In this article we will review issuing municipal securities as covered on the SIE and Series 7 exam.
Municipal securities are issued by municipalities including state governments, county governments, and school districts, etc. The securities issued by such municipalities typically finance the construction of roads and schools among other infrastructure projects.
Unlike offerings of Facebook or Starbucks common stock, municipal securities are exempt from registration requirements under the Securities Act of 1933 and the reporting requirements under the Securities Exchange Act of 1934.
Both concerns, however, are for the issuers of municipal securities—state, county and local governments, for example.
The broker-dealers who perform underwriting services for municipal securities issuers are regulated by FINRA and the SEC. And, the rules for municipal securities firms are written by the MSRB or Municipal Securities Rulemaking Board. The MSRB is the self-regulatory organization that writes rules for municipal securities firms. The MSRB writes the rules, while FINRA enforces them when a FINRA member firm violates them.
When bonds are issued to investors, the issuer borrows money at a stated rate of interest. To issue municipal bonds, the issuer puts together a bond resolution, the documents that legally authorize the process of issuing bonds for a specific purpose. This documentation describes the nature of the bond issue and the issuer’s duties to the bondholders, as well as the issuer’s rights to do X, Y, and Z. Issuing municipal bonds involves a detailed legal process, so the issuer hires a bond counsel (attorney) to guide them through the legalities.
A bond counsel is a law firm specializing in public finance and the complexities of state constitutions, tax codes, etc. The bond counsel provides a legal opinion to the issuer in which they attest to the issuer’s legal authority to issue the bonds and make a statement as to whether the interest will be tax-exempt, taxable, or subject to AMT. Typically, the interest paid to investors is tax-exempt, which is why only investors in high tax brackets purchase municipal securities as a general rule.
There are two types of opinions the bond counsel could render: qualified and unqualified. A qualified opinion means something is in doubt so that the attorneys had to attach “qualifiers” to their opinion. What the issuer hopes for is an unqualified opinion from the bond counsel. That means everything looks fine to the bond counsel or that they can render their opinion without attaching any lengthy explanations to qualify it.
Municipalities raise money by selling bonds, and those bonds are taken to the capital markets by underwriters, who keep part of the proceeds as their compensation. The big underwriting firms of Wall Street typically have municipal underwriting departments. There are also small underwriting firms specializing in public finance.
Municipalities find underwriters interested in taking their bonds to investors to fund their projects by advertising in the daily Bond Buyer, the industry publication for municipal finance. When a taxing authority such as a park district wants to raise money by issuing bonds, they attract underwriters by publishing an official notice of sale in the Bond Buyer. In this official notice of sale the issuer announces to prospective underwriters that they would like to raise, say, $6 million. They tell the underwriters what type of bond they want to issue, what they need the money for, how much principal they want to pay back each year to investors, when the bids will be accepted, where to send the bid, how much of a good faith deposit is required, etc.
Potential lead underwriters interested in winning this business submit a bid on the bid form included with the official notice of sale. The bid form shows what the interest rates must be on the bonds and how much the underwriter will pay the issuer for the bonds.
The debt service for a bond issue includes the interest and principal payments owed to investors by the issuer. The lower the debt service, the better for the issuer of the bonds.
Municipalities typically award service contracts to private contractors through a bidding process because when they are spending taxpayers’ money for construction or snow removal, they owe it to the taxpayers to get the best possible deal with that money.
Similarly, municipalities want the lowest debt service they can get when issuing the bonds that fund such construction projects, which is why they typically award their business to the group of underwriters who can sell bonds to the public at the lowest cost. The issuer’s total cost of borrowing includes the interest payments and the difference between the public offering price received by the syndicate and the proceeds to the issuer—known as the underwriting spread.
We call the issuer’s total cost of borrowing the net interest cost, or NIC.
That is all the municipality cares about—their cost of borrowing money from the bondholders. It is equivalent to the total cost of a loan shown when buying an automobile on credit.
Net interest cost is the total cost of all the interest payments the issuer will make until the bonds are retired. TIC stands for true interest cost. TIC factors in the time value of money, which has to do with the rate of interest money could have earned in a safe, interest-bearing account.
Whether the issuer is using NIC or TIC, they are looking at the cost of borrowing the money, the deciding factor in choosing the underwriter.
If it is a general obligation bond—backed by taxes—the municipality usually seeks competitive, sealed bids from potential underwriters. If it is a revenue bond—backed by project revenues only—they typically select a group of underwriters in a negotiated underwriting. What the issuer is looking for in either case is the lowest cost of borrowing available, whether measured as NIC or TIC. So, if it is a competitive underwriting, maybe the Park Board President will open the sealed bids at Park District Headquarters at noon on such-and-such a date, awarding the underwriting business to the syndicate who turned in the lowest NIC or TIC
We hope this article helped you understand some of the key concepts surrounding the issuing of municipal securities for your upcoming SIE or Series 7 exam.
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