A municipal bond is a form of debt issued by state or local governments to raise funds for projects that benefit the public, such as schools, roads and bridges, community facilities, utilities and essential services.
There are two primary types of municipal bonds: General obligation bonds (often referred to as GO bonds) and revenue bonds.
General obligation bonds
General obligation bonds are backed by the issuer’s full faith, credit, and taxing power. The issuer pledges to use all legally available resources, including tax revenues, to repay the bondholders.
These bonds are often used to finance projects that benefit the entire community. The issuance of general obligation bonds may or may not require voter approval, depending on the jurisdiction.
Revenue bonds are specifically backed by revenues generated by the project they financed. This could include toll collections from a new toll road or other forms of revenue from utilities, airports, and bridges. Revenue bonds do not usually require voter approval.
Key municipal bond financing participants
In any municipal bond issuance, there are key participants who play crucial roles in the financing process. From initiating the legal process to ensuring compliance and facilitating bond sales, each participant has specific responsibilities.
- Issues municipal bonds for financing of public projects
- Responsible for repaying principal and interest on the bonds through property taxes or generation of system revenues
- Represents the issuer’s best interests (fiduciary) and is legally required to act in the issuer’s best interest
- Assists in the structuring and issuance of bonds for lower financing cost
- Considers factors such as interest rates, bond maturity and repayment sources
- Drafts bond offering documents
- Reviews applicable state and federal laws to confirm the issuer’s authority
- Acts as an intermediary between the issuer and investors, providing market access with an obligation of fair dealing
- Determines the initial offering price and markets bonds to investors
Other municipal bond professionals
- Disclosure counsel, underwriter’s counsel, paying agent, trustee: These parties work with the key participants to ensure a smooth bond issuance process, adding layers of expertise to the transaction.
Method of municipal bond sale
When it comes to municipal bond sales, issuers generally have two primary methods of sale to consider: negotiated sales and competitive sales – each have their unique processes and advantages.
- Underwriter selection: Whether through a request for proposal (RFP) process or an existing relationship, the issuer appoints an underwriter based on its track record, expertise, and ability to effectively price the bonds.
- Discussion on bond structure, pricing, and marketing strategies: The issuer, along with its municipal advisor, consults with the underwriter to discuss terms, structure, pricing, and strategies for marketing the bonds. This collaboration helps determine the appropriate timing for the sale and the remainder of the schedule related to the bond sale.
- Review and possible negotiation of pricing with underwriter: The issuer and municipal advisor review the proposed pricing from the underwriter and negotiate adjustments if necessary, ensuring the issuer gets the best terms on the offering. This can include capital market transactions, private placements or bank loans.
- Underwriter selection through a formal bidding process: Unlike negotiated sales, competitive sales require the issuer to appoint an underwriter through a bidding process. This is often done through a web interface, where bids are collected, solicited and tabulated. The underwriter with the lowest net interest cost (NIC) or true interest cost (TIC) is awarded the opportunity to purchase and resell the bonds. This calculation is predetermined, based on whatever the municipal advisor advises to be best considering market conditions leading up to the date of the bond sale.
- Preparation of notice of sale: Working together, the issuer and municipal advisor determine the timing of the sale and the rest of the financing timeline. They prepare the notice of sale and preliminary official statement, circulate them to potential market participants.
Bond issuance process
The bond issuance process is an intricate procedure that moves through four main phases.
Planning and structuring
- Identify capital needs and fit: Issuers may wish to include professionals like bond attorneys and municipal advisors early in the process to identify capital needs and evaluate how new debt will interact with existing debt.
- Evaluate bond structures and repayment sources: Involving the municipal advisor and/or underwriter early in this process helps determine essential factors like amortization structure, final maturity, and how new debt needs to be wrapped around existing debt. Evaluating bond structures and determining repayment sources are vital at this stage.
- Prepare preliminary offering statement, indenture of trust, and notice of sale: This effort is cooperative among underwriters, counsel and the issuer’s municipal advisor. Focus areas include the security pledge, covenants, flow of funds, and terms of the bonds.
- Governing body passes a resolution to issue bonds: This step may vary depending on state statutes, but usually involves public hearings, bond referendums, or passing an authorizing resolution or ordinance. It can also include delegating authority to staff or an elected official to execute final bond documents if sale results are within certain preset parameters.
- Approve general financing terms and related documents: In some cases, this step can happen post-sale—such as during a board or council meeting—depending on state statutes.
Marketing and bond pricing
- Distribute offering information to prospective investors: This includes distributing the preliminary official statement, which outlines the terms of the bonds and helps investors determine the investment’s suitability. This is considered the issuer’s document and every effort must be taken to ensure it is materially complete and accurate. Its development includes counsel to the underwriter and issuer as well as the issuer’s municipal advisor and the issuer itself.
- Negotiation and tabulation of bids: This includes discussions, negotiations, and communication with the underwriter, especially in a negotiated sale. In competitive sales, the municipal advisor tabulates the bids received on the sale day. It also involves determining whether to pursue bond insurance or a rating to decrease interest costs.
Final document preparation, execution, settlement, and delivery: This phase includes the preparation of final bond documents, execution, and settlement delivery of the bonds and funds. Most of this is handled by the financing team, such as the bond council, municipal advisor, underwriter, and trustee or paying agent.
After the bond issuance has reached its closing, there are important considerations that ensure compliance with regulations and maintain quality bond market access for the future.
Handling of tax-exempt bond proceeds
- Project fund: Issuers must match the cash flows from investments in this fund with the investment maturities to avoid discrepancies.
- Costs of issuance: Costs can be paid out of the proceeds from the bond issue.
- Reinvestment of bond proceeds: This is an important aspect of financial prudence and is critical when short-term interest rates are high.
- Reimbursements: In cases where capital expenditures have already been made, reimbursements can be sought if done correctly with the guidance of bond counsel.
- Debt service reserve fund: This is often established in the case of a revenue bond. Having an investment policy and keeping separate accounts for different debt issues can be viewed favorably by rating agencies and aid in avoiding commingling of funds.
- Arbitrage calculations: Arbitrage involves the issuer collecting more interest from investments on bond proceeds than the bond yield on newly issued bonds. Regular calculations must be run, usually by certified public accountants (CPAs), to ensure compliance with IRS regulations, avoiding making a profit off a tax exemption. These calculations can be complex and typically require professional advice.
Continuing disclosure is a commitment to bondholders to provide updated operating information and financial data annually, as well as notifications of any material events. Many issuers opt for financial professionals to complete these filings to ensure accuracy and timeliness. Missed filings can disrupt the issuer’s market access for up to five years.
- Annual disclosure: This involves regularly providing financial data and operating information.
- Notification of material events: The issuer must also notify bondholders if any significant events occur, as defined in the continuing disclosure agreement or certificate.
The management of payment includes setting aside funds and sourcing revenues from operations. This encompasses various aspects:
- Payment collection: A paying agent or trustee will be responsible for collecting and distributing payments. This ensures timely and proper payment handling.
- Establishing debt service funds and levies: Establishing the debt service fund or levy for any general obligation bonds within the budget each fiscal year or designating specific revenues into a sinking fund is vital to ensure payments are made.
- Sourcing revenues: Whether from general operations such as water, wastewater, or electric, the revenues must be designated and set aside proportionately each month to cover the bond payment on the due date.
We’ve sketched out here the basic anatomy of a municipal bond offering, but we haven’t discussed critical factors such as market conditions and community-specific tax considerations. Our municipal advisory team is committed to serving cities, counties, and communities across the nation to help them maintain financial strength and achieve their organizational aspirations.
Learn more about how UMB Financial Services, Inc. municipal advisors can assist to help find a quality path forward during these complex conditions. Contact us to connect with a municipal advisory team member.
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