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By Michael Oyakojo
July 28, 2015
Municipal bonds are debt instruments utilised by municipal governments to finance infrastructure projects. A municipal bond is an interest-bearing certificate issued by a bond issuer (such as municipal government, agency, county, village, city or special purpose local authority like a school district) to the bondholder (investors) to raise funds. In return, the bond issuer pays back the principal and the interest to the bondholder in line with the terms of agreement.
In economics, the “benefits received” principle justifies the use of municipal bonds to finance infrastructure projects. In February 2013, Thompson Reuters reported that states and local governments in the United States financed more than $1.65 trillion of infrastructure investment between 2003 and 2012 through the tax-exempt bond market. The top five infrastructure projects financed with tax-exempt municipal bonds during the 10-year period include schools ($514.1 billion), hospitals ($287.9 billion), water and sewer projects ($257.9 billion), highways ($178 billion) and public power projects ($147 billion).
The initial municipal bond offering commences with the identification of an infrastructure project and the authority to issue municipal bond. Depending on the municipality, the selection of a capital project is influenced by societal need, regulations, legal mandate, health and safety concerns, environment and/or climate impacts. The project’s proposal is included in the capital budgeting plan for consideration and ratification by the municipal’s legislature. The proposal details the viability, including the justification for bond issue. If satisfied, the legislature approves the project as part of the capital budget and authorizes financing through bond issuance. In some municipality, the constitution and the law require voters’ approval of the bond issuance through election.
The next step is the structuring of the bond. Most municipal governments hire professionals and consultants, such as a financial adviser and bond counsel, to help with the bond issuance due to the complexities and associated technicalities. A financial adviser is an independent consultant hired by the bond issuer to assist with the planning and the preparation of the bond. The financial adviser examines the financial feasibility of the project; reviews the bond issuer’s revenue streams, cash flow quality, debt repayment capabilities and proposes a financing structure along with the timing of the issue.
In addition, the financial adviser prepares the official statement for distribution to potential underwriters and investors. The official statement is a document prepared by or on behalf of the bond issuer in respect to the municipal bond offering that discloses information on the purpose, terms, obligations, repayments, financial and the economic conditions of the bond issue.
Similarly, the bond counsel is an independent attorney hired by the bond issuer to opine on the legality and the taxability of the bond issue or its tax exemption. The bond counsel provides an independent legal opinion that the issue meets legal and other statutory requirements. It may then issue an unqualified or qualified legal opinion depending on the circumstance(s) of the bond issue. An unqualified legal opinion implies that the bond issue meets the legal and other statutorily requirements. However, a qualified legal opinion pinpoints a lower level of assurance on the bond issue, resulting from a contingent liability that is material to the bond issue, failure in reporting standards or material omission in the official statement.
In addition, the bond issuer hires a credit rating agency to provide a rating on the bond issue. A credit rating represents the credit worthiness of an issue. A high credit rating implies that the risk of default in the payment of the principal and interest is low.
Municipal bonds are sold through a competitive or a negotiated sale. In competitive sale, the bond issuer accepts the best bid from the underwriter(s) who bears the risk associated with the distribution and marketing of the issue. This approach minimizes politics from the process and it is applicable to a relatively simple issue. On the other hand, negotiated sale is applicable to a complex issue with high political interference. The bond issuer negotiates with the underwriter(s) on the best price for the issue. The risk associated with the distribution and marketing of the issue rests with the bond issuer. On certain occasions, municipal bonds are sold directly by the bond issuer to the investors (private placement).
Other important professionals involved in the process include the registrar, who maintains up-to-date registry of the bondholders. The trustee enforces the terms of the trust indenture and performs a fiduciary role on behalf of the bondholders. The auditor provides an independent opinion on the state of affairs of the bond issuer.
In summary, the bond issuer has full responsibility for the bond issue. All material information must be disclosed in the official statement. The bond issuer must ensure that the issue complies with the laws, regulations and guidelines by the Security and Exchange Commission, Internal Revenue Service and other statutory institutions to prevent fine, penalty and other disciplinary measures for seamless bond issuance.
Author: Michael Oyakojo is an economist, chartered accountant, policy analyst and finance professional with relevant experience in private and public sectors in three continents. He can be reached at: [email protected].