Funding Economic Development:
Comparing Direct Lending and Municipal Bonds

by: Lance S. Holman

Municipalities have been issuing debt for over 200 years and currently have over $4 Trillion in municipal debt outstanding. The municipal issuers (“municipalities”) include state and local governments, educational institutions, water agencies, airports, special districts, and authorities. The debt is used to fund infrastructure, equipment, facilities, energy projects, and pensions. This creates millions of jobs to design, build, and maintain the American economy and our global competitiveness.

Governments. Education. Water

WHY INVESTORS PARTICIPATE IN DIRECT LENDING AND BONDS

The investors include banks, insurance companies, investment funds, and individual investors that align with the risk and return profile of municipalities. In exchange for improving the quality of life, creating jobs, and funding growth in the US and its territories, investors expect to earn a return on their capital. Depending on the project and the cash flow needs of the municipality, financing terms range from a few days to over thirty years.

Subject to Section 103 of the IRS Code, the interest income earned on the debt is exempt from federal taxation to the investor. Since no taxes are paid to the federal government, the tax-free status of the investment allows the investor to lower its interest rate to the municipality, which reduces their borrowing cost, and fuels more economic development. The tax-free investment is a win-win for both the municipality and the investor, to fund a growing population and provide attractive investor returns. Furthermore, many states do not tax the interest income on their municipal debt, which boost the yield to investors and attracts more capital.

Investor Types

HOW DEBT FUELS ECONOMIC DEVELOPMENT

Governments need to build schools, bridges, water treatment plants and a wide variety of capital assets to grow with the population. Furthermore, municipalities are frequently replacing aging equipment, upgrading technology, converting to renewable energy sources, and funding pensions to manage its organizations to remain productive and efficient.

The debt proceeds are used to fund more projects, generate future revenues, expand economic development and create additional jobs. The cycle continues as governments keep pace with population growth.

Once the municipality has navigated its economic development plans, it then decides how to best fund its capital projects. Essentially, the municipality can either pay cash or borrow funds. The cash financing strategy takes time to accumulate the necessary funds, which can lead to rising asset costs and further deplete municipal reserves. The debt financing solution is faster, maximizes cash flow, fuels economic growth, and builds valuable cash reserves for the municipality.

CHOOSING MUNICIPAL BONDS OR DIRECT LENDING

When a municipality issues debt, it must decide to issue 1) Municipal Bond or 2) Direct Lending. It is important to understand the trade-offs between the two:

Types of Municipal Debt

The true cost of funds

MUNICIPAL BONDS

Municipalities issue billions of dollars of municipal bonds (public bonds) to fund new capital projects and refinance existing debt.

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Voter Approval – Issuing bonds in most states requires voter approval, which takes time to develop outreach campaigns to convince voters to approve a tax increase to repay the debt.

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Competitive Rates – Municipal bonds are sold to investors on a competitive or negotiated basis at current market rates and based upon the municipality’s financial wherewithal and the term of the financing.

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High Fees – The municipality will need to hire a team of public finance professionals, comprised of an investment banking firm, rating agency, trustee, bond counsel, and a financial advisor to market the bonds to investors on a fee basis. Additionally, the municipality will incur compliance and disclosure requirements that will demand internal resources or an external firm to manage. The combined fees should be added to the interest rate to compute the true cost of funds.

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Large Financings – Municipal bonds are most appropriate for large financings that enable the municipality to amortize the cost of issuance over a larger capital base.

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Prepayment Restrictions – Many long-term municipal bonds with twenty and thirty-year financing terms are structured with “No Call” provisions in years 1-10, that prevent the municipality from prepaying the bonds early, thus allowing time for the investor to earn a return on its capital.

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Long Funding Cycle – Municipal bond referendums can take months and sometimes years to garner the necessary public and political support to approve a tax increase. Meanwhile, labor and material cost continue to escalate project cost.

DIRECT LENDING

A growing number of municipalities are opting to direct lending (notes, capital leases, and installment purchase agreements) to fund their capital projects and unfunded liabilities. Direct lending offers more flexibility and speed than municipal bonds. The capital providers that support the municipal bond market, which include banks, insurance companies, investment funds and individuals, are also the same investors that fund the direct lending market.

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No Voter Approval Required – Direct lending debt is repaid from existing revenues and not a voter approved tax increase. The debt is an obligation of the general fund, a special fund, or its enterprise funds.

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Minimal Fees – Direct lending debt is purchased by experienced investors that have the skills and resources to analyze the municipality’s transactional and financial risk. Thus, eliminating the need for an investment banking firm, rating agency, trustee, bond counsel, and a financial advisor. The credit review process and loan agreements are drafted internally by the direct lender to streamline the process and eliminate fees.

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Competitive Rates – Interest rates are competitive and correlate with the municipality’s creditworthiness and the financing terms of the transaction.

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Financings Up to $200,000,000 – Transaction sizes range from $250,000 up to $200,000,000 to facilitate the funding of small and large transactions.

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Early Prepayment Options – The municipality can prepay the debt on any scheduled payment date, in full, at the purchase option price to provide additional balance sheet flexibility.

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Quick Funding – Direct lending transactions are typically credit approved, documented, governing-body approved, and funded in approximately thirty days.

COMPARING THE TRUE COST OF FUNDS

MUNICIPAL BONDS VS. DIRECT LENDING

True Cost of Funds Chart

CONCLUSION

Municipalities have been issuing public debt to fund economic development for over 200 years. During the past fifty years, municipalities have increasingly opted for direct lending to fund their unfunded pension liabilities, infrastructure, equipment, facility, energy needs.

Frequently, a municipal bond issuance requires a team of public finance professionals and a tax increase to repay the debt. The tax increase will require a comprehensive outreach campaign and can take months and sometimes years to garner the necessary public and political support to attain voter approval. Given the cost and time of a municipal bond issuance, they are most appropriate when voters are acceptable to a tax increase and larger bond transactions.

In many states, direct lending does not require a tax increase and therefore no voter approval is required to issue the debt. The funding process has been streamlined to approximately thirty days, by eliminating the need for an investment banking firm, rating agency, bond counsel, and a financial advisor. The municipality reduces its fees, saves time, and funds its project quickly and efficiently.

Both municipal bonds and direct lending are essential to keeping pace with population growth, funding new capital projects, refinancing existing debt, and fueling economic development to improve productivity and American prosperity.

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