There’s a specific process municipal issuers follow to issue general obligation (G.O.) bonds. Municipal securities are exempt from SEC registration, so they avoid SEC oversight during their sale to the public. Even so, the issuer still has a checklist of steps to complete before a G.O. bond can be issued.
Before the municipality talks with finance professionals, it first identifies a need. For example, suppose your city needs to build a new high school because the population has grown significantly. Schools are expensive to build; large projects can cost over $100 million. Once the need is clear, the city hires a financial adviser (also called a municipal adviser) to help plan the financing.
Acting in a fiduciary capacity, the financial adviser helps the municipality evaluate its current financial condition and design the bond issue. The first question is whether borrowing more money is realistic. If the city has a shrinking population or large existing obligations (such as pensions), taking on additional debt may not be wise. In weaker financial situations, municipalities may face difficult trade-offs, such as choosing between paying retirees and funding a needed school.
If borrowing appears feasible, the municipal adviser structures the high school bond. This includes recommending:
Many factors affect the structure, including forecasted tax collections and expected population growth.
G.O. bonds are typically issued in serial form. In a serial issue, all bonds are sold on the same day, but they mature on different dates in the future. This fits G.O. bonds well because tax collections generally occur annually. With maturities spread out, the issuer avoids having to make one large principal payment on a single day, as would happen with a term issuance (all bonds mature on the same day).
Once the financial adviser has structured the bond, their role is essentially complete. By law, the financial adviser cannot also serve as the underwriter. The underwriter sells the bonds to the investing public, so the municipality must hire one. State and local governments may be skilled at governing, but they typically don’t have the resources or experience to distribute securities in public markets. Before selecting an underwriter, the municipality also hires bond counsel.
The bond counsel (a group of specialized lawyers) reviews the legal aspects of the bond. Bond counsel provides a legal opinion addressing the bond’s validity, legality, and tax-exempt status. The municipality is hoping for an unqualified opinion. That may sound counterintuitive, so it helps to first see what bond counsel evaluates.
To determine whether a municipal bond is valid, bond counsel confirms that the bond has been properly authorized. G.O. bonds require voter approval. You may have seen a G.O. bond question on a local ballot. Because G.O. bonds are repaid with taxpayer funds, the municipality must obtain taxpayer approval before issuing them.
A bond issuance is legal if no constitutional provision, statute, or regulation prohibits it. For example, a city charter might require new high schools to be powered by solar panels. Bond counsel helps confirm the municipality is meeting all legal requirements, whether those requirements relate to the project itself or to the borrowing.
Bond counsel also considers constitutional debt limits. Governments set debt limits to prevent overspending taxpayer money. If an issuer sells bonds that push it above its debt limit, it would be violating its own laws. If the municipality is already at its debt limit, it may be able to request a vote to raise that limit.
Finally, bond counsel determines whether the bond’s interest will be tax-free for residents who purchase it. Taxes can significantly affect a bond’s return, so tax status is a key investment consideration. If a resident buys a G.O. bond, the interest is generally tax-free if the bond meets certain requirements. Bond counsel confirms whether those requirements are satisfied.
Once bond counsel has researched the bond’s validity, legality, and tax status, it issues a legal opinion. The municipality wants an unqualified legal opinion, meaning the bond is valid, legal, and tax-free without conditions. A condition is called a qualifier. For example: “This private activity bond is tax-free, but only for investors who are not subject to Alternative Minimum Tax.” The final clause is a qualifier. Qualifiers reduce marketability, so the preferred outcome is a clean statement that the bond is valid, legal, and tax-free.
Assume bond counsel provides an unqualified opinion for the high school bond. Before contacting underwriters, most issuers prepare a disclosure document called an official statement. Similar to the prospectus for a corporate security, the official statement contains key disclosures about the municipality and the purpose of the bond. 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. We’ll use it as a case study.
On the first page, you can quickly identify the issuer (Deschutes County), the total par amount ($93.5 million), and the bond’s rating (AA2) from Moody’s. You can also see that the bond will be issued in book entry format, pays interest on June 15 and December 15 each year, and has a dated date of July 24, 2019.
On the second page, you’ll see the bond is issued in a serial format. All bonds were issued in July 2019, but portions mature each year in June from 2020 through 2039.
To get a broader sense of what an official statement contains, jump to the table of contents (page V). That outline shows how the document is organized. Here are a few 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. For now, notice why items like debt limits, major taxpayers, and demographics matter: taxpayers ultimately repay these bonds, so investors look for warning signs in the official statement. In the Deschutes County example, there are no obvious red flags. 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 selling a bond without one is extremely difficult. Most investors wouldn’t buy the Deschutes County bond without the information in the official statement. Because of that, virtually every municipal bond issue includes one.
Before selecting an underwriter, the issuer typically prepares a preliminary official statement. Underwriters want to understand the bond’s features and risks so they can market it effectively to their customers.
The issuer may revise the disclosure document, but it releases the final official statement before the bonds are sold to the public. If the issuer creates an official statement, MSRB rules require the underwriter to deliver it to investors no later than settlement. Today, most issuers post the official statement to Electronic Municipal Market Access (EMMA). EMMA is owned and managed by the MSRB and provides investors with a wide range of municipal market information, including:
When the official statement is available on EMMA, the underwriter is no longer required to deliver a physical copy to investors. This is known as “access equals delivery.” Investors can still request a physical copy, and if they do, it must be provided.
Next, the municipality begins the process of hiring an underwriter. Because G.O. bonds are repaid with taxpayer money, the issuer typically focuses on keeping financing costs low.
To control costs, G.O. bonds are usually sold through a competitive bidding process. The city publishes an Official Notice of Sale in a publication called the Bond Buyer. The Bond Buyer is widely read in the underwriting community. Large underwriters (such as Goldman Sachs and Morgan Stanley) monitor these notices and may submit bids to underwrite the issue.
In the next section, you’ll look at the new issue process from the underwriter’s perspective. For now, assume the municipality awards the bond to the underwriter offering the lowest cost. Once selected, the city sells the bonds to the underwriter on a firm basis. G.O. bond commitments are always firm, meaning the underwriter pays the municipality for the entire issue up front. After that sale, the city has the funds needed to build the high school.
After purchasing the bonds from the municipality, the underwriter begins selling them to its customers. The underwriter’s profit comes from selling the bonds at a higher price than it paid. Once the bonds are fully distributed to the investing public, they trade in the secondary market until the bond is called or matures.
When the process works as intended, each party gets what it needs:
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