21109 Infrastructure Notes 0tatio,, beveX February 1997 ' The World Baiik Urban No. FM-8a Municipal Bond Markets Experience of the USA Samir El Daher INTRODUCTION implied sovereign guarantee-have lagged behind. Reforms are however taking place and municipal Municipal bond markets provide a vehicle to narrow markets (in Italy and Spain) are slowly developing. local governments resource gap through schemes Amongst other developed countries, Australia has also varying from debt funding based on the full faith and created a truly sub-sovereign debt market. credit of sub-sovereign issuers, to revenue bonds secured by the earnings of such projects as water facilities and Municipal bonds have been the primary vehicle for toll roads. This note reviews the main characteristics of financing local infrastructure in the US. They include the US municipal bond markets-the most advanced by general obligation bonds supported by the taxing power any measure of depth and sophistication. A separate note of local governments as well as project revenue bonds by discusses the conditions underlying the development of states and local jurisdictions such as counties and cities municipal credit markets in developing countries. (including their "special purpose" corporations). VARIOUS CATEGORIES OF MUNICIPAL BONDS General Obligation Bonds In their broadest definition, municipal bond markets General Obligation (GO) bonds are debt instruments refer to borrowings by sub-sovereign public entities, issued against the full faith and credit of local directly or through their public corporations, to fund governments. They remain essential financing general purpose expenditures or specific purpose instruments of tax-supported capital projects. Unless projects. The US municipal bond markets have certain tax revenues are specifically restricted, issuers developed over the past hundred years into a main generally back GO bonds with all their revenue raising component of the credit markets. The growth of these powers. Typically, local governments at the municipal markets may be attributed to the country's decentralized level issue debt obligations against their ability to raise federal structure and the innovations that have property taxes. Sub-national governments at the state characterized its financial system. The tax status under level usually issue debt obligations against unrestricted which US municipal debt is issued may have had an revenue streams such as sales or income taxes. The impact on market growth. Municipal securities are capacity and willingness of local governments to service sometimes referred to as the "tax-exempt" segment their GO debt depend upon the economy as well as their because interest earnings on municipal issues are exempt financial performance and debt burden. Property taxes from federal income, and possibly state and local, taxes. have been a main source of municipal income, although The tax regime has been subject of a number of reforms in the US their share of total revenues has been (including the major Tax Reform Act of 1986) and of decreasing (from over 95% in the thirties, to less than policy debates beyond the scope of this note. European 80% on average today) as a result of: (i) the value of real countries with centralized processes for regional resource property not being necessarily linked to household allocation-and where local government debt had often income and therefore to constituents' ability to pay taxes; and (ii) growing political resistance and legal Creditworthiness of General Obligation Bonds and barriers to increasing property taxes (as reflected for Revenue Bonds instance by Propositions "13" in California and 2&1/2 in Massachusetts). The comparison of GO bonds to revenue bonds in terms of creditworthiness is not straightforward as a number of Other Categories of General Obligation Bonds factors come into play. On the one hand, the attractiveness of financing capital projects through user Other categories of GO bonds have been developed in fees rather than broad-based taxes has, since the 1970's, the US. For instance, "Special Purpose Districts" are reduced the capital market dominance of GO financing political subdivisions created to provide economic over revenue bonds. This is due to the: (i) limited and development or related services to residential, uncertain legal capacity of governments to carry ever commercial or industrial areas. These can be both within larger debt burdens; and (ii) continuing market an incorporated municipality or outside its limits, in innovations which favor revenue bond issuance. "developing areas". These districts can represent viable Moreover, as strong as a tax-backed GO pledge might arrangements for effective delivery of public utility be, it is no absolute guarantee of repayment. In fact some services such as water, sewers, hospitals, fire protection investors might view a dedicated stream of revenues and roads, when demand overflows administrative from services by a government utility as a more flexible boundaries of individual local governments. Special and reliable security allowing for an increase in user fees district obligations are generally tax-backed although as opposed to tax rates/bases subject to voter their ability to raise taxes may often be restricted, by tax authorization, restriction or repeal. On the other hand, ceilings for instance. "Tax Increment Districts" can levy the security for revenue bonds remains narrower than taxes on the growth of property value and have been broad-based GO bonds which can call on property, used to fund the re-development of neglected downtown income and sales taxes to meet debt service areas. These have been viewed as viable and safe requirements. In addition, the competition which may instruments when the project area is of significant size exist among providers of services may squeeze and presents a good diversity amongst tax payers. Some profitability and market share and introduce uncertainty of the special districts may be more speculative in nature. as regards repayment ability compared to GO tax-backed obligations. Revenue Bonds Short-term Municipal Instruments and Other Features The second main category of municipal debt consists of of Municipal Debt "'revenue bonds". These are secured by user fees or dedicated taxes rather than the general taxing power of While municipal markets mainly consist of long-dated local governments. US revenue bonds have included issues, there are also short-term municipal instruments issues for a wide range of investments including health such as municipal notes and commercial paper. Although care, higher education, transportation (highways, mass commercial paper (CP) is issued for periods ranging transit, toll roads, ports, airports) and utilities (water, from 30 to 270 days, a CP "program" itself could be waste water, power, natural gas). Security for this kind rolled-over for several years so as to exhibit a strong of debt may vary considerably but is typically a single relationship to long-term debt. For instance, short-term dedicated revenue stream directly related to the services "revenue anticipation notes" and in particular "tax provided. For example, revenues from electricity sales anticipation notes" are issued to address seasonal can secure bonds sold to build a power plant. However, mismatches between expenditures for ongoing for municipal facilities for which revenues would not be operations and lump sum receipts. sufficient to service debt-such as convention centers, parking and street lighting-the security could be a Municipalities also use debt instruments with features dedicated sales tax, a fuel tax or a combination of both. aimed at minimizing initial cash outlays or interest costs. For instance municipalities may issue "zero coupon" Municipalities may sometimes issue a hybrid of general bonds with no coupon payment to bondholders. Instead obligation and revenue bonds to enhance the credit of the bond is issued at a deep discount and matures at marginal investments. These so-called "double-barreled" par-the advantage being the smaller initial cash outlay bonds are secured by an enterprise's revenues and, by the issuing municipality. The difference between par should these not be sufficient, an additional security value and the original discount price could be translated pledge of full faith and credit of the issuer government. into a specified annual yield. A variant is the "municipal multiplier" which is a bond issued at par and does provide for interest payments; however interest accruals fgv 3 Urban No. ip' "! are only paid at maturity assuming that the undistributed conventional issue-a "premium" that compensates the payments had been re-invested at an agreed yield bondholder as to the uncertain maturity of his holding. (usually the bond yield-to-maturity at issue). "Variable- Other derivatives, such as interest rate swaps or forward rate demand obligations" are interest-bearing notes with contracts, may allow municipal issuers to hedge their "put" features tied to specific short-term indices, sold by financial position in altering the risk profile of their municipalities to finance capital projects. These are part liabilities say from variable to fixed rates, or setting a of the "structured" finance products. cap on the potential cost of borrowing. Swaps are also used by bondholders to similar ends. Structured products Structured Municipal Finance entail though a number of risks, and in particular credit risk. "Structured" financings have become part of the municipal debt markets. These are conventional debt State Revolving Funds instruments combined with derivative products such as futures, options and swaps. (Futures are contracts where The US "State Revolving Funds" (SRFs) are pool financial commitments between two parties are "settled" finance arrangements that provide low-cost loans to local at a future agreed date. Options are buy/sell agreements entities for projects that comply with national where, against an up-front fee, one party acquires the regulations. These were introduced in connection with discretionary right-with no obligation-to settle a the 1984 "Federal Clean Water Act" on environmental financial contract at an agreed price and time. Swaps are regulations. They involve capital grants from the federal contracts whereby two parties agree to assume each government to the state, matched by a contribution from other's financial liabilities as these come due.) While the state (currently 20%). Matching contributions are derivatives may be used for speculative purposes, they primarily funded with proceeds of state general also are powerful instruments for "hedging" risk-i.e., obligation, and less frequently revenue, bonds. SRF for protecting a financial position against unwanted lending is mostly accomplished in leveraging central market price movements. Structured financings may thus capital grants and state matching funds through bond entail risk mitigating and credit enhancement features issuance. The size, composition and diversification of the embedded in the debt instruments. loans extended by the fund enhance the quality of the overall portfolio above the pool's weakest credit. A "putable" bond for instance gives investors the right to Mechanisms enhancing the credit of the bonds issued by sell back-if they so elect-the security to the issuer at the fund can also be considered, for instance in an agreed price (usually the par value) at designated subordinating one class of debt to the rights of senior dates or within specified periods. Bondholders may elect creditors. to "exercise" such a right should they become concerned about the deteriorating credit standing of an issuer. Put CREDIT RISK ISSUES options also provide bondholders with market protection in an environment of rising interest rates, as they could Unlike US Government securities, municipal debt redeem their investment at par-though the market value obligations are not immune to default. In the mid-70's, of their bonds might have fallen below par-and re- New York City had to default on its debt obligations invest the proceeds in higher yield instruments. rather than disrupt the provision of basic city services. Conversely, from the issuers' stand-point, municipal (Note that this default did not result in liabilities for, nor bonds may entail a "call option", an arrangement which prompt a rescue by, the Federal Government-a permits an issuing municipality to redeem-at its option reflection of the maturity of the US municipal bond under specified conditions-the bond before the markets.) Credit ratings which allow investors to gauge scheduled maturity. An issuer would elect to exercise the creditworthiness of municipal issuers, and financial such a right if, in an environment of declining interest and legal mechanisms (such as options or guarantees) rates, the outstanding debt-which carries a high fixed that enhance the credit quality of municipal debt have coupon rate-could be replaced by lower cost become important factors in investment choices. borrowings. Credit Rating. The capability of rating agencies to assess Derivative products which extend market and credit risk the creditworthiness of municipal and other issuers has protection to investors (e.g., put options) and market considerably evolved since the time of the Great hedge to issuers (e.g., call options) are provided at a Depression. Indeed, "of the municipal debt issues that price paid for by the beneficiary of the derivative were rated by a commercial rating company in 1929 and instrument. For instance a municipal debt issue with an plunged into default in 1932, 78 percent had been rated embedded call option should carry a higher yield than a AA or better, and 48 percent had been rated AAA". Credit ratings have now achieved "wide investor Bond Insurance. Bond insurance has played in the past acceptance as easily usable tools for differentiating credit 15-20 years an important role in the growth of the US quality". They have become important parameters in municipal bond markets. Indeed, individual investors investment decisions, particularly in the US municipal rely on bond insurance to enhance the quality of the bond markets which have a strong individual investor assets they are willing to hold. Yet, bond insurance in the base averse to, and ill-equipped to assess, credit risk. It is US has not been a vehicle for allowing non-creditworthy no surprise thus that most US municipal debt issuers issuers to have market access. Rather, the insurance by have secured a credit rating by one or more of the "AAA" rated insurance companies allows small issuers leading rating agencies. The stamp of a rating agency is at the lower end of the investment grade ("BBB" and however no guarantee against default as the financial "A") to access the national market for high investment condition of a rated entity may change, sometimes grade debt. This enhances the liquidity of the issues rapidly-as shown by the example of "Orange County" which can then trade on secondary markets. Close to in California which despite its high quality rating had to 50% of total US municipal bond (75% of "BBB" and file for bankruptcy protection as a result of speculative "A") issues are covered by bond insurance. Providing financial management. Another example is "Washington insurance coverage only to investment grade (i.e., low Public Power Supply System" which defaulted on its default risk) credits while charging low premia makes debt obligations in 1990 while these had high quality the economics of insurance attractive to issuers. ratings. Outstanding debt ratings may thus be subject to (Insurance firms further enhance their profitability downgrade/upgrade should a rating agency consider, in through high leverage and investment income.) the course of its surveillance process, that material changes in the financial condition of an issuing entity do PRICING OF MUNICIPAL DEBT warrant a rating review. The issuer rating may be put under "credit watch" until such time as a revised rating is Debt by non-sovereign, including municipal, borrowers announced. is priced in reference to the government securities yield curve, where spreads reflect issuers' parameters in terms Credit Enhancement Mechanisms. The creditworthiness of creditworthiness, liquidity and size. Given the tax- of municipal debt issues may be enhanced by special exempt features of municipal debt, the true reference for features which confer preferential status on debt investors in US municipal securities would be the obligations. These include seniority, collateral security, "taxable equivalent yield" which must be earned on guarantees, put options, joint and several liability of a taxable treasury bonds to produce the same yield as a number of entities, and bank letters of credit for short- tax-exempt municipal bond. term debt. Municipal debt can also have the legal provisions of "public credit enhancements" which may CONCLUSION entail state insurance programs, central/state guarantees, and automatic withholding and use of state aid-most Municipal bonds, an important segment of the US common in the US-to meet defaulted debt service. securities markets, have been a primary source of local Such programs may be used both to increase market infrastructure finance. The challenge would be to acceptance of bond issues and lower interest costs. develop these markets in developing countries, where Securitization is another credit enhancement tool. local government borrowings have been largely confined [Mortgage-backed securities, though not related to local to bank loans often with central government guarantees. government finance, provide an example of securitization which has considerably strengthened the housing finance market-its essential pillar being the TO LEARN MORE diversified residential housing stock that backs the debt issues. Added to the physical asset, is the "public credit Municipal Bond Portfolio Management, 1995, by Frank enhancement" resulting from the implied sovereign Fabozzi. guarantee for the federal housing agencies (FNMA, GNNMA) in the case of "pass-through" mortgage Infrastructure Note, FM-8b, February 1997, "Municipal securities]. Other forms of municipal credit Bond Markets-Prospects for Developing Countries" by enhancements may use separately capitalized Samir El Daher. subsidiaries which could be made "bankruptcy-remote". Finally, a potent form of municipal credit enhancement is bond insurance.