POLS 6930 Public Financial Administration

Capital BudgetingMunicipal Bonds

The Capital budgeting processI. Defining capital costsII. Steps in the capital budget processIII. Selecting capital projects IV. Financing capital projects

I. What makes something capital?

• size • purpose• useful life• payment structure• non-recurrence• ownership

I. What makes something capital?Size

• Threshold for fixed assets and capital determined by the size and scope of the government

• example: small town vs. county sewer district

$5,000 vs. $250,000

I. What makes something capital?Purpose

• Used in the production of a government service

• Non-consumable (not unit-level inputs)– Regardless of the size of consumable

expenditures

I. What makes something capital?Useful life

• The useful life of a capital asset must exceed the period of the operating budget

• Capital assets typically have long (multi-year) lives– Water/sewer lines: 50 years– Asphalt roads: 8 - 10 years– Concrete roads 35 - 40 years– Fire truck: 20 years

I. What makes something Capital? Payment Structure

• Capital assets/projects paid for across time

• Often involves long term borrowing• Payments often matched to useful life• Pay as you go vs. Pay as you use

I. What makes something Capital?Non-recurrence

• Capital asset expenditures are typically made for one-time purchases

• Capital assets are non-operational• 4J School District, Lane County, OR:

The case of the “Capital” custodians and books

I. What makes something Capital?Ownership

• Whether something is an asset depends on the perspective of the entity

• The city mainframe computer system is a capital asset to the Information Services Department

• The city mainframe computer system is an operational expenditure item to the sheriff’s department

II. Steps in the capital budget process

1. Develop a capital improvement plan2. Determine useful life3. Select a financing mechanism

II. Steps in the capital budget process 1. Capital improvement plan

• Identify capital needs for next 10 - 20 years• Separate one time from recurring capital

projects• Use realistic assumptions• Reconcile to annual budget• Update annually• Example: Onondoga County, NY

II. Steps in the capital budget process 2. Determine useful life

• separate land, improvements, equipment• use GAAP standard measures• when useful life and actual life disagree

II. Steps in the capital budget process 3. Select a financing

mechanism• Identify decision elements• pay-as-you-go or pay-as-you-use ?

Selecting a financing mechanism:Example: City of Lawrence,

Department of Trees and MothsDepartment of Trees and Moths: Capital Equipment Worksheet

Truck AgeMonthly Payment

New Truck year plan

No New Truck 10

New Truck year plan

New Truck Cash Purchase

1 5 years $1,100 $1,100 $1,100 $1,100 $1,1002 10 years $0 - $03 2 years $1,900 $1,900 $1,900 $1,9004 New ? $3,060 $0 $2,699 $150,000

Total Annual Expenditure $72,725 $36,000 $45,584 $186,000 Total Annual Budget $200,000 $200,000 $200,000 $200,000 Balance remaing for other uses: $127,275 $164,000 $154,416 $14,000

Interest Rate 8%

$1,900

5

Selecting a financing mechanism Key decision elements:

• Budget constraint• Amount of discretionary $• Values to maximize

– flexibility– cost efficiency– safety– program outcomes– equity (fairness)

Selecting a financing mechanism Key decision elements:

• Prevailing interest rates (volatility)• Risk• Equity: Who pays?• Alternatives

– Pay-as-you-go: Finance capital improvements all at once with current year expenditures

– Pay-as-you-use: Finance capital improvements through small current expenditure and the bulk through borrowing

Pay-as-you go vs. Pay as you use• Pay-as-you-go arguments

– No borrowing, avoid interest costs– Maintain borrowing ability for other projects– Less expensive in long term

• Pay as you use arguments– Costs spread across future beneficiaries– Free operating budget for current expenditures– Less expensive in near term

Selecting a financing mechanismPay-as-you-go issues

• Use pay-as-you go when interest rates are high (unless offset by inflation)

• (even with inflation high governments may wish to avoid locking in higher rates)

• Use in stable slow-growth settings (low urgency)

• Use when a window is available (resource availability)

Municipal Bonds

Municipal Bonds

1. Market facts2. Repayment Security3. The Municipal Bond Process4. Choosing a method of sale5. Empirical evidence6. Yield Burning and other scandals

Municipal Bond Market facts• State and local municipal debt: $1.3 trillion• Volume of municipal bond issuance (in

billions)– 1980 $ 76.2– 1984 $ 128.8– 1996 $ 226.6– 1998 $320.8

YearShort-Term

Long-Term Total Year

Short-Term

Long-Term Total

1980 27.7 48.5 76.2 1990 34.8 128 162.81981 37.4 47.8 85.2 1991 44.8 172.8 217.61982 44.8 79.1 123.9 1992 43 234.8 277.81983 36.9 86.8 123.7 1993 47.5 292.5 3401984 20.8 108 128.8 1994 40.3 165.1 205.41985 23.1 222.2 245.3 1995 37.9 160 197.91986 22.2 151.6 173.8 1996 41.5 185.1 226.61987 20.5 105.1 125.6 1997 46.2 220.7 266.91988 23.7 117.3 141 1998 34.6 286.2 320.81989 29.6 125 154.6

Source: Securities Data Company

Municipal Bond Issuance1980 - 1998 ($ Billions)

Municipal Bonds, Basics

• Tax exempt status lowers interest rates• Tax exempt status raises price• Bonds, Coupons, Indentures

Municipal Bonds, Players

• Government finance officers• Financial advisors• Bond counsel• Underwriters• Investors• Citizens• Voters

Municipal Bonds, Investors

• Munis compete with other investments • Relatively low risk• Double Tax Exempt

– Interest income is free from federal taxes– Interest income is free from (issuing) state

income taxes• Before TRA 1986 mostly held by banks• Since TRA 1986 mostly held by individuals

Municipal Bond Holders• Before TRA 1986:

– 30% Commercial Banks– 6% Savings and Trusts– 35% Households &

Mutual Funds– 17% Insurance

Companies– 3% Money Markets– 9% Other

• After TRA 1986: – 14% Commercial Banks– 7% Savings and Trusts– 56% Households &

Mutual Funds– 12% Insurance

Companies– 6% Money Markets– 5% Other

Source: Federal Reserve Banks, Bond Market Association

Municipal Bonds, Structure

• Face amount• Coupons• Sources and uses• Trust indenture/ covenants• Maturity schedule

– Serial Bonds– Term Bonds

Municipal Bonds, Term structure

• Principal due at end of term• Coupon payments made semi-annually• Term bonds have one face amount matures

on one date• Serial bonds have many different face

amounts which mature at different periods in the life of the issue

• Bonds vs. Bond Issues

Municipal Bonds; Repayment Security General Obligation Unlimited

Tax• Full Faith and Credit pledge• Unconstrained ability to levy the taxes

necessary to retire the debt• Considered the strongest security pledge• Low cost to issuer (interest rates)• Often subject to voter approval• May force fiscal restraint, accountability

Municipal Bonds; Repayment Security General Obligation Limited

Tax• Full faith and credit pledge• Constrained ability to raise taxes to repay• Typical security of governments issuing under

tax limitation restrictions• Price differential depends on room under limit• GOLT may have no practical rating or price

differential from GOULT bonds

Municipal Bonds; Repayment Security (Enterprise) Revenue Bonds

• Proceeds of project revenues pay the debt– Tolls, Parking garage fees, Airport gate fees

• Proceeds of government enterprises pay the debt– Waste Water Treatment, Electricity generation

• Higher default rate, higher interest costs• Preserve borrowing authority (avoid vote)• Maximize benefit equity

Municipal Bonds; Repayment Security Double Barreled Bonds

• Backed by revenue stream and a tax pledge• Improves the credit worthiness of the issue• May become general obligations when full faith

and credit and tax pledge offered• May be able to exclude debt from G.O. limits

while gaining the benefit of G.O. pledge

Municipal Bonds; Repayment Security Moral Obligation Bonds

• Expresses government intent to pay even though not obliged to do so

• Created as added security to non-GO debt• Invented by John Mitchell when bond counsel to

Nelson Rockefeller• Created expressly to avoid referendum or

initiative• May be ignored by rating agencies

Municipal Bonds; Repayment Security Lease Rental Bonds

• Three parties involved– Issuing authority or agency: lessor– Government which will rent the facility: lessee– Investor who buys bonds backed by the lease

payments• Avoids debt limits and voter approval• Higher costs

Lease Rental BondsCertificates of Participation

• Investors purchase shares of lease proceeds• Proceeds distributed less operations and

reserve payments through trustee• Avoids a liability classification for

government• Technically, this is not debt

Lease Rental BondsMortgage Bonds

• Designed to offer low rate mortgages• Designed to pay for housing authority

projects• Bonds repaid from mortgage payments

Municipal Bonds; Repayment SecurityPrivate Activity Bonds

• Used for private commercial endeavors• Limited by federal and state statute• Designed to encourage economic development• Windfall to recipients• Brokering private activity authority in CA

Municipal Bonds; Repayment SecurityBANS, TANS, and RANS

• Bond, Tax and Revenue anticipation notes• Short term government obligations• Provide temporary capital when

– anticipating a bond sale– anticipating tax revenue– anticipating intergovernmental grants

Steps in the Bond Sale Process• Consult capital improvement plan• Select a financial advisor

– line up investors or underwriters– prepare bid specifications

• Select bond counsel– get opinions on legal authorization– create official statement

• Obtain a rating• Select a Method of sale

Steps in the Bond Sale Process: Obtaining a rating

• Moodys, Standard & Poors, Fitch• Rating factors

– economic (macro)– debt– administration – fiscal– management

• The Black Box

Steps in the Bond Sale Process: RatingsMoody’s S & P

Aaa AAAAa AAA ABaa BBBBa BBB BCaa CCCCa CC, CC C1

D

Choosing a Method of Sale:Terms

• NIC = Net Interest Cost• TIC = True Interest Cost• Basis point = 1/100th of a percentage point• Negotiated Sales• Competitive Sales• Reoffering Yield• Underwriter Spread

Negotiated Sales: The Underwriter Hypothesis

• Negotiated sales are less expensive – during volatile markets– for complex and “story” bond issues– for advanced refundings

• Underwriters work harder to pre-market• Restricting negotiated sales will create

inefficiencies that will inflate borrowing costs

Testing the Underwriter Hypothesis in New Jersey

• Scandal, $2.9 Billion, EO 79• Pre and Post “ban” observations• Pre-ban 79% Negotiated Sales• Post-ban 52% Negotiated Sales• Comp sales .47 bp < negotiated sales• On average (23 YTFM) $7.19 million in

savings ($4.3m NPV) per issue

Conclusions

• Except for rare instances, competitive sales save money

• Issuers choose methods of sale based on other factors (relationships)

• Finance choices have implications for citizen trust and confidence in government

Municipal Bonds: Scandals

• Defaults• Pay-to-play• Yield Burning