Local Government Finance: Capital Facilities Planning and Debt Administration by Alan Walter Steiss

MARKETING MUNICIPAL BONDS

Constitutional provisions, general statutes, special acts, and local charters that regulate the authorization and issuance of municipal bonds vary from state to state. Controlling laws are not always conveniently codified, and as a consequence, procedural steps necessary to secure bond authorization often are confusing to local officials and administrators. Expert legal advice is important to ensure compliance with all applicable legal requirements. Even minor errors may result in annoying delays, expensive litigation, and possible invalidation of the issue or sale.

Preliminaries to Marketing

Some form of popular referendum is required in most states for the authorization of general obligation bonds. A few states permit governing bodies to authorize bonds, within certain limits, without popular vote. Experience has shown, however, that this option should be used sparingly and held in reserve for emergencies. Occasionally, an issue may represent the unsold portion of a larger issue that has been previously authorized.

Municipal bonds must be negotiable instruments, that is, they must contain an unconditional promise or order to pay. Bond ordinances or resolutions should be drawn with precision, setting forth, among other things the nature and limits of the security offered. Each issue must be approved by an attorney whose legal opinions satisfy the market where the bonds are to be sold. Usually the city attorney or corporation counsel is not a bond specialist. Therefore, the services must be secured of a bond counsel whose opinion is marketable. In preparing the opinion, the bond counsel addresses two key legal needs: (1) that the requirements of local laws, state constitution, judicial opinions, and enabling legislation have been met; and (2) if appropriate, the exemption of interest income from federal and state income taxes. The official notice of sale should specify that the legal opinion of the firm will be furnished to the buyer. While final approval cannot be given until the sale is completed, preliminary approval before bidding assures prospective buyers (underwriters) that the legal opinion (called a "transcript of proceedings") can and will be furnished without delay before the bond issue is distributed to investors. The sale is subject to the satisfactory provision of such legal opinion.

Notice of Sale

The official notice of sale should be published in The Daily Bond Buyer and perhaps in regional bond publications at least two weeks in advance of the date set for opening bids. In some states, notices must also be placed in the official state newspaper. In addition to notices of sale, The Daily Bond Buyer--the newspaper of the municipal bond industry--includes news articles, call notices, a new issue calendar and other announcements pertinent to the municipal market and financial community.

The following information should be included in the official notice of sale:

(1) The correct legal name of the issuing body, the special law (if any) under which it was organized, and the authority for the sale.

(2) Type of bonds to be issued.

(3) Amount and purpose of the issue, the maturity schedule, call features (if any), denomination, and registration privileges.

(4) Date, time, and place of sale; manner of bidding (sealed or oral); and basis for bidding (e.g., at par, discounts allowed, etc.).

(5) Limitations as to interest rate, payment dates of interest, and when and where principal will be paid.

(6) Amount of good faith check.

(7) Name of approving attorney.

(8) Provision made for the payment of principal and interest, i.e., from ad valorem taxes, special assessments, revenues of particular enterprise.

(9) Total tax rate in the governmental unit, rate for each levying body, and constitutional or statutory limits restricting debts or the taxes levied for their payments.

Adequate publicity through the notice of sale give prospective bidders the opportunity to form their bidding accounts and to secure information regarding the offering. It also eliminates any suspicion of collusion and demonstrates that the jurisdiction is willing to submit its financial condition to careful inspection.

If the enabling legislation permits, the best practice is to allow the rates of interest to be fixed by the bidding underwriters. When they can determine the coupon rate, underwriters can make a bid that best fits the market. If permissible under controlling state regulations, bidders should be able to bid different rates on various maturities or groups of bonds--known as split-rate bids--in order to obtain the most favorable overall net interest cost.

Supplemental coupons have been used to attract dealers where state requirements mandate that municipal bonds be sold at par. Supplemental coupons are additional coupons attached to a municipal bond and covering the same interest period as one or more regular coupons. When a supplemental coupon is in force, the locality is required to make two interest payments for the period. Supplemental coupons are usually detached by the underwriter at the time of original delivery from the issuer and may be held until payment date or sold by the dealer at a discount. These coupons represent the underwriter's profit on the sale of the bond.

Timing of an Issue

The bond market experiences minor fluctuations within the course of every few months, brought on by an excess of supply over demand, as well as economic and political trends. By following municipal bond publications and consulting investment bankers, the finance officer can often apply these fluctuations to the advantage of the jurisdiction.

The municipality should avoid setting the date of the sale in the midst of a general rush of new offerings (many large school bond issues, for example, reach the market in late spring or early summer), or immediately following large sales by other municipalities. It is unwise to set the sale date for the day before or after a holiday or on Mondays or Saturdays. It is unwise to enter the market too frequently (thus, the advantage of a consolidated issue). And if dealers have not completed the distribution of a previous issue, a less satisfactory price on a new issue may be anticipated.

The due dates for semi-annual interest payments are determined by the date on which the bond is sold. Since there are certain times of the year for each municipality when its funds are low, the timing of an issue should be scheduled so that interest and principal payments do not come due at a time when funds are not in hand to pay them.

Bond Prospectus

The availability of all essential facts concerning the financial condition of the municipality is fully as important as any other factor in the successful marketing of municipal bond. With the exception of certain revenue bond issues, however, no elaborate prospectus is necessary. The information that most investors seek regarding debt and the provision for payment includes an assessment of the adequacy of the community's revenue system and the effectiveness of its administration, the recent financial operations in the municipality, total tax rate and statutory limits restricting debts or the taxes levied for their payments, population according to latest census data, etc. This information is generally covered in the bond rating process, as outlined below.

Miscellaneous Requirements

The largest buyers of municipal bonds traditionally have been financial institutions that are exacting in their requirements. Failure to comply with their "rules of the game" tends to narrow the market and is reflected in the interest cost to the municipality. Where bonds have a wide marker, for example, principal and interest should be payable in a large financial center, preferably at a bank located in a city where there is a Federal Reserve Bank. Most large investors prefer to avoid the expense and inconvenience involved in collection of principal and interest payments outside such centers.

The bond owner should have the privilege of registering bonds as to both principal and interest or principal only. To safeguard against counterfeiting, bonds should be printed by a firm that specializes in such work.

Costs Involved in Marketing Municipal Bonds

The cost of borrowing involves not only the interest payable over the term of the bonds, but also costs incurred in readying bonds for market and their actual delivery to the initial investors. Such costs reflect the expense of conducting a referendum, fees for various legal and financial advisors, and a variety of miscellaneous costs, including: preparation and publication of bond notices and the bond prospectus; printing the bonds; obtaining a bond rating; costs of renting signature machines; filing fees; court fees; registration or recording fees; certification costs; and costs of delivering the bonds. Some marketing expenditures may result in a broader sale, culminating in lower interest costs. Other expenses may add little to the marketability of a bond issue.

A survey by the Municipal Finance Officers Association of 481 governmental units in the United States and Canada found that the average cost for marketing general obligation bonds amounted to $1.98 per $1,000, as compared to $3.84 per $1,000 for revenue bonds and $5.13 per $1,000 for special assessment bonds. As would be expected, the cost per $1,000 declines steadily as the size of the issue increases (see Exhibit 1).

While no single cost incurred is large, in the aggregate, these costs can amount to a considerable sum. The MFOA survey revealed that in some instances, total marketing costs amounted to as much as 5.5 percent of the value of the bonds. These costs usually are paid from the bond proceeds. This practice, however, reduces the amount available for the project or requires an increased borrowing to meet capital costs. In either case, interest costs also attach to that portion of the proceeds used to meet marketing costs.

Bond Insurance

Municipal bond insurance, first available in the early 1970s, did not become widely used until the mid 1980s, when the percentage of new bond issues insured rose to over 20%. By the mid 1990s, nearly half of all new municipal issues were insured, either directly or through investment trust or mutual funds. Bond insurance guarantees that the insurer will pay interest and principal on the insured bonds, as they become due, and make mandatory sinking fund payments if the bond issuer fails to make these payments for what ever reason. Most municipal bond insurance is sold as part of the new-issue process. The insurance becomes part of the bond description, and the insurance premium is paid by the investor when the new issue of bonds is delivered. The buyer of an insured bond owns "insured paper," which trades in its own market as an insured bond, increasing its desirability and its salability. Insured bonds have a higher rating but usually a lower yield, since the cost of the insurance is passed on to the investor.

Ratings for Municipal Bonds

Ratings have assumed considerable significance in determining interest rates and the eligibility of bonds for purchase by certain types of investors. Rating agencies assign a credit rating to bond issues that assesses the risk of nonpaymnent of borrowed funds. The better the bond rating, the lower the interest cost that the jurisdiction must pay. For a $1 million bond issued for 20 years at an interest rate of 5 percent, for example, one rating difference amounts to about $50,000 in interest costs.

Municipal bonds are rated only in terms of credit risk and not in terms of their investment merits. Bond ratings appraise two basic risk factors: (1) the risk that bond quality will be diluted by an inordinate increase in debt, and (2) the risk that ability to meet principal and interest payments may be impaired under depressed economic conditions. The first risk is within the control of the issuing government, whereas the second is related to the impact of general economic conditions on a given locality.

Rating analysts evaluate a wide range of information concerning economic, debt, financial, and governmental considerations to determine a bond rating. This information is supplied by the jurisdiction and derived independently by the analyst. Rating agencies do not explain completely their reasons for assigning a particular rating, nor do they provide a precise formula for obtaining better ratings.

Four nationally recognized rating services--Moody's Investors Service, Inc., Standard and Poor's Corporation, Fitch Investor's Service, and Duff & Phelps--rate a wide variety of bonds: tax-supported, revenue or enterprise supported, lease-rental, hospital revenue, mortgage-backed housing, higher education revenue, student loan revenue, and refunded bonds. The rate service fees vary according to the size of the prospective bond issue, according to the following general schedule:

The rating services use symbols, arranged in order from bonds with the least credit risk to those with the greatest risk. A comparison of the rating systems used by Moody's and by Standards and Poor's is provided in Exhibit 2. Some issues rated by one service are not rated by the other, and the opinions of the rating services may differ on specific issues.

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The bond rating process that the Standard and Poor's Corporation follows is shown in Exhibit 3. Moody's and Fitch use similar processes. Rating analysts evaluate new bond issues and maintain surveillance over current ratings. If the lowering of a current bond rating may be forthcoming, a jurisdiction is placed on a CreditWatch. A rating committee reviews the recommendations of the rating analyst and assigns the actual rating. The jurisdiction may appeal the assigned rating by furnishing additional information to the rating service. The type of information required by the rating service is shown in Exhibit 4.

Analysts evaluate various economic factors, including the locational advantages of the jurisdiction, its population, wealth, labor factors, the diversity of employers, and the area's economic prospects. Economic variables that are most significantly related to bond ratings include the percentage of the economy dominated by the ten largest taxpayers (which is intended to measure the concentration and dependence of the local economy); the rate of unemployment; the tax base per capita; and the change in population. Of the various criteria included in the rating analysis, economic factors are the hardest to improve. Economic development often is a very long-term proposition for most jurisdictions.

Rating analysts examine various debt factors, including the jurisdiction's debt policy, debt structure, debt burden, debt history, and prospective borrowing, to assess the likelihood of meeting its commitments to the bondholders. Planning for future debt and having a solid infrastructure is looked upon favorably by analysts. If public indebtedness becomes too high, analysts are concerned that the jurisdiction may be unwilling or unable to honor its debt commitments. Moody's has compiled national averages of net debt per capita and the ratio of net debt to estimated full value of all taxable property. Such averages are used to evaluate the amount of debt burden. Communities with high net debt have cause for concern. On the other hand, low net debt may not necessarily be a good sign if such jurisdictions have ignored needed infrastructure improvements by not issuing bonds.

Two important governmental considerations are continuity in management and good fiscal control. An assessment is made as to how professional the management team is and how long it has been in place; whether or not managerial and policy-making responsibilities are clearly delineated; the jurisdiction's compliance with the Government Finance Officers Association standards regarding financial reporting and budgeting procedures; and the jurisdiction's independence of overlapping or conflicting intergovernmental relationships.

A number of financial factors are examined. Financial reports and budgets are reviewed to: (1) determine existing and future fiscal trends, (2) assess if revenues meet or exceed expenditures and if a sufficient fund balance is available to meet unforeseen contingencies; (3) evaluate the diversity of revenue sources; and (4) identify what the property tax collection rate has been. The analyst will also seek to determine the jurisdiction's policies regarding interfund transfers; if generally accepted accounting principles (GAAP) are followed; and if pension liabilities are properly funded.

Generally speaking, there is only one rating for all of the general obligation bonds of a particular governmental unit and for all the bonds of a specific revenue project. Some governmental units or revenue projects may have more than one rating because special security has been pledged for some of the bonds. New issues of a previously rated governmental unit or revenue project usually are assigned the same rating as the outstanding bonds unless there have been material changes in the credit situation. Therefore, new issues of a previously rated unit usually increase the dollar value outstanding in a rating category but rarely affect the number of municipal credits in a rating category.

Jurisdictions can actively pursue better bond ratings by making improvements in one or more of the four areas of evaluation and by proactively selling the community through ongoing contacts with rating services. A "back and forth" relationship should be established with the rating services. Key staff members should be introduced to the rating analysts, who should be encouraged to ask for information from these persons as needed. Local managers should submit to the rating service any written materials, special reports, and newspaper accounts that highlight changes and improvements. Any changes in financial policy that might affect the jurisdiction's credit rating should first be reviewed with the rating analysts.

Some jurisdictions visit the bond rating services whenever they preparing a new issue; others make such visits only when seeking a better rating or if a downgrading is possible. It is important that the team representing the local jurisdiction be well-prepared for such meetings and make a highly professional presentation. A brief introductory statement should highlight the important features in the submitted documents, and the rating analysts should be encouraged to ask questions. The "pitch" is less important than the content of the answers. If unsure of an answer, the team should provide additional information following the meeting. The analysts are particularly interested in information that cannot be obtained from the rating documents that have already been provided.

Large institutional buyers are often limited by state law in the selection of their investments. Therefore, if a jurisdiction is now on the legal investment lists of leading investor states, it is very important that nothing be done to imperil this favored position.

The Bond Sale and Delivery

All bids made on a particular issue should be on a basis that permits a comparison of total cost to the issuer. Officials should insist that all bids comply strictly with the terms of the sale. All bids should be received and opened in public by the governing body at the designated hour, with the bonds awarded to the bidder on the basis of the lowest net interest cost. All papers required to complete the bond transcript should be forwarded to the bond attorneys as soon as possible.

Before the bonds are delivered, information required to establish the bond register (sometimes called the bond and interest record) should be recorded. At the time a bond issue is sold, the interest due on each date of maturity should be computed and recorded, as should the payments of principal or payments into a sinking fund. With such records, a complete schedule of debt service requirements can be readily prepared for the current budget and for all outstanding debt obligations.

Bonds should be delivered at the earliest practical date after the sale (no later than thirty days). The winning bidder usually has the option to cancel his obligations if delivery is not made on or before the date specified in the contract. The purchaser should stipulate where the bonds should be delivered. For bonds that are delivered as certificates, the issuer may prefer to have at least one official sign the bonds at point of delivery and to have the municipal seal imprinted at the time. Large bond issues usually are signed at the place of delivery because the travel expenses of officials frequently are less than the insurance on the delivery of signed bonds.

The issuer of the bonds provides a disclosure statement on the new issue, called an Official Statement. While not required by federal law, state and local governments are encouraged by the Municipal Finance Officers Association to disclose primary offering information. The Securities Exchange Commission requires underwriters to make sure that bond issuers agree to provide continuing financial information. The Official Statement fulfills this requirement. A preliminary official statement frequently is distributed to prospective buyers before the sale of larger bond issues. This preliminary statement contains the same information as the final Official Statement, except for the final terms of the issue. The cover page summarizes the issue, giving information on ratings, authority for issue, delivery date and place, security for the issue, maturity amounts, dates, coupon rates, and reoffering yields or prices. The document is also sent to various municipal bond information storage and retrieval centers.

Regulations of the Municipal Securities Rulemaking Board specify that a final Official Statement must be sent to every person who purchases a new issue bond during the underwriting period (generally, the period from the date the issue is first offered to the public to the date the bonds are delivered and paid for). The buyer's broker is responsible for providing the final Official Statement if the bonds were not bought from a member of the underwriting syndicate.

Insurance companies are available to underwrite policies to protect the bond issue in the event of a default. A typical insurer, such as the Financial Guaranty Insurance Company, guarantees the timely return of principal and accured interest to the investor. Insured bonds have a higher rating but usually a lower yield, since the cost of the insurance is passed on to the investor.

Municipal Bond Investors

Four categories of investors purchase most municipal bonds (1) mutual funds; (2) commercial banks; and (3) property and casualty insurance companies; and (4) households. The market shares of these investors have shifted over the last few decades due to economic events and changing federal legislation. While commercial banks dominated the market for municipal bond buyers in the 1960s and 1970s, they were superseded by households and mutual funds in the 1980s.

These trends can be understood in the context of economic events and changing federal legislation. Historically, sales to the household sector have been greatest when interest rates reach their cyclical peak, and thus the participation of this segment has fluctuated widely. Inflation during the 1970s pushed significant portions of the population into higher tax brackets, and the demand for tax-free bonds grew accordingly. [1]

In the 1980s, steep reductions in the top bracket marginal tax rates for individual investors reduced the value of tax-exempt securities relative to taxable issues. During the same period, however, mutual funds absorbed an increasingly larger share of the market. [2] While most tax-free debt is held by relatively wealthy, high-income households, a significant share also is held by middle-income households. [3]

The Tax Reform Act of 1986 had a profound impact on the municipal bond market. The elimination of many long-standing loopholes left municipal bonds as the last significant remaining tax shelter. The Act also removed or restricted the tax exemption on many private purpose bonds whose proceeds are used primarily to benefit private interests. As a result, the supply of tax-free bonds was reduced. Other provisions of the Act, however, made municipal bonds less attractive to banks and insurance companies. [4]

By 1994, mutual funds, bank personal trusts, and money market funds held 38.9% of the municipal bonds; households held 35.5%; property and casualty insurance companies held 12%; and commercial banks held 8.2%. [5]

Summary

The marketing of municipal bonds is a complicated process, the mysteries of which, insofar as the uninitiated is concerned, is comparable to that of the stock market. Local officials must be mindful of the procedures for marketing bonds, from the planning of the issue through the actual delivery of the bonds to the winning bidder. Failure to adhere to these procedures can result in unnecessary delays, higher interest costs, and possible legal ramifications. As a practical matter, almost any bond issue that is in proper technical form can be sold at any time. However, whether a particular offering is "successful" at the date of sale depends on the congruence of many factors.

The municipal finance officer is caught in the middle, faced on the one hand by uncertainties as to the political and economic structure of the community and, on the other hand, by uncertainties of a marketplace that he may not fully comprehend. Adherence to accepted marketing procedures can go a long way to reducing the uncertainties that confront the municipal officials on both sides. The success of a given issue may be determined by forces in the marketplace beyond the control of local officials. An awareness of these factors, however, can provide important insights in the overall planning of long-term bonds for capital facilities.

Endnotes

[1] Public Securities Association, Fundamentals of Municipal Bonds (New York, 1982) pp. 99-100.

[2] Daniel R. Feenberg and James M. Poterba, Which Households Own Municipal Bonds?: Evidence From Tax Returns (Cambridge, MA: National Bureau of Economic Research) November 1991, pp. 3-10. [3] Ibid., p.13.

[4] Wilson White, The Municipal Bond Investor (Chicago: Probus Publishing Co.,1991),, p. 16, and John Andrew, Municipal Bonds: The Common Sense Guide to Tax-Free Personal Investing (New York: The Free Press, 1987), pp. 186-87

[5] Penelope Lemov, "After the Fiscal Quake," Governing, Vol. 8, No. 5, (February 1995), p. 34.

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