Crazy Times, Even in the Municipal Bond Market

The last few weeks have seen the municipal bond markets feeling the effects of the COVID-19 pandemic. Today, however, the Bond Buyer reported in its “Daily Briefing” that there was some stabilization last week in the municipal bond market.

During the weeks of the worsening of the pandemic, the municipal bond markets saw less investments in municipal bonds and increased sales by holders of existing municipal bonds. With investors in mutual funds holding municipal bonds withdrawing their investments in those funds, those mutual funds in turn were selling the municipal bonds in which they were invested. Compounding this sell-off, mutual funds were not purchasing, at their historical pace, other municipal bonds. This outflow of cash from the municipal bond market, together with a reduced inflow of cash, resulted in lower prices being paid for municipal bonds, leading to increased interest rates being paid by issuers and increased yields to investors. 

Various reasons have been suggested for this change: for example, investor risk assessments associated with municipal bonds may have changed; potential increase in the cost to municipal bond issuers for public support systems; holders seeking to move into cash positions; and general uncertainty. 

Not all issuers and municipal bonds are of equal risk in the current economic environment. Consider, by way of example, that some issuers have sufficient rainy day funds to see them through the crisis; some municipal bonds are supported by a revenue stream that may be less impacted by the pandemic. 

This is all part of the new economic world we are living in and what is written here at this point in time could change by the time you read it.

Let's Talk Municipal Finance - Issuing Bonds

In my previous installment, I discussed several financing alternatives available to municipalities and certain other governmental entities to supplement revenues from their tax base or user fees. One common option is the issuance of bonds, either independently, or through a pooled issuance. 

The Issuance of Bonds

The first step to issuing a bond is the approval process at the local level.  The process varies depending on the municipality or governmental entity’s charter, enabling statutes, and other protocols that may be applicable to the issuer. It may require a formal recommendation from the governing officers followed by a vote of approval at a meeting of the residents of a municipality, or an approval only from the governing  body of a governmental entity.  Municipalities should note that their ability to incur debt is not unlimited.  For example, municipal debt it is capped by statute at an aggregate of 7.5% of the municipality’s last full state valuation, subject to certain exceptions for, by way of example, debt incurred for school purposes, storm or sanitary sewer purposes or for energy facility purposes.  Certain bonds, such as those for school purposes, may be funded primarily through payments from the state rather than from tax revenues at the local level.

Independent vs. Pooled Issuance

A municipality or governmental entity may choose to issue bonds completely on its own or through a pooled issuance, such as those with the Maine Municipal Bond Bank or New Hampshire Municipal Bond Bank. Bonds issued independently are done so via either a “directed sale” using a financial adviser or a “negotiated sale” using an underwriter.  The use of a pooled issuance, however, can help decrease costs and achieve a higher credit rating, which translates to lower interest rates.  According to the Maine Municipal Bond Bank, while the average cost of an individual municipality’s issuing a bond on its own would be approximately $15,000-18,000, a pooled issuance costs a municipality only about $2500 to $5000 (the cost of local bond counsel).  

Following a pooled issuance, however, the municipality is subject to on-going administrative fees while the bond is outstanding, which are not incurred by the municipality if it chooses to issue the bonds independently. If the municipality or governmental entity chooses to issue bonds using a pooled issuance, it must go through an application and approval process with the entity facilitating the pooled issuance and, if approved, follow the issuance schedule of the facilitating body, which often limits the number of issuances each year.

Regardless of whether a municipality or governmental entity decides to issue bonds independently or as part of a pooled issuance, it is subject to certain obligations following the issuance of the bonds until their maturity date. These obligations include, in the case of tax-exempt bonds, adopting a post-issuance compliance policy intended to maintain the tax-exempt nature of the interest on the bonds.  The municipality or governmental entity may also be required to enter into a continuing disclosure agreement or continuing disclosure certificate, which require the issuer to comply with certain Securities and Exchange Commission reporting requirements.

In my next installment in this series, I will discuss anticipation notes, which are commonly issued directly through a bank.  Anticipation notes are a short-term financing alternative used in anticipation of upcoming bond proceeds or tax revenues.

Let's Talk Municipal Finance – An Introduction

This is the first in a series of posts discussing financing alternatives available to municipalities and certain other governmental entities, such as school, water, and sewer districts. 

Municipalities and other governmental entities throughout Maine and New Hampshire are primarily dependent on real estate tax revenues to finance their municipal projects, however, at times the cost of a certain project may require a lump sum of capital that exceeds revenues. When such a situation arises, those entities may choose to borrow money, which is then repaid over time from tax or other revenues.

For long-term financing, municipalities and other governmental entities frequently issue bonds, either on their own or through a pooled issuance, such as those with the Maine Municipal Bond Bank, the New Hampshire Municipal Bond Bank or the United States Department of Agriculture. Generally speaking, there are two types of bonds – general obligation bonds and revenue bonds. Although municipalities may issue either type of bond, they most frequently issue general obligation bonds, which are payable from the general tax revenues of the municipality. On the other hand, other governmental entities usually issue revenue bonds, which are payable only from the revenues of the specific issuer. For example, an airport that issues a revenue bond to construct a new runway may only use revenues from the airport’s operations to repay the bond, rather than the general tax revenues of the municipality where it is located.

At times, a municipality or governmental entity may not be able to wait until a long-term bond can be issued or annual tax revenues are collected. In that case, they may turn to bond anticipation notes or tax anticipation notes obtained directly through a bank, each of which serve as interim financing until funds can be raised either through a full bond offering or from tax revenues. In other cases, a municipality or governmental entity may choose to avoid debt financing altogether through the use of a municipal lease purchase agreement for new equipment, which is similar to a lease-to-own agreement.

In our next installment in this series, we will discuss the bond application and issuance process and in later installments, other forms of financing such as anticipation notes and municipal lease purchase agreements.