Introduction to Municipal Finance 2006 2 U.S. Capital Markets U.S. Equities Market $13.7 Trillion ( Dow Jones Total US Market Index) as of December 31, 2004 Fixed Income Securities Market $19.8 Trillion (Par Value Outstanding)
Introduction to Municipal Finance 2006 3 Money Market Instruments 2.5 Trillion Municipal Securities 1.8 Trillion Asset Backed Securities 1.5 Trillion U.S. Treasuries 3.1 Trillion Mortgage Backed Securities 4.6 Trillion Corporate Bonds 4.0 Trillion Agency Securities 2.3 Trillion Fixed Income Market
Introduction to Municipal Finance 2006 4 Municipal Securities Market * Source: 2004 Bond Buyer Statistical Summary $419 Billion* 2004 $68 Billion*
Introduction to Municipal Finance 2006 5 Issuance Patterns
Introduction to Municipal Finance 2006 6 Who Issues Municipal Bonds ? Why Buy Municipal Bonds ? Who Buys Municipal Bonds ?
Introduction to Municipal Finance 2006 7 Who Issues Tax-Exempt Bonds? General Municipal Issuers CitiesStates Water Districts Trans. Auth. Special Districts Other Agencies School Districts Counties
Introduction to Municipal Finance 2006 8 Private Activity Bonds? Conduit Issues 501(c) 3 Non-profits Facilities for Airports, Docks, Warves Health care facilities Environmental facilities Multi-family and Single-family Housing Student Loan Bonds Industrial Development Bonds (IDBs) *Usually Requires Volume Cap Total U.S. Volume Cap - $25 Billion Private Activity Bonds
Introduction to Municipal Finance 2006 9 Tax Equivalent Yield Tax Exempt Rate ∕ (1- Income Tax Rate) 3.55% / (1 – 28%) = 4.93% Impact of State Income Tax Federal Income Tax Rate = 28% CA State Income Tax = 9.3% 9.3% x (1 - 28%) = 6.7% Marginal Tax Rate = 34.7% Taxable Equivalent Yield 3.55% / (1 - 34.7%) = 5.43% 1. 2. 3. It’s not what you earn, it’s what you keep!
Introduction to Municipal Finance 2006 10 Impact of Higher Tax Bracket Tax-exempt securities are more attractive to investors in higher tax brackets. Federal Income Tax Rate = 38.9% California State Income Tax = 9.3% 9.3% x (1 – 38.9%) = 5.7% Marginal Tax Rate = 44.6% Taxable Equivalent Yield 3.55% / (1 - 44.6%) = 6.40% 1. 2. 3. Tax-exempt securities often provide attractive investments to high net worth investors. 10-year AAA/AA corporate bonds yielding 4.50 – 4.75%. California issuers have lower borrowing costs (than national average): 10-Year Insured (National Scale) = 3.55% vs. CA-Insured = 3.45%
Introduction to Municipal Finance 2006 11 Holders of Municipal Debt
Introduction to Municipal Finance 2006 12 The Basics
Introduction to Municipal Finance 2006 13 What is a municipal bond? What is a bond? A loan secured by a pledge of revenues and/or assets (e.g., car loan, mortgage, etc.) Monetized cash flows. What is a municipal bond? A debt or obligation of a public agency. Bears interest. Recognize by specific maturity date. Generally used for capital financing.
Introduction to Municipal Finance 2006 14 Types of Municipal Securities Backed by Revenue of Project/Enterprise Backed by project/enterprise-specific revenues Revenue bonds - water and wastewater enterprise bonds, parking bonds, sales tax, etc.) Tax Allocation Bonds Direct Obligation of Issuer Requires an General Fund Pledge and/or asset pledge, but no voter approval required COPs / Lease Revenue Bonds / Tax-exempt Lease POBs (Pension Obligation Bonds) TRANs (Tax and Revenue Anticipation Notes) Backed by Property Tax or Special Lien Requires voter approval General Obligation Bonds – unlimited ability to raise taxes Assessment District Bonds – special assessment bonds CFDs (Community Facilities District) – special tax bonds
Introduction to Municipal Finance 2006 15 Impact of Interest on Borrowing
Introduction to Municipal Finance 2006 16 Sources & Uses Comparison of 15 and 30 –year financing
Introduction to Municipal Finance 2006 17 Sample Debt Service Schedule
Introduction to Municipal Finance 2006 18 Debt Service Comparison
Introduction to Municipal Finance 2006 19 Credit Ratings, Credit Enhancement and Borrowing Costs
Introduction to Municipal Finance 2006 20 Credit Ratings and Bond Insurance Bond that carry “AAA” bond insurance trade like natural “AA” bonds. Fees based on total debt service paid (principal + interest).
Introduction to Municipal Finance 2006 21 The Yield Curve Tax-Exempt Bonds take advantage of serialized (annual maturities) structure, as opposed to a single bullet maturity
Introduction to Municipal Finance 2006 22 The Yield Curve
Introduction to Municipal Finance 2006 23 U.S. Treasuries vs. Municipal Bonds The tax-exempt interest rates do not follow the Treasury market directly.
Introduction to Municipal Finance 2006 24 FITCH Default Study Municipal Bonds vs. Corporate Bonds Source: FITCH 1999 and 2003 Municipal Default Risk Studies
Introduction to Municipal Finance 2006 25 The Issuance Process
Introduction to Municipal Finance 2006 26 The Players Issuer Hires the team Approves financing Provides financing objectives Bond counsel Issues opinion as to validity and exemption Drafts basic legal documents (e.g. Trust Indenture) and Resolutions Underwriter Buys at wholesale, sells at retail Financial advisor Advises on suitability of financial plan, pricing, terms and structure Disclosure Counsel Drafts Offering Document (Preliminary Official Statement – POS) (Official Statement – OS)
Introduction to Municipal Finance 2006 27 The Role of the Financial Advisor Planning of the financing program How much money is needed; when is it needed; how much will it cost Management of the individual sales of debt required to execute the program Probably the most visible part of what we do, but by no means the most important Selection of the underwriter and other service providers Bond counsel, rating agency, trustee, insurer, others Advise on the reinvestment of bond proceeds
Introduction to Municipal Finance 2006 28 Method of Issuance Competitive (25%) Public Offering (97%) Private Placement (3%) Negotiated (75%) The issuer should decide which method of sale is likely to result in the lowest costs for its debt and achieve other important policy objectives
Introduction to Municipal Finance 2006 29 Public Offering Negotiated Sale May be used for transactions that require greater market support. Underwriting firm is selected in advance of the sale date. Final purchase price, reflecting underwriter’s discount and coupon-yield structure is negotiated on the sale date. Once the terms for the sale have been reached, a bond purchase agreement is executed. Competitive Sale Typically used for G.O. Bonds/investment grade issues. FA assists issuer in determining size and structure. Publish Notice of Sale (NOS) – serves as Purchase Agreement Solicit bids via competitive process Sell bonds to firm/syndicate that provides the lowest borrowing costs (TIC%)
Introduction to Municipal Finance 2006 30 Private Placement Issuer sells bonds directly to a limited number of sophisticated investors without a public offering. Includes tax-exempt leases Limited secondary market for trades. No offering documents needed. Lower issuance costs, slightly higher borrowing costs Smaller transactions / shorter maturity
Introduction to Municipal Finance 2006 31 Ten Helpful Tips
Introduction to Municipal Finance 2006 32 Ten Helpful Tips Focus on the borrowing costs and structure – not the cost of issuance. 1 bps reduction in a Term bond (10 years) for a 30-year borrowing saves more than $10,000. Tax-exempt bonds are not always better than taxable bonds. 3% NPV savings is a general rule Depends on time to maturity, level of interests rates, amount of savings, and refunding objectives. “Suit Rule” – The amount of savings from a refunding issue should exceed the fees of the “people in suits” (attorneys, bankers, consultants)
Introduction to Municipal Finance 2006 33 Ten Helpful Tips Cash-funded DSR may cost less than a Surety. Do not ignore the reinvestment of bond proceeds Refunding with 3% savings on $10 million = $300,000 In comparison, Increase DSR earnings by 1.0% for 30 years: ($1 million DSR x 1.0% x 30 = $300,000) Opportunity to make up negative arbitrage goes away when you call the bonds. You may not have to perform arbitrage calculations every 5 years.
Introduction to Municipal Finance 2006 34 Ten Helpful Tips G.O. Bond Election does not require majority voter approval Requires 1/3 + 1 voter to say no Include additional $ in Cost of Issuance (contingency) to cover future / on-going legal and consulting fees. Post Documents On-Line + Get Final Transcripts in Electronic (Pdf) Format.