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Unlocking the Mysteries of Municipal Bonds and Bond Ratings

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Stephen R. Rolandi
April 28, 2023

“The wicked borrows but does not pay back, but the righteous is generous and gives.”- Psalm 37:21 Old Testament  (between 9th & 5th Centuries BC)

“A nation may establish a free government, but without municipal institutions it cannot have the spirit of liberty.” – Alexis de Tocqueville Democracy in America (1835)

These two quotations help illustrate the changing philosophies of debt over the course of human history. In antiquity, the Middle Ages and most of modern history, indebtedness was considered sinful and unlawful. From about the mid-19th century onwards, this philosophy began to change to a more enlightened approach to debt.

Tocqueville admired the American system of towns, counties and states with their advantages of independence and authority in the intergovernmental Federal system under the Constitution.

Thus, the municipal institutions of modern America continue to encourage the spirit of liberty by incurring public debt through constitutional limitations and other means. One way this occurs is through the municipal bond market, which provides the arena for the approximately 90,000 units of state and local government to borrow money for capital projects and other infrastructure needs.

Municipal bonds are a type of debt security issued by local, county and state governments; they act like loans, with bondholders becoming creditors. The major types of municipal (“munis”) bonds are: General Obligation (GO) bonds issued by a governmental entity and not backed by a specific revenue source; and Revenue Bonds, which secure principal and interest payments through the issuer or via sales, fuel, hotel occupancy or some other tax.

The size and scope of the municipal bond market in the United States is vast—in 1999, total sales of long- and short-term bonds encompassing every state, U.S. territories and the District of Columbia, were more than $263 billion. For 2020 and 2021, the comparable data showed $451.2 billion and $483.2 billion, respectively (note: for 2022, due to rising interest rates and bond issuers flush with cash, the volume of bond sales declined to $384 billion—still greater than earlier times).

Proceeds from these bond sales are used to finance a vast array of projects including:

  • Elementary and secondary school buildings;
  • Streets and roads;
  • Government office buildings;
  • Higher education buildings, research laboratories and dormitories;
  • Transportation facilities, including bridges, highways, roads, airports, ports and surface transit;
  • Electric power-generating and -transmission facilities;
  • Water tunnels, water filtration systems and sewer treatment plants;
  • Resource recovery plants;
  • Hospitals, healthcare and assisted living facilities and nursing homes;
  • Housing for low- and moderate-income facilities
  • And in recent years, for cultural institutions and museums

There are guardrails put in place to ensure that state and local governments do not exceed their borrowing capacity. While there is no precise formula, numerous factors, such as the purposes for which the debt is incurred, the governmental community’s economic character, state constitutional limitations, adequacy of municipality’s revenue (tax) systems, the competency with which debt is planned and managed, the (intangible) factor of the people’s willingness to support the issuance of debt, etc. Another major guardrail is provided by the private-sector rating agencies (this is in addition to bond counsel, underwriters and financial advisors). A rating is an alphabetic ad or numerical symbol (similar to an academic grade given to an examination or term paper) used to provide relative indications of credit worthiness/quality; a rating is considered obligatory for the sale to the public of any major public bond issue.

There are three major rating agencies, all headquartered in New York City:

The rating agencies provide a review process for local governments seeking to improve or upgrade their credit ratings. These agencies and others evaluate and rate long-term issues, short-term notes and other credit enhancements. Their objective is to assign to a municipal/public bond a rating to facilitate for market institutions to evaluate risk.

While each agency has unique features in its own rating scale, a “Triple A” grade is the highest rating a public entity can receive (lowest risk and interest charged); each grade below the alphabet (B, C, D, F, etc.) signifies an opinion of less financial strength and conversely, more risk. Politically speaking, elected officials like to use an improved credit rating as an argument to the voters that they should be re-elected. The rating agencies and the ratings themselves are a good way to professionally evaluate the financial and economic health of the public entity seeking to issue these bonds; they provide a measure of transparency to the general public and for those individuals seeking to purchase such bonds for personal investment purposes. They represent a fascinating insight into public sector finance.

For further reading:

A good overview of municipal bonds can be found in “The Fundamentals of Municipal Bonds,” 6th edition (2012) published by the Securities Industry and Financial Markets Association (SIFMA); the work of rating agencies is covered in Giulia Mennillo’s book “Credit Rating Agencies” (2022). If you are looking for how credit rating analyses are developed, I would suggest you read the 2009 publication written by Herwig and Patricia Langohr “The rating agencies and their credit ratings.”

Author: Stephen R. Rolandi retired in 2015 after serving with the State and City of New York. He holds BA and MPA degrees from New York University, and studied law at Brooklyn Law School. He teaches public finance and public management as an Adjunct Professor of Public Administration at John Jay College of Criminal Justice and Pace University. Professor Rolandi is a Trustee of NECoPA; President-emeritus of ASPA’s New York Metropolitan Chapter and past Senior National Council Representative. He has  served  on many  association boards in Washington, DC and New York. He is a frequent guest commentator on  public affairs and political issues affecting the nation and New York State.  You can reach him at:  [email protected] or [email protected]   or  914.441.3399 or 212.237.8000.

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