US Municipal Securities Market – Part II: Evolution and Current Status

By Krushna Ranaware, Intern, IFMR Finance Foundation

This post follows our earlier post on US Municipal Securities Market.

The evolution of US Municipal Securities Market can be divided into three distinct phases1

i. 1800s-1950
ii. 1950-1975 and
iii. 1985-present.

i. 1800s-1950

The idea of using public financing for infrastructure works emerged in the early 1800s. The financing of Port of New Orleans in the 1800s was the first instance of an authority using public financing. Until then (and for a few decades after) the dominant form of financing transport, canals and railroad was corporate debt. Following this, the issuance of Erie Canal bonds issued between 1812 and 1825 were guaranteed by New York State. The Port Authority of New York and New Jersey were among the first conduit bonds issued by state for a specific public purpose which overlay multiple municipal boundaries and whose debt was paid not from taxes but from operating revenues.

As the United States moved into the new century, city governments were granted “home rule” by state legislatures. This broadened their ability to borrow and spend. This period also witnessed an expanded Federal agenda of public work programmes. Post-World War I, the rate of increase in outlays for public works by states tended to exceed the proportional expansion of tax revenues. Moreover, outlays constituted an increasing proportion of total governmental cost payments during this period. Thus, the states experienced a growing need for borrowing to finance public works. By 1925, municipal revenue bonds became an established method.

The Federal Government had a major impact on local governments accessing public financing for public works projects through its regulatory standard setting powers. For example, the Flood Control Act of 1917 and 1928 was passed to control of floods on three rivers. Local interests protected because of flood control were to contribute not less than one-half of the cost of construction. The Hill Burton Act of 1946 was designed to provide federal grants and guaranteed loans to improve the nation’s hospital system. The federal money was only provided in cases where the state and local municipality were willing and able to match the federal grant or loan, so that the federal portion only accounted for one third of the total construction or renovation cost. The Housing Act of 1946 required municipalities with populations over 50,000 to finance one-third of the cost of redevelopment activities to match the two-thirds federal share.

ii. 1950-1975

The post- World War II period saw an increase in individuals’ taxable incomes as well as an increase in average effective tax rate for insurance companies. It also saw the emergence of a range of environment protection legislations. In addition, pent-up housing demand, the changing character of transportation and a shift in structures for manufacturing facilities, all combined to produce a huge demand for additional public and private facilities. In response to that demand, the level of state and local government debt rapidly increased. So while the total outstanding debt in 1960 was only $66 billion, by 1981 the amount was over $361 billion.

This period also saw an increase in the total outstanding amount of short term borrowing. In the early 70s, the annual dollar amount of short term debts issued equalled or exceeded the amount long-term debt issued. Also, revenue bonds began to constitute over half of new issues in the late 1970s. During this period, there were four purposes for which short term borrowing was put to use:

  • Over one-third was for public housing or urban renewal purposes
  • Synchronizing flow of current disbursements with current tax receipts
  • Reducing financing costs associated with capital projects, in order to avoid borrowing the amount required to finance an entire capital project before all of the funds are needed
  • Financing expected and unexpected operating deficits.

Some of the important federal legislations in this period that influenced the kind of debt issued in this period are:

  • The Veterans’ Adjustment Act of 1952 included benefits like low-cost mortgages, loans to start a business or farm, cash payments of tuition and living expenses to attend college, high school or vocational education, as well as one year of unemployment compensation for World War II veterans. They could receive state and federal benefits, the federal benefits beginning once state benefits were exhausted.
  • The Air Pollution Control Act of 1955 left states principally in charge of prevention and control of air pollution at the source. Under the Clean Water Act of 1972, the Congress created a major public works financing program for municipal sewage treatment. In the initial program the federal portion of each grant was up to 75 per cent of a facility’s capital cost, with the remainder financed by the state. In subsequent amendments Congress reduced the federal proportion of the grants and in the 1987 Water Quality Act, it transitioned to a revolving loan program. The environmental legislations permitted companies to borrow through state and local agencies for pollution control purposes, allowing them to enjoy lower interest rates because of the tax exempt status of interest on state and local debt.
  • The Elementary and Secondary Education Act of 1965 is one of the most far reaching federal legislation affecting education ever passed by the Congress. Under this act, federal funds would not serve as replacements for local funds but rather they would serve as ancillary resources.
  • The Housing and Urban Development Act or New Communities Assistance Program of 1970 was established to guarantee bonds, debentures, and other financing of private and public community developers and to provide other development assistance through interest loans and grants, public service grants, and planning assistance.

iii. 1985-present

As of 2010-2011, the municipal securities market had close to 44,000 state and local issuers, and with a total face amount of $ 3.7 trillion. Figure 1 below shows that while the amount issued per year has not fluctuated much, the number of issues has seen great fluctuation since 1986. Each dip in the number of securities issued roughly corresponds with periods of recession in the American economy2.

Figure 1 Summary of debt issued (1986-2010)

As Figure 2 shows, retail investors or individual investors have been the largest owners of municipal debt for more than the last decade and half. These investors usually buy and hold securities till the end of the maturity period. As of 2010-2011, approximately 50 per cent of the outstanding total outstanding debt was held directly by individuals and up to 25 per cent was held on behalf of individuals by mutual, money market, closed end and exchange traded funds.

Figure 2 Ownership of debt (1996-2010)

As shown in Figure 3, most of the total outstanding debt, despite many fluctuations, is issued for general purpose. General purpose debt is issued for long range capital needs issuing agencies as well as to support construction of public work facilities and their upkeep improvements especially when there is a shortfall of federal funds. General purpose is followed by education as the purpose with the second largest issue.

Figure 3 Purpose of debt as percentage of total outstanding debt (1986-2010)

1-This analysis is incomplete due to unavailability of data for some individual years between 1959-1962, 1962-1967 and 1974-1984
2-The sudden leap in the total outstanding amount from 2004 to 2005 is a result of revision in the Federal Reserve’s figures on municipal securities and loans due to a change in data sources. New data indicate that municipal securities and loans outstanding in 2004:Q1 is $740 billion greater than previously estimated in the flow of funds accounts. The estimate of household holdings of municipal securities and loans is revised up by about $840 billion, on average, from 2004 forward.


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.

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