court decision was in favor the Commission as long the linkage between the expansion and the require-ments of new development can be demonstrated.

Developers contribute to infrastructure costs under the Adequate Public Facilities Ordinance in Montgomery County, Maryland. For example, each developer is assessed a proportional share of the cost of providing the additional capacity required to accommodate the trips generated by households and commercial activities in that developer's subdivision during the morning peak traffic hours.

The State of Texas requires developers outside areas currently serviced by sewer and water systems to establish a Municipal Utility District. The developer is responsible for installing all the capital facilities necessary to provide services. Once the system is built, the developer may operate it, sell it to the residents, or find another form of private management.

Broward County, Florida, has implemented one of the more innovative and sophisticated impact fee systems, covering additional road, park, and school costs generated by new development. The fees are adjusted annually to the GNP price deflator for the previous 12 months and are deposited in a nonlapsing trust fund. Revenues for parks are set at a level equal to the assessed value of that would otherwise be dedicated or are calculated according to the type of residential unit in a development. School fees are determined in a similar fashion based on provisions in the county code for impacts generated by specific types of housing units and the number of bedrooms they contain. A computerized model is used to determine the proportional share of road capacity that the developer must finance. Each subdivision development is charged according to its share of use of expanded or extended network segments.

Notwithstanding early legal challenges, the system in Broward County appears to be working fairly effectively. Developers benefit by knowing beforehand how much they will have to pay for a given type and scale of project, and the county achieves the necessary capital facilities with a minimum processing time and negotiations and without having to finance them.

Endnotes

[1] CUSIP numbers are named for the Committee for Uniform Securities Identification Procedure, which was to deal with the securities transfer problems that developed during the late 1960s. These numbers are assigned by the CUSIP Service Bureau, part of Standard and Poor's, under contract with the American Bankers Association. The first six numbers or letters of the CUSIP number (called the base number) identify the issuer of the security; the next two numbers or letters identify the particular security of the issuer; and the last number is a check digit, used for processing purposes to help ensure the accuracy of the first eight digits. Each issuer has its own base number (issuers which have issued many securities may require more than one base number).

[2] William Dawson, "Variable Rate Demand Notes", in The Handbook of Municipal Bonds and Public Finance, eds. Robert Lamb, James Leighland and Stephen Rappaport (New York: New York Institute of Finance, 1993), pp. 531- 5.

[3] John E. Peterson, "Debt Markets and Instruments," in Local Government Finance: Concepts and Practices, eds. John E. Peterson and Dennis R. Strachota (Chicago: Government Finance Officers Association, 1991), p. 308.

[4] Bruce McDougall, "Derivatives De-Mystified," Canadian Banker, vol. 101, no. 2, (March 1994), p. 28.

[5] Kathryn Engebretson and Gary Gray, "An Introduction to Municipal Derivative Products," Government Finance Review, vol. 9, No., (February 1993), pp. 22-23.

[6] Ibid., p. 23.

[7] J.P. Morgan and Co., "Municipal Swaps," in The Handbook of Municipal Bonds and Public Finance, eds. Robert Lamb, James Leigland, and Stephen Rappaport (New York: New York Institute of Finance, 1993), pp. 440-1.

[8] Engebretson and Gray, op. cit., pp. 444-445.

[9] Aaron Pressman, "Quick Study: Interest Rate Caps, Floors, and Collars Help Buyers Hedge, Bet on Rate Moves," The Bond Buyer (December 1, 1993), p. 6.

[10] Aaron Pressman, "Derivatives Study Queries GFOA Members," The Bond Buyer (June 6, 1994), p. 10- A.

[11] Percy R. Aguila and John E. Peterson, "Leasing Service Contracts" in Local Government Finance: Concepts and Practice, eds. John E. Petersen and Dennis Strachota (Chicago: Government Finance Officers Association, 1991), p. 322.

[12] Patrice Hill, "State High Court Will Not Review Earlier Ruling on Texas Leases," The Bond Buyer (January 24, 1992), p. 1.

[13] Aguila and Peterson, op. cit., p. 335.

[14] John W. Gillespie, Jr., Morgan Stanley & Co. Incorporated. "Tax-Exempt Lease Financing," Paper presented at the First Annual Debt Management Conference, Austin, Texas, (December 5, 1991), p. 9.

[15] John Vogt and Lisa Cole, Guide to Municipal Leasing (Chicago: Municipal Finance Officers Association, 1983), p. 35.

[16] Gillespie, op. cit., p. 7.

[17] Public Securities Association, A Guide to Certificates of Participation (New York, New York, 1991), p. 3.

[18] Ibid., p. 23.

[19] Jan Chaiken and Stephen Mennemeyer, Issues and Practices in Criminal Justice: Lease Purchase Financing of Prison and Jail Construction (Washington, D.C.: U.S. Department of Justice, National Institute of Justice, November 1987), p.2.

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