Tax-exempt municipal bonds are securities issued by a state or local government, or one of their creations such as local tollway authorities or special districts. Bonds are issued either as a general obligation of the state or local government (relying on the full faith and credit of the entity in question), or as revenue bonds, backed only by the credit worthiness of the project being financed.
Municipal bonds represent a stable, fixed-income investment. After initial placement with investors, these bonds are traded in the open market until called or defeased (paid in full by the issuer). The interest income on most municipal bonds is exempt from federal income taxes, making these financial instruments attractive primarily to retail investors in high marginal tax brackets (it should be noted that investors in municipal bonds are "private investors").
Given this tax advantage, highly taxed investors are generally willing to accept lower yields on municipal bonds than they would for a taxable equivalent. Since public employee pension funds are already exempt from taxation, a tax exempt bond provides little additional value to them, and thus these entities usually seek the higher yields offered by taxable securities.81
The market price of municipal bonds, as with any other bond, varies in response to changes in interest rates, which are themselves subject to Federal Reserve monetary policy and changing investor expectations regarding inflation.82 Changes in demand for these securities on the part of investors, the perceived creditworthiness at a point in time of a particular bond issuer or a particular bond, and the total volume of municipal bonds issued at a given time can also cause wide fluctuation in market bond yields.
The ability to issue debt (whether by a state, municipality, or public authority) is contingent upon having a dedicated source of funds that can support the debt repayment.
However, unlike a corporation that borrows to build facilities that will improve its return (thus repaying the debt through the profits generated by that investment), municipalities do not earn profits. Thus, deciding who will issue and pay for the debt, and in what way, depends on the local political and economic climate.
The theory behind municipal revenue bonds is, in part, a direct extension of "pay as you go" philosophy. In a toll project, the beneficiaries of the project - the customers or users - are the ones paying off the debt through the toll box. However, these motorists may not necessarily be residents of the community in question. This is a delicate issue that needs to be balanced, given that those who authorize a given project are not necessarily the same entities governing and managing the debt, and that these entities or persons are not necessarily the ones paying for the debt or benefiting from the project.
A very important issue with municipal revenue bonds has to do with issuer debt capacity, borrowing limits, and credit quality of the project being financed, which bear a direct relationship to the overall creditworthiness of both the issuer and the project.83 This is especially significant when considering system finance versus a one-off project.
It is axiomatic that the better the credit quality, the higher the credit rating and the lower the interest rate on the debt. This is true whether the bond is a revenue bond - where the source of repayment consists of revenues from the project itself - or a general obligation (GO) bond, which is backed by the full faith and credit (i.e., the general revenues and ultimately the taxing powers) of the entity in question.
In addition, there are various tools to "enhance" credit, ranging from bond insurance to guarantees by entities with GO taxing powers. An example would be toll road revenue bonds, payable by the project's toll revenues, but guaranteed by a local entity's taxing powers. The interest rates on such bonds would be lower than on standard revenue bonds as investors would be protected from default by the GO guarantee.
It is important to note at this point that a GO bond does not imply unlimited debt capacity. Taxpayers can and do revolt when taxes become burdensome, or if they do not support a project for which they are being taxed. Moreover, the use of general obligation bonds must be done prudently, given that the taxing authority must keep capacity available to cover all the activities and needs of the state or locality. Borrowing today constrains borrowing tomorrow, and some economists have even questioned the borrowing capacity and creditworthiness of the federal government in light of the current economic situation.
For local governments especially, one of the biggest challenges is the ability to raise the capital required to fully fund a particular project, especially given the vagaries of traffic and revenue forecasts.
An additional negative of municipal bonds as a way to finance transportation projects is that such debt securities typically have a term limit of 30 years,84 which may be too short to match the life expectancy of the project.85
Moreover, municipal bond indentures usually require the issuer to place part of the capital raised into a reserve fund to ensure that debt service repayments can be made on a timely basis, especially in a project's early years when it may not be open or may not generate sufficient revenue to meet its debt service requirements. This has the practical effect of forcing the entity to raise more capital than necessary, resulting in the borrower paying additional interest.
Last, we must address two of the most misunderstood aspects of municipal bonds: the risk factors and the concept that rates for municipal bonds will always be lower than those of corporate securities (tax considerations aside).
The last few months have witnessed an unprecedented amount of turmoil in the capital markets. Prior to 2008, the municipal securities market, estimated now to be worth approximately $2 trillion, was viewed as a reliable, low risk, and even stodgy environment. Earlier this year, however, this "safe" market essentially came to a screeching halt. No new issues were being done, and trading volumes dropped sharply. For many government entities, this financial market meltdown became a real crisis. For instance, California's government briefly stalled when it could not sell Tax Revenue Anticipation Notes (short term securities backed by future tax collections). The safety and security long associated with municipal capital is no longer.
Moreover, the traditional method to enhance municipal credit - bond insurance - has fallen by the wayside as the monoline insurers (AMBAC, MBIA, among others) ventured away from their primary business and began insuring exotic securities that they did not fully understand. The losses the monoline insurers incurred from these ventures destroyed their own creditworthiness and made their insurance virtually worthless in the eyes of investors.
Without bond insurance or other credit enhancement tools, there is little investor demand for revenue bond financings that are not at least rated 'A' or better on a stand-alone uninsured basis. Issuers with lower ratings simply cannot obtain financing in today's climate (though this, of course, is subject to change).
As a result, projects with specific timelines are now delayed - a very expensive proposition that adds to eventual total project costs or, in the worst case, may terminate the project altogether, leaving the issuer (and perhaps local taxpayers) to cover the costs incurred in non-completion.
Finally, we address the perception that municipal securities will always have a lower cost of capital. For instance, one witness provided testimony at the August committee hearing in Irving that "a public sector infrastructure provider can always deliver more value than a private sector provider since its cost of funds is at least 30 percent less"86 - primarily due to the tax advantage.
As a generalization, this has some appeal. However, while public sector entities may well be able to deliver more value due to lower borrowing rates, this is the case only if these entities are well established and enjoy strong credit ratings. Smaller RMAs attempting a large project for the first time, as well as newly organized RMAs, would face high costs of capital more in line with those of similar start-up enterprises in the private sector.
On the other hand, large private sector companies with established reputations for building quality projects on a timely basis have the credibility in the marketplace - due to many years of strong performance - to provide investors with comfort in their financial security sufficient to justify lower interest rates.87
Moreover, the public advantage is limited in a volatile market environment. The ongoing turmoil in the financial markets has virtually frozen the municipal debt market, and the ability of localities to raise large sums of capital at rates approximating five to six percent has, as a general rule, disappeared.
In addition, many of the traditional underwriters of municipal debt have either gone bankrupt or are suffering from severe financial problems themselves. Two of the formerly top tier municipal underwriters - Lehman Brothers and Bear Stearns - have disappeared entirely. First Albany is part of the distressed Depfa Bank. One of the (formerly) most stable, long-time municipal underwriters - Citigroup - has now become the recipient of a massive federal bailout.
Despite unprecedented efforts by the federal government to unclog the credit markets after the September 15 bankruptcy of Lehman Brothers, the municipal market re-priced to higher levels. The three month LIBOR rate, a key borrowing rate for credit markets, rose from 2.6% prior to the Lehman bankruptcy to over 4.6% in mid October.
During this time, tax-exempt interest rates also increased as capital needed to support the municipal market became scarce, and institutional investors who relied on borrowing in the short term market to finance long term investments found that capital was either non-existent or too expensive to take new positions or even to hold existing ones.
Institutional liquidations in the secondary market thus resulted in a decline in the value of bonds, which pushed bond yields to levels not seen in nearly a generation. Municipal bond issuers found themselves competing with institutions for investors who were able to purchase high yielding bonds sold under such extreme and adverse conditions.
This is not to say that the current crisis is permanent, nor will the financial turmoil affect all public toll authorities equally. When the credit markets finally start to thaw, entities such as the NTTA or HCTRA that have reputations as well-run organizations delivering a quality product will find financing more readily, and at lower cost, than a small start-up RMA undertaking a toll project for the first time.
Finally, we do agree with Mr. Enright's point that in spite of the debate over public versus private cost of capital, the infrastructure finance problem boils down "not to one of the availability of capital, but rather the establishment of an acceptable method of charging motorists for roadway usage."
Moreover, the traditional method to enhance municipal credit - bond insurance - has fallen by the wayside as the monoline insurers (Ambac, MBIA, among others) ventured away from their primary business and began insuring exotic securities that they did not fully understand. The losses the monoline insurers incurred from these ventures destroyed their own creditworthiness and made their insurance virtually worthless in the eyes of investors.
Without bond insurance or other credit enhancement tools, there is little investor demand for revenue bond financings that are not at least rated 'A' or better on a stand-alone uninsured basis. Issuers with lower ratings simply cannot obtain financing in today's climate (though this, of course, is subject to change).
As a result, projects with specific timelines are now delayed - a very expensive proposition that adds to eventual total project costs or, in the worst case, may terminate the project altogether, leaving the issuer (and perhaps local taxpayers) to cover the costs incurred in non-completion.
Finally, we address the perception that municipal securities will always have a lower cost of capital. For instance, one witness provided testimony at the August committee hearing in Irving that "a public sector infrastructure provider can always deliver more value than a private sector provider since its cost of funds is at least 30 percent less"86 - primarily due to the tax advantage.
As a generalization, this has some appeal. However, while public sector entities may well be able to deliver more value due to lower borrowing rates, this is the case only if these entities are well established and enjoy strong credit ratings. Smaller RMAs attempting a large project for the first time, as well as newly organized RMAs, would face high costs of capital more in line with those of similar start-up enterprises in the private sector.
On the other hand, large private sector companies with established reputations for building quality projects on a timely basis have the credibility in the marketplace - due to many years of strong performance - to provide investors with comfort in their financial security sufficient to justify lower interest rates.87
Moreover, the public advantage is limited in a volatile market environment. The ongoing turmoil in the financial markets has virtually frozen the municipal debt market, and the ability of localities to raise large sums of capital at rates approximating five to six percent has, as a general rule, disappeared.
In addition, many of the traditional underwriters of municipal debt have either gone bankrupt or are suffering from severe financial problems themselves. Two of the formerly top tier municipal underwriters - Lehman Brothers and Bear Stearns - have disappeared entirely. First Albany is part of the distressed Depfa Bank. One of the (formerly) most stable, long-time municipal underwriters - Citigroup - has now become the recipient of a massive federal bailout.
Despite unprecedented efforts by the federal government to unclog the credit markets after the September 15 bankruptcy of Lehman Brothers, the municipal market re-priced to higher levels. The three month LIBOR rate, a key borrowing rate for credit markets, rose from 2.6% prior to the Lehman bankruptcy to over 4.6% in mid October.
During this time, tax-exempt interest rates also increased as capital needed to support the municipal market became scarce, and institutional investors who relied on borrowing in the short term market to finance long term investments found that capital was either non-existent or too expensive to take new positions or even to hold existing ones.
Institutional liquidations in the secondary market thus resulted in a decline in the value of bonds, which pushed bond yields to levels not seen in nearly a generation. Municipal bond issuers found themselves competing with institutions for investors who were able to purchase high yielding bonds sold under such extreme and adverse conditions.
This is not to say that the current crisis is permanent, nor will the financial turmoil affect all public toll authorities equally. When the credit markets finally start to thaw, entities such as the NTTA or HCTRA that have reputations as well-run organizations delivering a quality product will find financing more readily, and at lower cost, than a small start-up RMA undertaking a toll project for the first time.
Finally, we do agree with Mr. Enright's point that in spite of the debate over public versus private cost of capital, the infrastructure finance problem boils down "not to one of the availability of capital, but rather the establishment of an acceptable method of charging motorists for roadway usage."
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81 Note that changes to the Internal Revenue Code in 1986 imposed significant restrictions on the types and amounts of tax-exempt municipal securities that can be issued.
82 Given their fixed interest rate, as interest rates rise, the prices of the bonds decline. Similarly, when rates drop, a bond's interest rate becomes more valuable, and thus the price of the security increases. The longer the term of the bond, the greater the price swings in response to current interest rate changes.
83 We note, however, that market conditions can swing wildly, and that there may be times where a good project in a bad credit market cannot find financing, as well as instances, such as the case of the sub-prime mortgages of the past few years, where investors will buy extremely questionable securities (and regret it later).
84 Long term bonds are generally priced based on the current rate for 30 year US Treasuries, which is considered the "risk free" rate.
85 Most municipal bonds have a "call provision" that at a certain point in time gives the issuer the right during the duration of the financing (starting typically at 10 years) to pay off the debt at a predetermined price, typically the unamortized principal plus a premium of 3 to 5%. These factors all affect how the bonds are credit rated and evaluated, all of which will affect the pricing.
86 Written testimony of Dennis Enright, 12 August 2008.
87 Microsoft, for instance, could borrow money at a lower rate than many financially strapped municipalities today.