One doesn't need a double-0 license to gain access to the multibillion-dollar municipal bond market
The buzz about record-low mortgage rates and how they've led millions of people to invest (or reinvest) in real estate has been front-page news for much of the year. Less attention, however, has been given to the bond market, where investors are also finding a boon. Last year $359 billion in bonds were sold, $70 billion more than in 2001. By June, the market was on pace for another record-setting year.
Accounting for a third of last year's bond market activity, municipal bonds, or munis, are especially attractive investments for several reasons. Retail or individual buyers, who make up the majority of municipal bond investors, generally pay little or no income taxes on the securities on both state and federal returns. Additionally, the interest income they earn usually surpasses what they would receive from investments in corporate bonds of comparable risk and maturity (munis can be long-term issues of anywhere from 10 to 30 years, but on average mature at 20 years). Regarding risk, municipal bonds are considered to be relatively safe from default.
All in all, these reasons lead investors to finance thousands of municipal projects nationwide, from airports to bridges to recreation facilities. In an era in which financing public recreation is a struggle in many communities, the municipal bond market holds plenty of promise, especially since munis - unlike tax referendums, which release funds in periodic installments per a government's fiscal budget - provide the entire amount up front. But obtaining such funding isn't as simple as filing an application or writing a grant proposal. The process is complicated because municipal bonds, as securities, represent an issuance of debt and are thus subject to a number of state and federal regulations designed to protect both taxpayers and investors.
It's inevitable, then, that recreation departments interested in tapping into the municipal bond market will need some help along the way. "While parks and recreation boards tend to operate their programs somewhat autonomously, I'm not aware of too many parks and recreation boards that have their own bond-issuing power. Usually that gets back to the core municipal governments," says Greg Stype, a partner in the Columbus, Ohio-based bond counsel firm of Squire Sanders & Dempsey, which guides governments through the legal ABCs of municipal bonds. "Get connected to the financial people in your municipal government early. It's complicated, so don't plan this thing on your own and necessarily expect it to be a slam dunk. A lot of this stuff gets pretty dry and technical. But if I'm sitting on a parks board, trying to figure out what I need to know, first I need to know that I can't do this in a vacuum."
Which Way Do You Go?
Unlike tax referendums, most municipal bond issues don't require voter approval - but some do. There are two types of municipal bonds, each of which is named according to how the debt will be repaid. Revenue bonds are paid off by future revenues to be generated by the project being funded. General obligation (GO) bonds are secured by the issuing government's tax revenue and its ability to impose new taxes (by law, the municipality is required to levy taxes in order to repay the debt).
"There are fundamental questions that municipalities need to address," says Stype. "Do you need an additional revenue source to support your debt? Or do you plan to pay from your general fund or an existing parks and recreation revenue source that you can apply to debt service?"
If the answer to the latter question is no and government officials choose to pursue GO bond money, obviously new taxes will be required to retire the debt. The next decision, then, will determine what kind of tax will be levied. Will the municipality ask its constituents to consider a property tax increase or a sales tax? It's a crucial point that can make or break a bond issue proposal, says Ron Vine, vice president of Leisure Vision/ETC Institute, a market research consulting firm that specializes in public recreation. Before putting such a question before voters, Vine recommends conducting a phone or mail survey asking voters what kind of tax they would support, how they would like to see the money spent and how long they would like the tax to last (some taxes have "sunset clauses," or terms that end the tax after a project is fully funded).
In one mid-sized Iowa city, such a survey revealed to officials that voters approved of funding public swimming pool improvements and preferred a quarter-cent sales tax to either a half-cent sales tax or a property tax increase. Armed with this information, the city then drafted a bond election proposal that easily passed. "A lot of the decision-making is asking voters, 'Which one do you prefer?' " says Vine. "Our experience is that a sales tax is something that they typically support."
A municipality's decision to pursue a GO or a revenue bond package also depends on its standing in the eyes of the three agencies - Moody's, Standard & Poor's and Fitch Ratings - responsible for rating municipalities' credit-worthiness.
Munis are repaid with interest, similar to home mortgages. And just as the personal credit histories of would-be homeowners are largely responsible for determining the interest rate at which they repay their mortgage loans, municipal governments that borrow bond money are also subject to review. S&P's, for example, assesses ratings anywhere from AAA (the highest) to D (the lowest) based on several basic considerations:
• The likelihood of payment, or the obligor's capacity and willingness to meet its financial commitment in accordance with the terms of the obligation;
• the nature of and provisions of the obligation; and
• the protection afforded investors by, and relative strength of, the obligation in the event of bankruptcy, reorganization or other arrangement under bankruptcy laws.
"If a government, for whatever reason, was at a loss - say its largest taxpayer pulled out of town - first of all, would it feel the same level of commitment to pay off the parks bonds as it would bonds for the school system?" asks Amy Resnick, editor-in-chief of The Bond Buyer, which monitors and reports on the bond market. "And if the municipality ever ended up in a bankruptcy court situation, would the court require it to forgo payments on something that is not an essential service in order to pay for essential services? That whole concept of 'essentiality' comes into play, although I think most governments would argue that recreation facilities are essential."
Working with a rating agency can involve face-to-face meetings between municipal officials and agency representatives, although at other times the relationship simply requires governments to supply reams of documents and financial statements. "Rating agencies look at the past 10 years, including your plans and policies, so they can see if you do what you say you will, or what you plan to do," says Marsha Grigsby, finance director for the city of Dublin, Ohio, which obtains its credit ratings from Moody's and Fitch. "Of course, they like to see balanced budgets and capital improvement plans that are at least five years in length, and the fact that you update them annually. They see if you're conservative, that you don't overestimate your revenues - because they're very conservative."
Upstart communities without an established credit history can encounter a more difficult road. For example, in the mid-1980s, Dublin experienced a significant commercial and residential growth spurt and was incorporated as a city after spending more than 150 years as a village. Dublin city officials - faced with a number of suddenly critical public improvements - put together the city's first bond issue in 1990. Despite a limited history of income-tax revenues, Dublin secured an issue of approximately $50 million (thanks in part to Dublin voters' approval of a property-tax increase to repay the debt). "At that time, we didn't even have a five-year capital plan. We just looked like the kid in the candy shop," says Grigsby. "The longer a track record you have, the more comfortable the rating agencies are, especially because elected officials are involved. Every two years, you're having elections and there's turnover. But if they can see that, historically, even when councilpeople change, the city still follows its policies, that gives them a great deal of comfort."
Bond insurance is a viable option for municipalities not able to obtain either a desired credit rating or interest rate. Purchased from a private insurance company, the premium guarantees payment of the bond's principal and interest when due. As a result, the municipality receives a AAA credit rating and a lower interest rate. Bond insurance isn't ideal for all entities, however. "If the cost of the insurance is less than the difference in the interest rates, then the insurance is worth it," says Resnick. "It's something that should be evaluated on a case-by-case basis."
Release the BondsBecause municipalities don't have the capability to issue bond money on their own, such funds are generally issued on the entities' behalf (a municipality is an "issuer") by deep-pocketed underwriters - large, national investment banks such as UBSPaineWebber and Merrill Lynch, or smaller, regional firms. Most of the time, the decision whether to choose a large or small underwriter depends on the size of the issue. "If there are only $5 million of bonds and you think you can sell them within your state, you may stick with a regional firm," says Resnick. "If you're selling $500 million worth of bonds, and you really need to distribute them to mutual funds and around the country to as many buyers as you can, you probably want to enlist one or more national firms."
These firms, of course, are experienced players in the bond market, unlike most public recreation officials. It's to a rec department's benefit to seek the help of its municipal bond committee, comprised of professionals more familiar with the market's ins and outs.
A municipality's bond committee can vary in size and makeup, and can include both inhouse staff members and professionals hailing from private circles. Most often, a committee will feature at least one financial advisor (like Grigsby) and a tax attorney to serve as bond counsel (Stype, for example). Committee responsibilities include guiding rec department officials through any legal proceedings, city ordinance drafts or elections that may arise, as well as representing the department at the bond market.
There are two manners in which bonds are issued: either through competitive or negotiated sales. Similar to a request-for-proposal process, a competitive issue involves the municipality publishing a notice of sale requesting bids from underwriters. The underwriter submitting the lowest bid (in essence, offering the lowest interest rates) is selected. "Some governments only work with the lowest bidder to protect the public purse," says Resnick. "You don't pick a banker, you work with a financial advisor and an attorney and you say that 'At 11 o'clock on Tuesday, June 3, we're taking orders and the lowest bidder wins.' That's a good way to go if the bonds are very straightforward and you don't need an advocate in the market."
In a negotiated issue, a municipality will work with a single underwriter, selected based on predetermined factors such as prior relationships, area of expertise and reputation. Together, the municipality's bond committee and the underwriter's senior manager will negotiate terms of the sale, prepare the issue's official statement and obtain a bond rating.
Resnick says that because they typically provide municipalities with more flexible interest-rate schedules and involve the underwriter aggressively selling the bonds on the market (as opposed to the municipality doing the work itself), negotiated sales make up about 70 percent of all bond issues. Such dealings are especially attractive to municipalities with unique situations or shorter credit histories. "If you have what the industry would call a 'story bond,' whatever the story is that you want investors to understand, you might want to hire an investment banker before going to market and have the banker be your advocate in the market," says Resnick. "That way you, the issuer, get your money from the investment banker and it's the banker's problem to sell the bonds."
Outside of the business relationship between the underwriter and the issuer, negotiated issues - especially large-scale issues - represent a faceless process in which the bond seller, or issuer, never directly interacts with the eventual purchaser. For some municipalities, that's not all bad. "I don't think that raises any concern," says Grigsby. "We get our money on the day of the issue, so at that point it really doesn't matter to us."
For other municipalities, getting to know the investors can be advantageous. According to Resnick, it's not impossible to know who's buying your bonds, but it can be difficult. Municipalities will most likely have to negotiate with their underwriting teams to receive a post-issuance list of the zip codes in which their bonds were bought. "In cities and counties where bonds have to go to the voters to get approval before they can be sold, governments will get that data so they know who they can mail information to when they're trying to get support for a future campaign," says Resnick. "If you're only issuing once for the next 20 years, it might not be worth it. But if you're frequently in the market, every three years or so, and you know that you have to go back to the voters, it doesn't hurt to build a 'friends of the parks' database. They're already interested in what you're doing, they've bought your bonds once, so they may become a constituency for you."