Public Finance Introduction & Overview
In the United States, a municipal bond (or muni) is a bond issued by a city or other local government, or their agencies. Potential issuers of municipal bonds include cities, counties, redevelopment agencies, school districts, publicly owned airports and seaports and any other governmental entity (or group of governments) below the state level. Municipal bonds may be general obligations of the issuer or secured by specified revenues. Interest income received by holders of municipal bonds is often exempt from the federal income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.
Purpose of Municipal Bonds
Municipal Bond Issuers
Municipal bonds are issued by states, cities, and counties, or their agencies (the municipal issuer) to raise funds. The methods and practices of issuing debt are governed by an extensive system of laws and regulations, which vary by state. Bonds bear interest at either a fixed or variable rate of interest, which can be subject to a cap known as the maximum legal limit. If a bond measure is proposed in a local county election, a Tax Rate Statement may be provided to voters, detailing best estimates of the tax rate required to levy and fund the bond.
The issuer of a municipal bond receives a cash payment at the time of issuance in exchange for a promise to repay the investors who provide the cash payment (the bond holder) over time. Repayment periods can be as short as a few months (although this is rare) to 20, 30, or 40 years, or even longer.
The issuer typically uses proceeds from a bond sale to pay for capital projects or for other purposes it cannot or does not desire to pay for immediately with funds on hand. Tax regulations governing municipal bonds generally require all money raised by a bond sale to be spent on one-time capital projects within three to five years of issuance. Certain exceptions permit the issuance of bonds to fund other items, including ongoing operations and maintenance expenses, the purchase of single-family and multi-family mortgages, and the funding of student loans, among many other things.
Because of the special tax-exempt status of most municipal bonds, investors usually accept lower interest payments than on other types of borrowing (assuming comparable risk). This makes the issuance of bonds an attractive source of financing to many municipal entities, as the borrowing rate available in the open market is frequently lower than what is available through other borrowing channels.
Municipal bonds are one of several ways states, cities and counties can issue debt. Other mechanisms include certificates of participation and lease-buyback agreements. While these methods of borrowing differ in legal structure, they are similar to the municipal bonds described in this article.
Municipal Bond Holders
Municipal bond holders may purchase bonds either directly from the issuer at the time of issuance (on the primary market), or from other bond holders at some time after issuance (on the secondary market). In exchange for an up-front investment of capital, the bond holder receives payments over time composed of interest on the invested principal, and a return of the invested principal itself.
Repayment schedules differ with the type of bond issued. Municipal bonds typically pay interest semi-annually. Shorter term bonds generally pay interest only until maturity; longer term bonds generally are amortized through annual principal payments. Longer and shorter term bonds are often combined together in a single issue that requires the issuer to make approximately level annual payments of interest and principal. Certain bonds, known as zero coupon or capital appreciation bonds, accrue interest until maturity at which time both interest and principal become due.
Characteristics of Municipal Bonds
Tax Exempt Status
One of the primary reasons municipal bonds are considered separately from other types of bonds is their special ability to provide tax-exempt income. Interest paid by the issuer to bond holders is often exempt from all federal taxes, as well as state or local taxes depending on the state in which the issuer is located, subject to certain restrictions. Bonds issued for certain purposes are subject to the alternative minimum tax.
The type of project or projects that are funded by a bond affects the taxability of income received on the bonds held by bond holders. Interest earnings on bonds that fund projects that are constructed for the public good are generally exempt from federal income tax, while interest earnings on bonds issued to fund projects partly or wholly benefiting only private parties, sometimes referred to as private activity bonds, may be subject to federal income tax.
The laws governing the taxability of municipal bond income are complex; however, bonds are typically certified by a law firm as either tax-exempt (federal and/or state income tax) or taxable before they are offered to the market. The legal opinion that determines that the interest on the bonds is exempt from Income Taxes is provided by Bond Counsel. Purchasers of municipal bonds should be aware that not all municipal bonds are tax-exempt. Bond Counsel is part of the working group that put together a bond offering.
The risk ("security") of a municipal bond is a measure of how likely the issuer is to make all payments, on time and in full, as promised in the agreement between the issuer and bond holder (the "bond documents"). Different types of bonds are secured by various types of repayment sources, based on the promises made in the bond documents:
• General obligation bonds promise to repay based on the full faith and credit of the issuer; bonds are typically considered the most secure type of municipal bond, and therefore carry the lowest interest rate.
• Revenue bonds promise repayment from a specified stream of future income, such as generated by a water utility from payments by customers.
• Assessment bonds promise repayment based on property tax assessments of properties located within the issuer's boundaries.
In addition, there are several other types of municipal bonds with different promises of security.
The probability of repayment as promised is often determined by an independent reviewer, or "rating agency." The three main rating agencies for municipal bonds in the United States are Standard & Poor's, Moody's, and Fitch. These agencies can be hired by the issuer to assign a bond rating, which is valuable information to potential bond holders that helps sell bonds on the primary market.
The Official Statement - Disclosure To Investors
Key information about new issues of municipal bonds (including, among other things, the security pledged for repayment of the bonds, the terms of payment of interest and principal of the bonds, the tax-exempt status of the bonds, and material financial and operating information about the issuer of the bonds) typically is found in the issuer's official statement. Official statements generally are available at no charge from the Electronic Municipal Market Access system (EMMA) at HTTP://EMMA.MSRB.ORG operated by the Municipal Securities Rulemaking Board (MSRB). For most municipal bonds issued in recent years, the issuer is also obligated to provide continuing disclosure to the marketplace, including annual financial information and notices of the occurrence of certain material events (including notices of defaults, rating downgrades, events of taxability, etc.)
Comparison to Corporate Bonds
Because municipal bonds are most often tax-exempt, comparing the coupon rates of municipal bonds to corporate or other taxable bonds can be misleading. Taxes reduce the net income on taxable bonds, meaning that a tax-exempt municipal bond has a higher after-tax yield than a corporate bond with the same coupon rate.
Subprime Mortgage Crisis
The municipal bond market was affected by the subprime mortgage crisis. During the crisis, monoline insurers that insured municipal bonds incurred heavy losses on the collateralized debt obligations (CDO's) and other structured financial products that they also insured. Consequently, the credit ratings of these monoline insurers were called into question, and the prices of municipal bonds fell.
The historical default rate for municipal bonds is lower than that of corporate bonds. Municipal bonds have been issued by U.S. local government since 1812. Infrastructure in the U.S. is generally financed through capital financing vehicles, termed municipal bonds, which encompass the issuance of bonds by state and local governments, their agencies and quasi-public bodies generically termed special districts. While the term comprises issuers other than municipalities, the first bond of this trail-blazing genre was issued in 1812 by New York City. This pioneering debt instrument was a general obligation bond, which meant that it was backed by the taxing power and tax revenues of the issuer.
A distinguishing feature of the U.S. is its extensive use of municipal bonds (and notes) to provide for capital-raising needs. The nature of the market has evolved a great deal, as additional types of issuer and the bonds issued by them have developed.
Evolution of the Market
It has been argued that without the ability of state and local governments to issue debt - with the growth of revenue authorities as major debt issuers and wholesale providers of basic services - today's America, as we know it, would cease to exist.
In 1902 outstanding state and local government debt was US$2.1 billion or $27 per capita. By 1927 the amount had jumped to $14.9 billion - $125 per capita. Then there was a downturn because of the Great Depression and the onset of the First World War. After the end of that war, America was faced with a 15-year drought in capital spending, a significant growth in population and a major relocation from rural to urban areas. In addition, pent-up housing demand, the changing character of transportation and a shift in structures for manufacturing facilities, all combined to produce a huge demand for additional public and private facilities. In response to that demand, the level of state and local government debt rapidly increased. By the end of 1960 the amount was only $66 billion, by year-end 1981 the amount was over $361 billion - a 611 percent increase over 21 years. By 1998, the amount stood at 1.3 trillion. According to the Federal Reserve, by 2007 about $2.3 trillion in municipal bonds were outstanding, sold by more than 60,000 issuers.
Bond Categories and Their Role in Fiscal Determinations
Generally, the two main categories of long-term obligations are classified thus: General Obligation Bonds that are secured by a pledge of the government's taxing power; and Revenue Bonds that are secured by the exclusive (in most cases) pledge of project revenues. However, there exist hybrids of these two categories.
Initially, U.S. issuers were inspired by English innovations in the 17th and 18th centuries. Then, over the course of time, U.S. issuers developed mechanisms far beyond anything that applied in England.
Whereas general obligation bonds were of the type issued the most in the early phases of the market, they have in recent times been far outpaced by revenue bonds (those backed solely by the revenue stream of a particular entity, generally user fees and service charges) and bonds issued by special districts.
England also provided the early revenue bond model via its issuance of bonds for toll roads in the 1770's. The Port of New Orleans financing in the 1800's was the first expression of an authority to demonstrate financing in the United States. Revenue bonds in the U.S. were initially issued for capital construction, but are now applied to various other purposes. Until 1957 most revenue bonds were either for utility projects (their original use) or for local public housing projects. The early 1960's saw the expansion of this mechanism for financing purposes previously financed by general obligation bonds.
In 1921 the landmark legislation for the first interstate authority, The Port Authority of New York and New Jersey, replicated The Port of London Act, drafted over three hundred years earlier - as noted by Robert A. Caro in a work about Robert Moses, a major force in the evolution of this market, entitled The Power Broker. The creation of this entity signaled the implementation of special districts with broad functional and territorial jurisdictions appropriate for a new era. Special districts have played an important role in the development of area-wide metropolitan facilities.
Proxy Bond Issuing Mechanisms
Further, there also exist proxy bond issuing mechanisms for those entities unable to gain cost-effective access (from a failure to obtain investment-grade ratings) to the municipal bond market; or for those that find such a vehicle preferable for their use.
In addition to long-term bonds, many issuers also use short-term note borrowing. This was especially so in the post-1960's era when the use of this option grew tremendously.
Evolution of Industry Safeguards
Legal frameworks for the issuance of municipal bonds in the United States, lawyers play a pivotal role in representing all the parties involved in the issuance of a municipal bond (generally the issuers, the initial purchasers and the bank responsible for making payments to the investors).
A key reason for this is the provision for a legal framework in the individual states of the United States that was borne out of financial ruin brought about by the unregulated and uninhibited issuance of municipal debt. Consequently, in the 1800's, America suffered three successive depressions caused by the over-issuance of municipal bonds by states, local government and special districts between 1837-43, 1873-79 and 1893-99, respectively. To avoid the repeat of such a crisis, the first Constitutional restrictions were thereafter imposed on state and local government spending. Subsequently, further developments in the laws governing the issuance of municipal bonds were inspired by the individual histories of the states with this financing vehicle. For those reasons, individual states have some laws that are unique.
Because of the prevalence of the legal frameworks that governed the issuance of municipal bonds, the default rate did not exceed 1.1 percent between 1940 and 1999 - despite the large number of bonds outstanding.
However, as defaults and their associated financial crises (preceding or existing concurrently) are not a thing of the past, some states (including North Carolina, New Jersey, Michigan and California) have moved towards ways of monitoring and/or managing the financial activities of their local subdivisions, agencies and special districts.
Rising Role of Credit Rating Agencies
Whereas between 1839 and 1969 there were 6,195 defaults, the vast majority (4,770) took place during the Great Depression. There were, however, 79 municipal defaults during the 1940's, 112 in the 1950's and nearly 300 in the 1960's boom years. As a result, the importance of credit and risk analysis started to play a more vital role in the eyes of the investment community, which in its early days was once dominated by institutional investors. Today individual investors instead dominate it.
History of Credit Rating Agencies
The modern credit rating industry grew out of various firms that began classifying bonds - mainly railroad bonds, by the late nineteenth century. By 1890, Poor's Publishing Company, the predecessor of today's S&P, was publishing Poor's Manual, an analysis of bonds. In 1909 John Moody, founder of today's Moody's Investors' Service, published his first rating scheme for bonds in a book entitled Analysis of Railroad Investments. During that period the rating agency market was more competitive and less monopolistic than its current manifestation.
In the early period the revenues of these agencies came from charging investors subscription fees - hence, they did not charge issuers as they do today (and for some commentators the cause of the current crisis in their credibility lies in this change). Following the 1929 crash, the credit rating industry began a general decline as investors lost interest, owing in part to the agencies' poor track record in anticipating the sharp plunge in bond values. The ratings business remained stagnant for decades until increased reliance on the rating agencies grew in the post-1960's, facilitated also by changes in Federal government policy of increased reliance on them. During the 1970's the National Statistical Rating Organization ("NSRO") designation was established and various regulations began to rely on NSRO ratings thereafter.
Municipal Bond Insurers
Issuers that meet certain credit criteria can purchase municipal bond insurance policies from private companies. Insurance guarantees the payment of principal and interest on a bond issue if the issuer defaults. Bond ratings are based upon the credit of the insurer rather than on the underlying credit of the issuer. The municipal bond insurance mechanism began in 1971. Since then, the number of insured issues has expanded exponentially from only 3% of bond issues in 1980. The Association of Financial Guaranty Insurers, AFGI, the trade association of the insurers, claimed on their website that since the 1990's about half of new bond issues have been insured. Since the inception of such insurance in 1971, AFGI asserts that municipalities have saved more than $40 billion in borrowing costs through bond insurance, saving about $2 billion annually over the past decade.
A municipal bond insurance policy may result in significant interest cost savings, depending upon the issuer's underlying credit and market conditions at the time of the bond sale. Interest cost savings are attributable to the higher bond rating as well as enhanced liquidity for insured bonds.
Some types of bond are not generally insured, such as risky lower-rated issuers, (A or Baa-rated hospitals, nursing homes, development projects, etc.) and the highest-rated issuers (who do not require insurance) as well as those who gain little added benefit from insurance because their credit is recognized (such as an Aa-rated state issuer which rarely purchases insurance because its credit is well-known). But an issuer not in that precise category would purchase insurance, even though an Aa-rating applied, since buyers would not necessarily be familiar with such credit.
The credit crisis and the burdens on issues guaranteed by municipal bond insurers currently, the Municipal Bond Insurers' credit ratings are under review because of subprime lending exposure. This exposure threatens the insurers' claims paying ability and for some insurers has either resulted in present rating downgrades, or will in the future. In 2007 seven insurers were rated triple-A by the three major rating agencies. Today that number has vastly shrunk. As noted in a February 11, 2009 article in Bloomberg: "investors are shunning insured bonds after three of the biggest guarantors, owned by Ambac, Security Capital and FGIC Corp., were stripped of at least one AAA credit rating amid losses on debt tied to subprime mortgages."
Fallout from this debacle is that bond insurance is raising borrowing costs instead and leading some issuers to avoid them altogether (such as the state of California) or to go to the market with a higher debt burden.
This crisis has also led to the failures in the variable bond rate market, known as the Auction Rate Securities Market. The biggest casualty of this so far is the potential bankruptcy of Jefferson County Alabama, which - if it happens - will be the biggest in U.S. history (including the 1994 Orange County bankruptcy).
Like Orange County, Jefferson County has been caught in the vice of its use of derivatives. The use of such vehicles by state and local governments was not reduced by the California county's crisis and has instead exploded over the past decade - a symptom perhaps of their increased fiscal and structural challenges. The County was also punished in the collapse of the auction rate securities market due to the unwillingness of financial firms to maintain market liquidity. According to a recent Citigroup report, this market (a $340 billion segment) will become a permanent casualty of the credit crunch crisis.
As a Bloomberg article on April 11, 2008 observed: "Jefferson County played the derivatives game as part of financing a $3.2 billion sewer cleanup." The county engaged in a batch of interest-rate swaps with the banks that helped underwrite the debt, in a strategy designed to save the county and its taxpayers some money. However, an article by the same journalist on April 15, 2008 also pointed out: "Jefferson County is in trouble for a combination of things, some its own doing - too much floating-rate debt, too many interest-rate swaps - and some not: downgrades to insurance companies, securities firms giving up on the auction market."
The Bond Buyer
The trade publication of the industry, the municipal bond market has its own trade newspaper based in New York City, The Bond Buyer, which is a century-old daily. It is published Monday through Friday, except holidays.
The Municipal Securities Rulemaking Board
The Municipal Securities Rulemaking Board, as noted on its website, was established in 1975 by Congress to develop rules regulating securities firms and those banks involved in underwriting, trading, and selling municipal securities, bonds and notes issued by states, cities, and counties or their agencies to help finance public projects. The Board, composed of members from the municipal securities dealer community and the public, sets standards for all municipal securities dealers. The Board is a self-regulatory organization subject to supervision by the Securities and Exchange Commission ("SEC").
SEC Regulation of Municipal Bond Issuers
In the April 2008 issue of Governing magazine it was noted in an article that a former congressman from Orange County (the location of the biggest municipal bond default in American history in 1994), Christopher Cox, the current head of the SEC, announced his opinion that federal regulation should be imposed over the issuers of municipal bonds. Essentially the SEC Chairman would like to see the SEC regulate the way issuers disclose information and do their accounting. His view, as the article notes, is: "State and local governments have $2.4 trillion in outstanding debt, but they are subject to less stringent debt-disclosure rules than private businesses are. State and local issuers don't have to follow accounting rules as set out by the Government Accounting Standards Board - even though private companies must adhere to the rules developed by GASB's corporate counterpart, the Financial Accounting Standards Board." The irony here is that currently the SEC is being accused of not enforcing the Credit Rating Agency Reform Act of 2006 by the Association for Financial Professionals! [See: "Are Rating Agencies Forever Broken?" by Sarah Johnson and Tim Reason, CFO Magazine, March 27, 2008]. As the article notes: "In letters to Securities and Exchange Commission" Chairman Christopher Cox, the AFP has pleaded with the commission to "aggressively exercise its regulatory authority."