Municipal Securities Market – Economic and Productive Role in the Capital Formation Process
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Municipal Securities Market – Economic and Productive Role in the Capital Formation Process
I. Abstract: The main objective of this paper is to show how the municipal securities market
has fostered in the capital formation process. This paper will be written by the student
under the supervision of the instructor and will contain many credible sources as a basis
for research.
Municipal securities are usually known for their tax benefits. There are many reasons for
their issuance such as providing funds for projects such as building schools, roads, and to
fund other projects for public use. This research paper will examine municipal securities
and the reasons they are issued, tax benefits, yields and interest (coupon) payments, and
market risk. These elements will explain how the municipal securities market has a
productive role in the capital formation process.
This research paper will cover multiple areas of the municipal securities market including
information about municipal notes and more importantly municipal bonds. It will include
coverage of how and why municipal bonds are issued, comparisons to corporate bonds
and other securities, bond ratings, and ultimately how municipal securities have fostered
in the capital formation process.
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II. Municipal Securities Overview –
Municipal securities are debt obligations that are usually issued by states, cities, or counties to
finance projects for public use. Municipal securities are essentially issued by ‘municipalities’ or other
government entities other than the federal government. A surplus unit invests money by purchasing
either a municipal note or municipal bond. Municipal securities typically pay interest or coupon
payments semiannually. At maturity the surplus unit who invested in the security receives a principal
payment of the face value of the bond. According to Investinginbonds.com, Municipals are attractive to
many investors because the interest income is exempt from federal income tax, and in many cases, state
and local taxes as well (“Overview”).
A. Municipal Note vs. Municipal Bond –
A municipal note is a short-term municipal bond with a maturity of a few months to a few years
or less. Municipal bonds, on the other hand, are long-term investments which have maturities of a few
years to several years and may even have very long periods to maturity.
III. Kinds of Municipal Bonds –
There are two main types of municipal bonds which are both used to raise money for certain
projects. The difference between the two is the method in which a bond issuer raises money to pay
coupon and principal payments.
A. General Obligation (GO) Bonds –
A general obligation (GO) bond is a debt instrument issued by states and local governments to
raise funds for public works. They are backed by the full faith and credit of the issuing municipality.
This means that the municipality commits its full resources to paying bondholders, including general
taxation and the ability to raise more funds through credit. General obligation bonds are considered less
risky since they can be paid back through increased taxation or by borrowing more money. Since they
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carry less risk and are less likely to default, they typically have a lower interest rate than revenue bonds.
They do not rely on the revenue of a project like revenue bonds do. GO bonds give municipalities a way
to raise funds for projects that do not directly provide sources of revenue such as roads and bridges. As a
result, GO bonds are typically used to fund projects that will serve the entire community (“What Are
General Obligation Bonds?”).
B. Revenue Bonds –
Unlike general obligation bonds, revenue bonds rely on the revenue produced from the project
the bond was initially issued for. For example, if a government agency issued bonds to construct and
maintain toll roads; those bonds would be paid back with the tolls that are paid to use such roads.
Interest and principal payments are paid from the revenues of the project. “Income from a municipal
enterprise is put into a revenue fund. From this fund, expenses for operations are paid first. Only after
operations expenses are paid do revenue bondholders receive their payments” (“What Are Revenue
Bonds?”). There is never a guarantee that a project will be successful, and generate revenue, which
makes revenue bonds slightly more risky than general obligation bonds. Revenue bonds carry default
risk if the project cannot generate enough revenue. Therefore, revenue bonds typically yield higher
interest rates than GO bonds.
IV. Who Issues Municipal Securities –
There are several groups or organizations that issue municipal securities. Municipalities and
other government entities issue municipal securities. State, county, and city governments, as well as
their agencies, and even schools may issue municipal securities.
A. Government Issue & School Issue –
Government agencies at the state level and below may issue bonds to raise funds for public use
projects. There are several projects that governments can undertake with funds from municipal bonds.
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They can be used to build or repair roads, develop and maintain sewer systems, or other projects. They
may also be used to construct hospitals and prisons.
Schools may also issue municipal bonds to raise money for projects. They might issue bonds to
build new facilities, or maintain existing ones. Most projects that use funds from municipal bonds are for
public good.
B. Bond Offerings –
“Municipal bond underwriters are required to file a prospectus called an "Official Statement"
with the Municipal Securities Rulemaking Board (MSRB) for all new public bond issues”
(Zimmerman). Ohio recently issued a preliminary official statement for the Ohio Water Development
Authority to raise $69,345,000. The bonds will be used to assist public water systems to finance the
costs of infrastructure needed to achieve or maintain compliance with the Safe Drinking Water Act
requirements and to protect public health (“Ohio Water Development Authority” 10).
In 2002, Mahoning County sold $22,040,000 in bonds to lend to Youngstown State University
that would fund a project to bring more housing to the YSU campus. The bonds were to be used to
finance the acquisition, development, and construction of a 130-unit housing project, the University
Courtyard Apartments. The bonds have a maturity date of February 2033; twenty-one years after their
issue (“County of Mahoning, Ohio” 1). Other information, such as underwriters and ratings, can also be
found on an official statement.
Municipal offerings do not always go as planned, however. In 2003, the city of Miami, Florida
failed to disclose a shortage of cash flows which they attempted to partially ease by using the bond
proceeds for unintended purposes and operating costs (“Disclosure and Accounting Practices in the
Municipal Securities Market” 1). The Securities and Exchange Commission (SEC) found that Miami’s
public officials ignored the city’s disclosure responsibilities. The City Manager admitted that he was not
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very familiar with Miami’s disclosure requirements and dismissed the importance of bond offering
documents by stating:
“Let me ask you this, does anybody read this [Official Statement]? I mean, only experts read t
his…. [M]ost people don’t read this, nobody reads this. They go by what the raters, that is
Moody’s, Standard & Poor’s, saying these bonds are safe to buy” (“Disclosure and Accounting
Practices in the Municipal Securities Market” 10).
Unlike the corporate security market, the SEC does not have adequate authority to address such
problems in the municipal securities market.
IV. Municipal Bond Risk –
As stated before, revenue bonds carry more risk than general obligation (GO) bonds.
Consequently, revenue bonds have a higher yield than GO bonds. There are also other risks that can be
associated with all municipal bonds.
A. Market & Interest Rate Risk, Liquidity Risk –
Market risk is “the risk that the bond market as a whole would decline, bringing the value of
individual securities down with it regardless of their fundamental characteristics. When interest rates
rise, bond prices fall; conversely, when rates decline, bond prices rise. The longer the time to a bond’s
maturity, the greater its interest rate risk” (“Risk of Investing in Bonds”). Not all municipal bonds have
the same degree of interest rate risk (Kuhn 771).
When an investor has difficulty unloading their investment they are experiencing liquidity risk.
Liquidity risk is the risk that investors may have trouble finding a buyer when they want to sell and may
be forced to sell at a significant discount to market value. There is greater liquidity risk for thinly traded
securities such as lower-rated bonds, bonds that were part of a small issue, bonds that have recently had
their credit rating downgraded or bonds sold by an infrequent issuer. Bonds are generally the most liquid
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during the period right after issuance when the typical bond has the highest trading volume (“Risk of
Investing in Bonds”).
B. Default & Credit Risk –
Credit risk, also-known-as default risk, is the risk that an issuer of a security will default on
either interest or principal payments, or both. “Default risk is the possibility that a bond issuer will be
unable to make interest or principal payments when they are due. If these payments are not made
according to the agreements in the bond documentation, the issuer can default” (“Risk of Investing in
Bonds”).
“The largest default in the history of the municipal bond market was the Washington Public
Power Supply System's (WPPSS) default on $2.25 billion in bonds. WPPSS launched a risky program to
build five nuclear power plants in the 1970s to supply electricity to the Pacific Northwest. Only one of
the five planned nuclear plants was ever completed” (“Municipal Bonds and Defaults”).
In 1999 Fitch Ratings published its first study of municipal defaults, which was updated in 2003.
The 2003 study covered 2,339 cases of municipal defaults worth $32.8 billion between 1980 and 2002.
It found that the cumulative default rate on bonds issued through 1986 was 1.5 percent, while the
cumulative default rate on bonds issued between 1987 and 1994 was 0.63 percent. Municipal bonds
issued on behalf of corporations or by municipal entities had a much higher overall default rate because
of their exposure to corporate risks such as bankruptcy (“Municipal Bonds and Defaults”).
Another study, produced by Standard & Poor’s in June of 2000, looked at monetary defaults in
the 1990’s. The study defined a monetary default as the “…failure of an issuer or borrower to pay
principal/interest payments when due. Monetary defaults include those issues where a debt service
payment to bondholders was either missed or delayed” (“A Complete Look at Monetary Defaults During
the 1990’s” 3). Findings from the study show the highest amount of defaults in Industrial Development
Bonds (IDBs), Multifamily Housing, and Healthcare sectors. These three sectors had default rates by
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dollar amount of 29%, 21%, and 20.3%, respectively (“A Complete Look…” 5). The study reported a
total of 917 municipal bond defaults with more than $9.8 billion of defaulted principal in the 1990’s (“A
Complete Look…” 1). This study shows that defaults can occur which makes it a concern and
consideration for investors who buy municipal bonds.
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C. Bond Insurance –
To reduce the risk of default, an investor can consider municipal bonds that carry municipal bond
insurance. Municipal bond insurance is an insurance policy that guarantees that interest and principal
payments will be paid as scheduled should the bond issuer default. The insurance protects investors
primarily in two ways. Sometimes an issuer of debt securities gets into financial difficulty. Then they
may not be able to pay interest and/or principal on their debt as scheduled. The first protection involves
the insurer paying interest or principal payments if the issuer defaults. But, even if an issuer does not
default, the rating agencies might lower the ratings on an issuer’s securities if it’s financial condition
deteriorates, causing the market value of its securities to decline. “Investors in bonds insured by TripleA rated municipal bond insurers are insulated from these risks because they can depend on the insurer,
whose claims-paying ability is rated Triple-A, to make timely payment of scheduled principal and
interest” (“What Are AAA Rated Municipal Bonds?”).
When municipal bonds are insured the issuer pays an insurance premium which is ultimately
passed on to investors. Insured municipal bonds have lower interest rates because of the reduced risk
associated with them (“Disadvantages of Insuring Municipal Bonds”).
V. Bond Ratings –
There are a few agencies that assess the quality of municipal bonds, and other bonds for that
matter. Standard and Poor’s, Moody’s, and Fitch are three of the major bond rating agencies. A bond
rating is essentially “a grade given to bonds that indicates their credit quality” (“Bond Rating”).
Investors then use the grade to determine whether or not they would like to invest in that security.
A. Investment Grade vs. ‘Junk Bonds’ –
Bond ratings are broken down into investment grade and ‘junk bonds’. Investment grade bonds
are bonds in which the credit of a company is good or efficient. “Most [municipalities] are issued a
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Municipal Securities Market – Economic and Productive Role in the Capital Formation Process
rating based on their financial strength, future prospects and past history. [Municipalities] that have
manageable levels of debt, good earnings potential and a good debt-paying records will have good credit
ratings” (“What Does Investment Grade Mean?”).
Junk bonds on the other hand are non-investment grade and are considered highly speculative.
These bonds may be issued by governments or schools that have less-than-average credit quality (“What
Does Investment Grade Mean?”).
For better understanding, this table shows how Moody’s and Standard & Poor’s rates bonds:
Moody's S & P
Investment Grade Ratings
Aaa
Aa
A
Baa
AAA
AA
A
BBB
Below Investment Grade
("Junk Bond")
Ba
B
Caa
Ca
C
BB
B
CCC
CC
C
In Default
D
VI. Tax Benefits –
Most municipal bonds are tax-exempt meaning they are not taxed as other securities are. “When
you own a muni, your interest payments will be free from federal taxes, and, if the municipality that
issues the bond is located in your state, your interest payments also may be exempt from state and local
taxes” (“Municipal Bonds Offer Tax Benefits”).
Actually, because of their tax considerations an investor may be able to earn a higher yield by
investing in municipal bonds than they can by investing in taxable securities. The following example is
provided by Investinginbonds.com and assumes a 33% federal tax bracket, filing jointly with $175,000
of taxable income. It shows that a tax-exempt investment at 5% versus a taxable investment at 7% has a
higher after tax yield.
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Effect of federal income taxes on yields of tax-exempt and taxable instruments
5.0% Tax-exempt Bond 7.0% Taxable Bond
Cash investment
$30,000
$30,000
Interest
$1,500
$2,100
Federal income tax in the 33% marginal tax bracket $0
$693
Net return
$1,500
$1,407
Yield on investment after taxes
5.0%
4.7%
(“The Advantages of Tax Exemption”).
VII. The Municipal Securities Market –
The municipal securities market does not have an organized exchange such as the New York
Stock Exchange. Municipal securities must be bought and sold in the over-the-counter market through
dealers who are registered with the Municipal Securities Rulemaking Board (MSRB). There are
approximately $1.7 trillion worth of municipal securities in the hands of investors, with 2 million
separate bond issues still outstanding. “While some of the bonds are ‘actively traded,’ some bonds may
not trade for months at a time—because most individual investors buy and hold their bonds until they
mature” (“Buying and Selling Municipals”).
A. Market Participants –
The main participant is, obviously, the issuer of the municipal security. This can be a state or
local government and its entities, schools, and other municipalities. Then there are the investors or
bondholders. Bondholders can be institutions or households that purchase bonds and receive 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%”
(“Municipal Bond Basics”).
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Underwriters are also an integral part of the municipal bond market. They advise the issuer on
the bond offering and bring bonds to the market by purchase the bonds and selling them to investors.
Municipal bond dealers facilitate transactions to buy or sell in the bond market (“Municipal Bond
Basics”). Rating agencies and bond insurers are also involved, which we have already discussed.
B. Regulatory Agencies –
One of the main regulatory agencies is the Securities and Exchange Commission (SEC).
“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” (“Municipal Bond Basics”).
The Municipal Securities Rulemaking Board (MSRB) “is an independent, industry selfregulatory 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” (“Municipal Bond Basics”). According to the MSRB website, they make
rules that regulate dealers who deal in municipal securities (“Welcome to the MSRB”). One of their
main rules is that underwriters must register an official statement with the MSRB.
VIII. Overall Impact on the Capital Formation Process –
Municipal securities can be a great investment for those looking to invest in a secure, but usually
not-so-risky investment. They are another investment vehicle that allows surplus units to provide funds
to deficit units. Municipalities benefit by getting the financing they need to undertake projects. Investors
who provide financing to local municipalities can also reap the benefits of public use projects the funds
were used for. Municipals are attractive to many investors because the interest income is exempt from
federal income tax and in many cases, state and local taxes as well. The tax benefits associated with
municipals also makes these investments especially appealing to investors with high tax brackets since
the income from such investments is usually tax-exempt.
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IX. Conclusion –
This paper has examined several aspects of municipal securities. The purpose was to give readers
some insight into municipals and how they relate to a positive role in the capital formation process.
Municipal securities have fostered positively in the capital formation process by becoming yet another
investment vehicle investors can choose from. The readers can now make an informed decision about
where they would like to invest their money.