28
Mar

US Municipal Securities Market – Part I: Introduction

By Krushna Ranaware, Intern, IFMR Finance Foundation

This post is part of our blog series on Municipal Finance.

In the United States, critical infrastructure financing has been facilitated to a great extent through the issuance municipal bonds or ‘munis’. States and local governments and their agencies issue municipal securities primarily to finance public infrastructure as well as to provide for cash flows and other needs of the government and sometimes to finance private projects. America’s local governments spend about one-eighth of the GDP, one-fourth of total government spending, and employ over 14 million people. Some of the distinct features of local governments are:

i) property taxes form majority of local taxes;
ii) inter-governmental taxes form one-third of local revenue;
iii) relatively balanced budgets.

As of December 31, 2011, there were over 1 million municipal bonds outstanding, in the total aggregate principal amount of more than $ 3.7 trillion with 44,000 state and local issuers (compared to 50,000 corporate bonds with outstanding principal amount at $11.5 trillion).

Types of Municipal Securities

Securities issued by state or local entities can be classified as:

  1. General Obligation (GO) bonds: Bonds that are supported by the taxing power and/or full faith of and credit of the issuing authority. Holders of GO bonds can be repaid using revenue from all legal sources of the issuing authority and hence their issuance needs voter approval.
  2. Revenue bonds: Revenue bonds are supported by specific revenues only, like revenue earned from taxes levied on a particular project for which financing was undertaken using revenue bonds.
  3. Other types of securities: Conduit revenue bonds are issued by a state or local authority or their agencies on behalf of a third party that in turn bear the responsibility of repayment of the bond. College savings plans or ‘529 Plans’ which are sponsored by states or their agencies, provide tax advantages in order to assist saving for future college costs. Municipal issuers also use derivative products to execute interest rate swaps while investors use this instrument to hedge risks or increase returns.

Features of Municipal Bonds

Tax exemption

Federal tax exemption is one of the primary reasons for preference of municipal securities over other forms of securities. Interest payable on such securities is not subject to federal income tax if certain requirements imposed by the Internal Revenue Service regulations are met. In 2008, taxable municipal securities accounted for 11% of the aggregate principal amount of municipal securities issued; that number rose to 18% in 2009 and 32% in 2010(U.S. Securities and Exchange Commission, 2012).

Credit enhancement

The issuance of municipal securities is affected by the availability of credit enhancement, a form of bond insurance, which often takes the form of a letter of credit issued by a bank, a governmental guarantee, or an insurance policy issued by a bond insurance company. Municipal bond insurance was first introduced in 1971 and letter of credit supported municipal bonds became very popular after the introduction of variable rate municipal bonds in the early 1980s. Credit enhancements were common during 2000-2007, with more than half of the municipal securities principal issued supported by at least one type of credit enhancement during that period. As seen in figure 1, this trend was reversed in 2008 due to the effect of the financial crisis on banks and municipal bond insurers.

Types of Markets

Primary Markets

There are two types of purchases in the primary market one where securities are offered to anyone with the wherewithal to purchase them and the other where, through private placement, securities are bought by investment banks. The following chart shows the process of initial issuance bonds in the primary market.

The first step involves state or local governments getting authorization to issue debt through voter referendum or existing statutes. In the next step, the issuer determines the details like dollar amounts, maturities and coupon rates for the bonds. The third step involves bidding for the issue publicized using advertisements, setting in motion the underwriting and rating processes. The rating agencies contract with the issuer to rate the debt issue and publish the ratings. The rating agency collects the information it requires for the analysis and then publishes the rating a week before the sale of the debt issue. Instead of requiring formal competitive bidding, many short term municipal issues and some long term issues are privately placed with local commercial banks or other institutions through negotiated sales. Offerings of municipal securities are issued through an underwriting process where brokers and dealers or a ‘syndicate’ of under-writers purchases securities directly from issuers and reoffer them to investors for a fee known as the underwriter’s discount gross underwriting spread. Nearly all long term state and local debt issues are sold initially to underwriters. The syndicate submits a bid stating net interest cost to the municipality and if it is successful, the syndicate then owns the securities. The underwriters then try to sell the securities to institutional and individual investors at prices that cover their underwriting spreads and provide them with an adequate profit for their risk.

Secondary markets

The secondary market refers to all transactions in an issue that occur after the original underwriting and sale processes are completed. A good secondary market is important for a debt issue as investors are more likely to be willing to purchase state and local securities if they believe they can easily liquidate their holdings when they want to. Liquidity is an important factor for long term than short term municipal debt since most short term debt is purchased and held to maturity. Data on the size of the secondary market for state and local debt are scarce since the market is conducted over the counter, i.e. the securities are not listed or traded in a formal exchange. This means that participants dealing in the secondary market are not required to report their transactions. Thus little is known about the size of the market or the characteristics of the participants in the market. However, as seen in Figure 3, in 2011, the five biggest dealers in the market conducted 54 per cent of the total transactions in the secondary market.

References:
U.S. Securities and Exchange Commission -“Report on the Municipal Securities Market” (2012)