There’s a specific and unique process that municipal issuers go through to issue their general obligation (G.O.). bonds. Municipal securities are exempt from SEC registration, and therefore avoid SEC oversight during their sale to the public. Regardless, a checklist of items must be accomplished prior to issuing a G.O. bond.
Before any discussions with finance professionals, the municipality will first become aware of a need. For example, let’s say your city needs to build a new high school as its population has increased significantly. Schools aren’t cheap to build; larger school-building projects can cost over $100 million dollars. Once the need is established, the city will hire a financial adviser, sometimes referred to as a municipal adviser, to help them navigate the project.
Acting in a fiduciary capacity, the financial adviser helps the municipality understand its current financial situation and creates the structure of the bond. It’s important to first take a look at the city’s finances to determine if borrowing more money is feasible. If the city has a dwindling population or significant obligations (like pensions), it may not be smart to borrow more money. Poorer municipalities may be forced to make tough decisions, like deciding between paying retirees or opening a much-needed school.
If borrowing more money seems feasible, the municipal adviser structures the new high school bond. They help the city determine how long the bond should last, the interest rate they can expect to pay, and other features of the bond (e.g. if the bond will be callable). Many factors influence the bond structure, including forecasted tax collections and population growth.
G.O. bonds are issued in serial form, which means all bonds within an issuance will be sold on the same day, but mature on different days in the future. This works well with G.O. bonds as tax collections occur annually. With sets of bonds maturing on different days, the issuer isn’t required to make a huge principal payment on a single day, as they would with a term issuance (all issued on the same day and mature on the same day).
Once the financial adviser creates the structure of the bond, their job is essentially done. By law, the financial adviser cannot act as the underwriter of the bond. The underwriter is responsible for selling the bond to the investing public, and the municipality must obtain one. States and local governments know how to govern, but don’t have the resources or experience selling securities in public markets. Before the underwriter is hired, the municipality must hire a bond counsel.
The bond counsel, which is essentially a group of specialized lawyers, is responsible for checking the legal aspects of a bond. Specifically, they provide a legal opinion on the validity, legality, and tax-free status of bonds to be issued. It may sound counter-intuitive, but the municipality is hoping for an unqualified opinion to be issued. Before we discuss this, let’s go through what the bond counsel explores.
To determine if a municipal bond is valid, the bond counsel must confirm if it has been legally mandated. G.O. bonds require voter approval to be issued. In fact, you may have noticed a G.O. bond on your last voter ballot. Because G.O. bonds are repaid with taxpayer funds, the city must first obtain approval from its taxpayers.
A bond issuance is legal if there is no constitutional law or regulation that prevents its issue. For example, your city’s constitution may require all new high schools to be powered by solar panels. The bond counsel will help determine if the municipality is meeting all of its legal requirements, whether it pertains to the project being built or the money being borrowed.
Also, the bond counsel needs to be aware of constitutional debt limits. Governments have debt limits to prevent them from overspending taxpayer money. If an issuer attempts to issue a bond that puts them over their debt limit, they would be breaking their own laws. Even if the municipality was at its debt limits, it could request a vote to raise its debt limits.
Last, the bond counsel will determine if the bond being issued will be tax-free if purchased by residents. Taxes can significantly affect the return of a bond and are an important investment consideration. If a resident of a municipality purchases a G.O. bond, they should receive tax-free interest if the bond meets certain characteristics. The bond counsel must confirm that this will occur.
Once the bond counsel researches the validity, legality, and tax status of the high school bond, they will issue a legal opinion. The municipality is hoping they receive an unqualified legal opinion. Although it sounds bizarre, an unqualified opinion means that the bond is valid, legal, and tax-free without qualifiers. An example of a qualifier would be “this private activity bond is tax-free, but only for investors who are not subject to Alternative Minimum Tax.” The last part of the previous sentence is a qualifier, which is not desirable and makes the bond less marketable. It’s always best if the bond is simply valid, legal, and tax-free.
Let’s assume the bond counsel gives an unqualified opinion for the high school bond. Prior to reaching out to underwriters, most issuers will create a disclosure document known as an official statement. Similar to the prospectus for a corporate security, the official statement provides many important disclosures relating to the municipality and what the bond will support. Common items in an official statement include:
Here’s a real-world example of an official statement for a general obligation bond from Deschutes County, Oregon. Let’s use this official statement as a case study on official statements.
On the first page, you immediately see the issuer (Deschutes County), the overall amount of the bond issuance ($93.5 million), and the bond has a high rating (AA2) from Moody’s. Also, the bond will be issued in book entry format, pays interest on June 15th and December 15th every year, and the dated date is July 24th, 2019.
On the second page, you’ll see this bond is being issued in a serial format. All of the bonds were issued in July 2019, but a certain amount matures every year in June from 2020 to 2039.
To get a good idea of what an official statement includes, skip forward to the table of contents (on page V). There, you’ll find what’s included in this 50ish-page document. Feel free to explore on your own from here, but here are some highlights:
Use of proceeds (pg. 4)
Debt limits (pg. 8)
List of major taxpayers (pg. 18)
Demographics of the municipality (pg. 39)
In the analysis section later in this material, we’ll discuss the details of analyzing general obligation bonds, but for now, know that debt limits, major taxpayers, and demographics are all important to determine the bond’s quality. With taxpayers paying off these bonds, investors should be concerned if there are red flags in the official statement. There aren’t any obvious red flags with the Deschutes County bond. The municipality has a high credit rating, a diverse economy, low debt levels, and a growing population.
MSRB rules do not require issuers to produce an official statement, but it’s very difficult to sell a bond without it. Would you purchase the Deschutes County bond if you didn’t know the information contained in the official statement? Probably not. Because of this dynamic, virtually every municipal bond has an official statement. Prior to obtaining an underwriter, the issuer typically creates a preliminary official statement. Underwriters will want to know the characteristics and risks they’re facing so they can effectively market it to their own customers.
The issuer may make some changes to the disclosure document, but they’ll release the final official statement before the bonds are sold to the public. If the official statement is created by the municipal issuer, MSRB rules require the underwriter to deliver it to investors no later than the settlement of the transaction. In today’s digital age, most issuers post the official statement to Electronic Municipal Market Access (EMMA). Owned and managed by the MSRB, EMMA provides investors with a wide range of information about the municipal market, including:
When an issuer posts their official statement to EMMA, the underwriter is no longer required to deliver a physical copy to investors. This saves a lot of money - the Deschutes County official statement was 167 pages long! The MSRB refers to this rule as “access equals delivery”, which states the physical document does not need to be delivered if it’s available on EMMA. Investors do have the right to ask for a physical copy, which would then be required to be delivered.
At this point, the municipality will begin the process of obtaining underwriting services. G.O. bonds are paid back with taxpayer money, so the municipality needs to be cost-sensitive when they hire an underwriter. How would you feel if your city spent millions of dollars hiring the most expensive financial firm and paid them with your tax dollars?
To keep their finance costs as low, G.O. bonds are sold through a competitive bidding process. First, the city publishes an Official Notice of Sale in a publication called the Bond Buyer. The Bond Buyer is viewed and circulated by the underwriting community. You’ve probably heard of some of the larger underwriters, including Goldman Sachs and Morgan Stanley. Financial institutions like these read the Bond Buyer, and if interested in underwriting a bond, will consider submitting a bid for it.
In the next section, we’ll learn much more about the new issue process from the perspective of the underwriter. For now, assume the municipality awards the bond to the underwriter with the lowest cost. Once the underwriter is chosen, the city sells the bond to them on a firm basis. G.O. bonds commitments are always firm, which means the municipality is paid by the underwriter for the entire bond issuance up-front. Once the sale to the underwriter occurs, the city has the necessary funds to build the high school.
After the underwriter purchases the bond from the municipality, they immediately begin selling the bond to their customers. To make a profit, the underwriter aims to sell the bond issue at a higher price than what they paid for the bond. Once the bond is sold completely to the investing public, it then trades in the secondary market until the bond is called or matures.
At this point, everyone should be satisfied. The city raised the necessary funds to build the new high school by selling the bond to the underwriter. The underwriter made a profit when they re-sold the bonds to the public. The investing public gained access to another interest-paying investment and funded the construction of a new high school. When it works as it should, G.O. bonds can benefit many parties and help facilitate necessary municipal projects.
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