Bond Basics | Municipal Bonds



Municipal bonds are usually, but not always, issued to pay for capital improvement projects—new schools (or school renovations), roads, water-treatment plants, prisons, etc. rather than current operating expenses. There are three main types of munis:
  • Taxable municipal bonds are securities issued by public entities that do not meet federal requirements for tax exemption. They may, for example, be issued to finance sports facilities or certain kinds of housing projects.

  • 501(c)(3) bonds are securities that are issued by government entities on behalf of private non-profit organizations such as schools, hospitals and museums. These are known as pass-through or conduit bonds, given that responsibility for interest and principal payments rests with the non-profit rather than the government issuer.

  • Industrial revenue bonds (IRBs) are another form of conduit financing included under the umbrella of municipal bonds.  IRBs (also called industrial development bonds) are a form of economic development incentive for private corporations. The companies enjoy low-cost financing as a result of the fact that the bonds are issued via a government entity and thus are tax-exempt. As a result, they can get away with offering a lower rate of interest. IRBs are, in effect, corporate bonds laundered through public agencies to make them tax-free in the name of economic development.
  There are two forms of IRBs:
  • Small issue IRBs – which are restricted to the construction, expansion or renovation of manufacturing facilities – are limited to $1 million, but that amount can under certain circumstances go up to $10 million.

  • Exempt facility IRBs have no size limits, but they can be used only for specific types of projects, such as airports, docks, parking garages, water & sewer facilities, and certain rental housing. There is a $40 million aggregate limit (nationwide) on the total amount of IRBs that can be outstanding for the same company.
501(c)(3) and industrial revenue bonds are known as private activity bonds.

In 2002, state and local governments issued $358 billion in long-term bonds and $72 billion in short-term securities, for a total of $420 billion. These numbers were all-time highs, up from a total of $55 billion in 1980 and $162 billion in 1990. The total value of outstanding municipals is about $1.8 trillion.  
The following table shows the main categories for the use of proceeds from municipal debt in 1999:
General purpose............................26%
Public power.................................. 2%
Water, sewer & gas.......................7%
Pollution Control............................. 4%
Other.............................................. 29%
Prisons fall within the catchall “other” category. The Bureau of Justice Statistics reports that in 1996 (the latest year available), states spent a total of about $808 million on prison construction. If all of this was raised through municipal bonds, it would represent about one half of one percent of the total value of municipals issued in 1996.
Issuers are government entities that borrow money for a public purpose by selling bonds. There are tens of thousands of such entities in the United States. They may either be existing government agencies or else authorities that are created expressly to issue bonds for a specific activity. Authorities—which were pioneered in New York City with the Port Authority (created 1921) and the Triborough Bridge & Tunnel Authority (1933)—can also issue bonds on behalf of non-profit organizations (such as hospitals and universities) for capital projects or on behalf of for-profit companies for purposes such as financing pollution-control equipment.
Here is a breakdown by type of issuer for long-term bonds in the period 1989-1999:
  • local governments................ 39.5%
  • state authorities.................... 30.0%
  • local authorities..................... 18.6%
  • state governments................ 9.7%
  • public colleges...................... 1.7%
New issues of less than $10 million account for about 70 percent of offerings, but only about 15 percent in dollar terms.
The states with the largest issuance of bonds in 2001 (in dollar terms) were:
California - about 11% of U.S. total
Texas – about 9%
New York – about 8%
Florida – about 5%
Illinois – about 5%
Investors/bondholders are institutions and households (usually wealthy ones) that purchase the bonds and are thus entitled to periodic interest payments and ultimately repayment of the principal. According to the Federal Reserve, the main largest categories of holders of municipals in 1999  were:
Households...................................... 35.0%
Mutual funds..................................... 33.7%
Insurance companies...................... 13.7%
Commercial banks........................... 7.2%
Bank personal trusts........................ 5.8%
Underwriters are financial intermediaries that help issuers bring their bonds to market. They advise the issuer on the bond offering and purchase the bonds for resale to institutional and individual investors. The difference between the price the underwriter pays to the issuer and the price at which it resells the bonds to investors is its profit, which is called the gross spread or the underwriter’s discount. This represents compensation for services provided and the risks taken in the transaction. The spread for municipals has tended to decline over the past decade and now tends to be about $7 per $1,000 of par value.
Underwriters are chosen in two main ways. In a competitive sale, the issuer puts out a call for bids and chooses the lowest one, which may be submitted by a group of investment banks operating as a syndicate. In competitive sales, which are also known as advertised sales or sealed-bid sales, the issuer has already structured the bond issue before seeking an underwriter.
Alternatively, in a negotiated sale, the issuer chooses a lead underwriter or senior manager to help it plan the bond issue from the start, including the financial structuring of the offering, and to manage the process through to completion. In this case, the underwriter, which is selected after a request-for-proposal process, may not be the one offering the best financial terms. Past relationships, reputation and other factors may come into play.
Competitive sales used to make up the lion’s share of municipal bond issues, but that has been changing for the past two decades. Today about three-quarters of long-term municipal issues (measured in dollar terms) are done through negotiated sales. Among revenue bonds, negotiated sales are about twice as common as competitive sales, while G.O. bonds are about evenly split.
Underwriting is heavily concentrated among the large national investment banks. The top 10 firms -- such as Salomon Smith Barney, UBS, Merrill Lynch, Goldman Sachs and Lehman Brothers-- are senior managers on about two-thirds of the volume of new long-term issues.
In some cases, an investment bank is used to manage a sale in which there is no public underwriting, and the bonds instead are sold directly to a single investor or a small group of investors. This process is known as a private placement, and the investment bank handling such a deal is known as a placement agent.
For more on underwriting and private placements, see the Major Players section.
Financial advisors are often hired by issuers to assist in planning a bond issue that is going to be offered to underwriters in a competitive sale. A firm that serves as an advisor is not eligible to be chosen as an underwriter.
Municipal bond dealers are traders that buy and sell municipal bonds in the secondary market. A subset of these dealers are municipal bond brokers, who facilitate trading among dealers.
Bond counsel is a lawyer or law firm that represents the legal interests of the bondholders. The bond counsel provides a legal opinion affirming, above all, that the bonds are legitimate and binding obligations of the issuers, and that the interest paid on the bonds will be tax exempt. The opinion is based on a review of relevant law and a determination that the issuer has followed all the necessary procedural steps. Underwriter’s counsel is a lawyer or law firm retained by the underwriter to perform due diligence analysis of the issuer; i.e., a review of the financial condition of the government entity offering the bonds. The underwriter’s counsel also prepares the contract between the issuer and the underwriter. For more on bond lawyers, see the Major Players section.
Trustees are institutions that carry out the administrative duties required by the terms of the bond agreement. These include creating accounts and holding funds collected from the issuer, making payments to bondholders, maintaining lists of bondholders and representing the interests of bondholders in the event of a default.
Rating Agencies are private bodies that do independent financial analyses of issuers and offerings to determine the credit quality of the bond. The quality is expressed in terms of a system of ratings. These ratings are closely consulted by investors and thus have a significant influence on the interest rates that issuers need to offer.
The three dominant rating agencies for municipals are:
  • Standard & Poor’s
  • Moody’s
  • Fitch
Each of the three has its own system of ratings, though there are strong similarities. The highest rating given by Standard & Poor’s and Fitch is AAA; for Moody’s it is Aaa. For more on the rating agencies and their methods, see the Major Players section.
Bond insurers are insurance companies that sell coverage to issuers that guarantees payments of interest and principal in the event that the issuer cannot live up to its financial obligations. Bond insurance is a device to increase the security of a bond in the eyes of a potential investor. Given this reduced level of risk, investors are willing to accept somewhat lower interest payments.
For municipals, insurance came about in the late 1970s in response to the default by the Washington Public Power system (known informally as “Whoops”) and the near-default of New York City bonds in the 1970s. Today, about half of all long-term debt is issued with insurance.
The leading bond insurance firms are:
  • Municipal Bond Insurance Association (MBIA)
  • Financial Guaranty Insurance Company (FGIC)
  • American Municipal Bond Assurance Co. (AMBAC)
  • Financial Security Assurance (FSA)
 All of these firms are rated AAA and thus the bonds they insure have the same rating.
Another form of credit enhancement are letters of credit (LOC) provided to issuers by banks. LOCs, however, are not quite as protective as insurance. They promise that the bank will lend a certain amount of money to the issuer to cover interest payments, not that the bank itself will assume that responsibility. These days, bond insurance is much more common than LOCs. For more on bond insurers, see the Major Players section.
Regulatory agencies are government or industry bodies that set standards for the issuance and trading of bonds. Ultimate regulatory power is in the hands of the Securities and Exchange Commission, though in 1975 Congress created the Municipal Securities Rulemaking Board to develop rules and set standards specifically for the municipal bond market. The MSRB is an independent, industry self-regulatory body whose authority covers dealers and brokers in municipal securities—but not issuers. Its mandate covers standards of operational capability, professional qualifications, rules of fair practice, recordkeeping and the like.
Among the MSRB’s rules is one (adopted in response to an SEC rule) requiring underwriters to provide the Board with copies of all muni bond prospectuses (known as Official Statements). Free access to electronic versions of these documents is available at the Board’s headquarters in Alexandria, Virginia, but not on the internet.
The MSRB website does, however, contain quarterly Forms G-37/G-38 submitted by dealers. On these forms, dealers must report which issuers it has worked with in the previous quarter and must disclose any political contributions to issuer officials or to state and local political parties.  The dealer must also list any consultants who were used and disclose what the consultant did and how much he or she was paid.
A regulatory role is also played by the Internal Revenue Service, which enforces provisions of the Internal Revenue Code relating to bonds. The most significant of these provisions, created as a result of the 1986 Tax Act, put restrictions on the use of tax-exempt bonds to finance private activities.
For more on municipal bond regulation, see the Major Players section.
The CUSIP (Committee on Uniform Security Identification Procedures) numbering system was created in 1967 to provide a uniform way of identifying municipal and corporate bonds. It uses a nine-digit number.
When municipal bonds are offered to the public, the issuer must publish a prospectus (known as an Official Statement) that summarizes the main features of the bond and the financial condition of the issuing entity; this requirement does not apply to private placements. Unlike the main disclosure documents for stocks and corporate bonds, Official Statements are not available on the SEC’s online EDGAR system. Instead, they are distributed through private entities known as Nationally Recognized Municipal Securities Information Repositories. These NRMSIRs are private document-retrieval services that charge a fee.
The most accessible NRMSIR is DPC Data, which has a website <> from which one can order Official Statements. Another useful online source of municipal bond documents is Thomson Financial's Munistatements <>, which is not an official NRMSIR but which has an extensive archive of Official Statements. One advantage of the Munistatements website is that users can, after registering,  view OS cover pages at no cost. Munistatements and DPC each charge $25 to download an entire OS.
In addition to the information provided in the Official Statements, issuers with more than $10 million of bonds outstanding are required to make annual financial disclosure of their financial condition. These continuing disclosure documents can be purchased online from DPC Data.

Updated: June 2004

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