As we enter 2019, portfolio manager Matt Buscone discusses what’s top of mind in the muni market for our investment team.
The $4 trillion municipal market includes a wide range of bonds with varying issuer types, funding sources, credit risks and other characteristics. In this informational piece, we break out the major types of municipal bonds and provide some of our general credit perspectives on each.
Municipal debt can be categorized into two major families: tax-backed bonds and revenue bonds.
Tax-backed bonds are supported by the state or a political subdivision’s taxing power, either explicitly or implicitly. They include:
- Traditional General Obligation (GO) Bonds
Traditional GO bonds are backed by an unlimited amount of property taxes and/or the issuer’s full faith and credit. In many states, GO bonds can be issued solely with voter approval. Depending on the state, GO bonds may be paid from a specific property tax levy earmarked for principal and interest retirement, or from a combination of a property tax levy and the issuer’s general resources. Bond proceeds are typically used to finance essential projects such as operating public transit or public schools.
Typical issuers: States, local governments or special district governments.
Examples: State of New Jersey GOs, Colorado school district GOs, California health district GOs.
Key Positives: Historically low default risk; broad-based tax or full faith and credit pledge.
Key Negatives: Taxes pledged to bonds sometimes compete with operating needs during times of fiscal stress; GO bonds may be susceptible to impairment in Chapter 9 bankruptcy filing.
- Limited-Tax GO Bonds
Limited-tax GOs are backed by a limited amount of property taxes and sometimes a full faith and credit pledge. The tax levy limit is typically set by the state statute. Voter approval to issue these bonds often is not required. Bond proceeds are typically used to finance essential projects.
Typical issuers: Local governments and school districts.
Examples: Certain local government and school district issuers in Illinois, Michigan and Oregon.
Key Positives: Historically low default risk; broad-based tax pledge; pledged levies are sometimes collected apart from operating levies, which can help to insulate the bonds from general fund stress.
(Operating and capital expenditures that are financed from general resources are accounted for in a government’s ‘general fund.’ By contrast, spending that is financed from specific revenue streams or restricted bond funds may be accounted for in segregated funds.)
Key Negatives: Issuer cannot levy taxes beyond a certain limit to back the debt.
- Dedicated Tax/Special Tax Bonds
Dedicated tax bonds are secured by specific taxes of a state or local government. Taxes pledged often include income or sales taxes. The structure is designed to be a form of nonrecourse financing. Bondholders have a claim on the taxes pledged, and only those taxes. If there is a default, bondholders lack recourse to other funds of the issuer. Bond documents and state laws determine the extent to which pledged funds can be used for purposes other than repaying bondholders. Pledged taxes may be completely unavailable to the general fund, or available for general purposes after debt service is paid.
Bond proceeds are often used to finance essential projects, including transportation. They may also be used to fund less-essential needs like convention centers, entertainment spaces or other desires.
Typical issuers: States or local governments.
Examples: California transportation districts, New York state personal income tax bonds, Colorado local government sales tax bonds.
Key Positives: Specific tax revenue streams are legally pledged to service debt; the design is supposed to be self-supporting and nonrecourse; in theory, the structure should insulate bondholders from impairment in Chapter 9 bankruptcy.
Key Negatives: Potential ratings splits due to ratings agency views on legal structure risks (see The Chicago Downgrades); questions about the nature of public sector nonrecourse financing following Puerto Rico Highways and Transportation Authority ruling (see What Happens in Puerto Rico No Longer Stays in Puerto Rico).
- Appropriation Bonds
Appropriation bonds are backed by appropriations of a state or local government. These bonds are often (though not always) structured as leases under state law; they are not legal debts of the government. The government always retains the legal authority not to appropriate principal and interest costs in its annual budget.
In the event the government fails to appropriate principal and interest, bondholders are often entitled to the property that has been financed – at least when a deal is structured as a lease. However, foreclosing on the lease may prove challenging if the assets in question are of vital need for the government. In other cases, bondholders may lack any substantive recourse.
Despite the comparatively weak security features backing appropriation debt, they are a common form of issuance in the municipal market. Because appropriation bonds often finance essential needs, and because defaulting on these bonds would severely limit market access for essential projects, state and local governments have long honored them.
Typical issuers: Public authorities and nonprofit corporations on behalf of state and local governments.
Examples: California local government lease-appropriation bonds and certificates of participation (COPs), New York state service contract bonds.
Key Positives: Credit quality is linked to the state or local government’s credit fundamentals; failure to appropriate principal and interest may result in bondholders taking back a leased property.
Key Negatives: Technically not debt; when a government is under fiscal stress, appropriation of funds may be at risk.
- Tax Increment/Tax Allocation Bonds
Tax allocation bonds are payable from property taxes generated by the incremental appreciation in property within a designated area. Bond proceeds are typically used for redevelopment needs within the area’s boundaries. Per U.S. bankruptcy code, these bonds should be treated as secured obligations in a Chapter 9 bankruptcy as they are included in the category of “special revenues.” Pledged tax revenue is segregated from an issuer’s general fund.
Typical issuers: Local governments or redevelopment authorities.
Examples: California redevelopment agencies, Florida TIF districts.
Key Positives: Credit quality is distinct from the host local government’s credit fundamentals; principal and interest repayments should be insulated from impairment in Chapter 9 per plain language in the U.S. bankruptcy code, although this language has never been tested.
Key Negatives: Repayment depends on future development within the designated area.
Revenue bonds come in two general forms: bonds issued by essential services (monopoly utilities) and bonds issued by business-like “enterprises” that face greater degrees of competitive pressure.
- Utility Revenue Bonds
Utility revenue bonds are typically secured by the net revenues of utilities. Utility bonds are mostly composed of water, sewer and electric revenue bonds, and are repaid from the revenue available after operating and maintenance needs are met. Revenues typically derive from water, sewer and electric rates paid by customers.
Proceeds are used to build and maintain power generation and transmission facilities, water-sewer and sanitation facilities and other infrastructure. Utility revenue bonds are intended to be insulated from the bankruptcy of a host government under Chapter 9 of the bankruptcy code.
Typical issuers: State and local utility enterprises.
Examples: Chicago water-sewer bonds, Los Angeles Department of Water & Power.
Key Positives: Often finance highly essential needs; revenue environment is highly stable even through economic cycles, as these systems are usually monopoly providers.
Key Negatives: Bondholders have recourse solely to the pledged utility revenues; other host government resources are not pledged to debt service.
- Enterprise Revenue Bonds
Enterprise revenue bonds include bonds issued by nonprofit hospitals, private universities, housing authorities or other public and private entities that operate in competitive sectors of the economy. They are typically secured by a gross or net revenue pledge of the issuer. Unlike utility revenue bonds, enterprise revenue bonds are not always insulated from impairment in Chapter 9; many types of enterprise revenue bonds (e.g., those issued by nonprofit hospitals) are ineligible for Chapter 9.
Typical issuers: Nonprofit hospitals, private universities, housing authorities, industrial development bonds.
Examples: Princeton University (New Jersey), Scripps Health (California), New York City Housing Development Corporation (New York).
Key Positives: Often finance essential needs.
Key Negatives: Subject to market forces and competitive environment; security strength may be weaker than for utility revenue bonds.
Other Categories of Municipal Bonds
- Prerefunded Bonds
Prerefunded bonds are backed by an escrow of U.S. Treasuries or other bonds. A prerefunding takes place when a borrower issues a new bond and uses the proceeds to purchase low-risk assets like U.S. Treasury bonds. The assets are placed in escrow. The interest on the purchased U.S. Treasury bonds is used to pay debt service on the prerefunded bond.
The Tax Cuts and Jobs Act (TCJA) passed in December 2017 prohibited prerefunding tax-exempt bonds. This class of bonds will eventually disappear but prerefunding bonds currently make up between 8 percent and 9 percent of the market.
- Green Bonds
With municipal green bonds, issuers commit to using proceeds for environmental purposes. Green bonds sometimes come with additional disclosure so that investors can track the use of proceeds, and because investors demand a degree of disclosure presently atypical in the municipal market. Municipal green bond growth has been steady: U.S. issuance totaled $10.4 billion in 2017, versus $4.1 billion in 2015, per S&P. However, the muni green bond market is still in its infancy, and in-depth, fundamental credit analysis remains important for all bonds – even those with the green label (see Look Before You Leap into Green Bonds). We expect more calls for standardization in the muni green bond market as issuer demand for environmental, social and governance (ESG) investments continues to increase.
- Taxable Municipal Bonds
Taxable municipal bonds are bonds that are ineligible for tax exemption due to federal tax law. Taxable municipal bonds outstanding total about $411 billion, or 13 percent of the entire municipal bond market, per JP Morgan.1
GOs, education bonds and water-sewer bonds are common in the taxable municipal space but the market overall is fragmented, with many small segments represented. Taxable municipal bonds may also finance projects that benefit a private business or are repaid by private businesses. These projects may have a riskier credit profile relative to other bonds (see Private Activity Bonds below).
- Build America Bonds
Build America Bonds (BABs) were issued by municipal borrowers in 2009 and 2010. The bonds were authorized by the American Recovery and Reinvestment Act. Interest on BABs is fully taxable for investors. Interest costs remain subsidized for the issuer, however, because the federal government pays a portion of annual interest costs for the government that issued the bonds.
With their introduction, BABs opened up municipal bonds to the taxable bond market. Nontraditional municipal investors (such as pension funds and other institutional investors) were the main buyers of BABs. The BAB program was discontinued in 2010. About $181 billion in BABs debt was issued during the program’s runtime.
- Private Activity Bonds
Private activity bonds (PABs) are municipal bonds that finance projects for the benefit of nongovernmental borrowers. As a general rule, a bond qualifies as a PAB if: (a) 10 percent of the bond proceeds are used in a private business and 10 percent of the principal interest payments are secured by property used in a private business, or (b) more than 5 percent or $5 million of bond proceeds is lent to a nongovernmental borrower.
Interest on PABs is federally taxable. However, some PABs, known as “qualified private activity bonds,” retain tax-exempt status. This includes bonds issued on behalf of nonprofit hospitals and universities, as well as a variety of exempt facility bonds and housing bonds.
- Alternative Minimum Tax Bonds
Interest on most PABs is subject to the alternative minimum tax (AMT). These bonds are known as AMT bonds. Historically, AMT bonds have traded at higher yields due to the possibility that bond interest may be taxable to an investor. The TCJA increased the tax bracket at which the AMT takes effect, so more investors can purchase AMT bonds without worry that the investment will be taxed.
 JP Morgan, as of August 17, 2018. Taxable municipals with municipal cusips assigned.
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