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TOOLS TO IMPROVE LOCAL INFRASTRUCTURE
FOR ECONOMIC GROWTH MUNICIPAL BOND ISSUANCE
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CONTENT:
WHAT IS A MUNICIPAL BOND?
WHAT ARE THE BENEFITS OF A BOND ISSUANCE?
HOW BONDS AND BOND ISSUANCES WORK?
CONTACTS AND WEB RESOURCES
One answer for the City is to go to the investor market and borrow the funds necessary to meet its requirements. Issuance of a municipal bond is a method that allows the City to accomplish this. But issuance of a municipal bond is not a casual undertaking. Most important, of course, is that when a city borrows money through a municipal bond issuance, the city obligates itself to pay the financing back in full, with interest. The city must therefore have a reliable, well-designed and fully transparent scheme for how it will repay its investors, and that scheme and obligation must be in place for every successive city administration throughout the life of the financing. Thus, as a prerequisite to a bond issuance and for purposes of sound public policy, a city needs to clearly define and analyze the purpose of its borrowing-what need will the financing meet, the value to the city of meeting that need, and the cost that the city is willing to pay to meet the need.
Definitions
A municipal bond is a security issued by a city (or communal service enterprise) that confirms:
- the city has borrowed money from an investor;
- the city promises to pay a stated interest rate and to repay principal in full;
- the city agrees to a set a schedule for principal and interest payments; and
- the availability of funds, and the interest rate and term, are determined at the time of issuance by the investors who buy the bonds (i.e., the market).
Bonds may be issued by:
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City Council
- City bonds are backed by the city's revenues and assets.
- Bonds are repaid from city revenues--preferably from operating surplus, but sometimes from land sale revenues.
- Collateral is not usually provided.
- Ministry of Finance must approve borrowing.
- Credit rating is required by law, and also to provide investors with an independent verification of the reliability of the city to repay its obligations.
- Detailed public disclosure of financial condition is essential to inform and persuade investors to l buy the bonds.
- A bond issued by a city must comply with Securities and Stock Market State Commission municipal bond regulations and must be registered by the Commission.
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Communal Service Enterprises (Note: At present, few if any communal enterprises in Ukraine are sufficiently profitable to issue bonds successfully.)
- Bonds are backed by the credit of the enterprise, based on its profitability, its balance sheet and history of timely repayment of previous debts.
- Bonds are repaid from enterprise operating revenues.
- Collateral is optional.
- Guarantee by the city is not permitted by current State Budget Law.
- A communal service enterprise bond must comply with Securities and Stock Market State Commission regulations for company bonds and must be registered by the Commission.
- Credit rating by objective and competent credit rating bureau is required so that investors receive an independent verification of the reliability of the borrowing enterprise to repay its obligations. Rating agency must also be authorized by SSMSC.
- External audit is required.
- Detailed public disclosure of financial condition is advisable.
- Ministry of Finance approval is not required.
- There has not yet been a successful bond issue by a communal service enterprise in Ukraine.
WHAT ARE THE BENEFITS OF A BOND ISSUANCE?
Bond issuance is most appropriate for a long-term, capital need of the city and the Budget Code permits borrowing only for Development Fund expenditures. Such expenditures require an immediate outlay of money beyond the means of the normal revenue sources of the city. For instance, if the city is interested in upgrading durable communal services or developing public housing stock or expanding existing transportation infrastructure, a municipal bond issuance might be appropriate. Similarly, capital construction on public facilities such as public hospitals might be a suitable project for municipal bond financing. All of these reflect creation of long-term city assets with a useful life of many years. It is these types of projects that warrant the city's taking on the type long-term debt obligations typical of municipal bonds, to be repaid over a number of years.
Transactional Advantages and Disadvantages of Bonds
Municipal bonds are alternatives to other types of financing, Note-at present bank lending to cities is virtually nonexistent based on latest Ministry of Finance data (June 06) and their transactional advantages and disadvantages must be considered. It is important to remember as a fundamental principle that when municipal bond issuances are undertaken, the city must make a complete public disclosure of its full financial condition so that potential investors will fully understand the city's outstanding obligations, accountability and repayment capacity.
Advantages
- Competition among investors can reduce interest rates, Note-small bond issues are frequently purchased (and held) by a single investment bank.
- City builds a direct relationship with investors.
- With timely repayment, city builds a public record of creditworthiness that will allow future and larger municipal bond issuances and other borrowing.
- Detailed public disclosure of the city's financial condition promotes transparent city management and overall trust in the city administration.
- The amount of bonds issued is limited only by law and investor perception of city creditworthiness and the underlying logic of the borrowing Note-we don't think investors evaluate the latter. (In contrast, bank credit limits depend on the lending portfolios, risk analysis and business plans of commercial banks).
Disadvantages
- Credit rating and other issuance expenses can be substantial, especially for a small bond issue.
- Bond issues are not suitable for small borrowings of less than UAH 5 million.
- The detailed financial disclosure that is required to back up a bond issuance requires considerable expenditure of time by the city's staff.
- From start to finish, the preparation of a bond issue can take 4-5 months or more.
HOW BONDS AND BOND ISSUANCES WORK?
Example purposes of bond financing:
First and foremost, the city must decide why it needs a long-term financing such as a municipal bond. In Ukraine, the Budget Code requires that bond proceeds be used for Development Budget expenditures only. Suitable purposes common to many cities in Ukraine could therefore be: reconstruction of street-lighting; purchase of energy-saving equipment; housing construction; reconstruction of the city's stadium; reconstruction of the central part of the city; reconstruction and building of roads and bridges; or reconstruction and modernization of communal enterprises (heat utility, water utility, sewage, water treatment etc.).
General Framework of Municipal Bond Offerings
Let us say that a City needs to borrow UAH 10 million. In general, it will work this way:
- The city will break the large borrowing into small parts. For example, a city wishes to borrow UAH 10 million; it could borrow this money by issuing 10,000 bonds, each bond having a value of UAH 1000.
- Each bond is a promise from the city to repay principal and interest to the bond buyers (investors).
- The city hires an authorized credit rating agency to prepare a credit rating report and issue a rating. The rating is a grade that indicates the likelihood that the city will default on the bond (fail to repay in full, on time).
- An Investment Memorandum is prepared as part of the issuance process. This Investment Memorandum is usually prepared by an investment bank hired by the city, and discloses comprehensive information about the bond issue to potential investors, including:
- the bond payment schedule;
- detailed information about the city's financial condition;
- a description of the risks of investing in the bonds;
- whether the bonds will be listed with a securities exchange or trading system (listing enables investors to buy and sell bonds throughout the bond term);
- legal matters, including evidence of government borrowing approval and SSMSC registration.
Because bond issuances require technical knowledge in all phases, including preparation of the Investment Memorandum, the city should consider retaining a Financial Advisor to assist it with the bond issuance. A Financial Advisor is typically an investment bank hired by the city issuing the bonds to manage preparation and marketing of the bond issue.
It performs the following critical tasks:
- Analyzes borrowing capacity of prospective issuers, cities and communal service enterprises.
- Advises on structuring the borrowing (size, interest rate, maturity, credit enhancements).
- Prepares detailed information about the city, the bond issue and proposed investment projects for disclosure to investors.
- Ensures that all legal and regulatory requirements are met.
- Manages the process of placing the bond issue with investors.
- May purchase the entire bond issue as an investor.
- Lists bonds for secondary market trading if the city decides to do so.
Characteristics and Cost of an Example Municipal Bond
Let us take a look at our example of a UAH 10 million bond issuance:
- Total amount borrowed: UAH 10 million.
- Number of bonds: 1000.
- Face value of each bond: UAH 1000.
- Interest payment frequency: 4 times per year.
- Bond term: 2-5 years from date of issue.
- Bond term: 2-5 years from date of issue.
- Note: the actual interest rate will depend on market conditions at the time of issuance, and on the issuer's creditworthiness.
- Principal and interest payment = UAH 2.98 million per year for 5 years.
- Investors evaluate: will repayments be timely and complete?
Steps in Preparing A Bond Issue
- Evaluate your city's operating surplus over the past 3 years, and project your surplus for the next year. Operating surplus is the difference between recurring operating revenues and recurring operating expenses. Your operating surplus is the recommended source for the principal and interest payments you will owe to bond investors.
- 1. Evaluate your city's operating surplus over the past 3 years, and project your surplus for the next year. Operating surplus is the difference between recurring operating revenues and recurring operating expenses. Your operating surplus is the recommended source for the principal and interest payments you will owe to bond investors.
- Identify essential infrastructure projects that could be financed for the targeted amount of borrowing.
- Hire an authorized credit rating agency to rate your city and the bond issue itself. Credit ratings are required by the Law on State Regulation of Securities Market and by Cabinet of Ministers Resolution 207. Ratings cost from UAH 30,000 to UAH 125,000, depending on the rating agency you select.
- The city should prepare a draft borrowing resolution including a maximum amount to be borrowed, a maximum interest rate, and a maximum term (maturity).
- The city should prepare documents required for Ministry of Finance approval of the borrowing (following the requirements of Cabinet of Ministers Resolution 207.) Among other things, the Ministry will require detailed information about the city's land holdings.
- The local Rada must approve the borrowing resolution, as well as a budget deficit in the development budget equal to the size of the planned borrowing.
- The local Rada must approve the borrowing resolution, as well as a budget deficit in the development budget equal to the size of the planned borrowing.
- The local Rada must approve the borrowing resolution, as well as a budget deficit in the development budget equal to the size of the planned borrowing.
- Publish the Information on bond issue.
- "Place" or sell the bonds, either through an auction to investors or directly to the investment bank serving as the Financial Advisor. Immediately after bonds are sold, the issuer receives the bond proceeds, i.e., the amount borrowed.
- Submit Bond Placement Report to the Securities and Stock Market State Commission.
- List bonds for trading on PFTS or another other securities trading system. Listing enables investors to sell bonds for cash, before they mature. This makes bond investment more attractive and can reduce your interest expense.
- Manage bond proceeds carefully as infrastructure construction proceeds. Seek State Treasury permission to deposit bond proceeds in an interest-paying account.
- Budget carefully for timely repayment. The Budget Code makes debt repayment obligatory, and imposes a five-year borrowing ban for cities that violate agreed repayment schedules for debt (default).
How to Improve Your City's Creditworthiness?
- Creditworthiness is your capacity to repay debts on time, and in full..
- To improve your city's creditworthiness, manage city finances so that you generate a steady operating surplus equal to at least 5% of your recurring operating expenses every year (operating surplus equals recurring operating revenues minus recurring operating expenses).
- Seek expert advice on how to classify your revenues and expenses properly to get an accurate picture of your operating surplus.
- Build a strong financial profile for your city:
- Try to increase locally modifiable revenues such as land leases, market taxes, local taxes.
- Build a diversified, growing economic base that will increase your Personal Income Tax revenues.
- Increase predictability of your finances by limiting reliance on volatile State equalization grants.
- Maintain good performance of budget execution versus budget plan.
- Implement indexed, full-cost recovery tariffs for city communal enterprises.
- Enable communal service enterprises to become profitable by enacting cost-indexed, full-cost-recovery tariffs.
- Reduce contingent liabilities by restructuring communal enterprise payables and receivables.
- Practice financial transparency
- Consider regular, public disclosure of your financial reports to the State Treasury, throughout the term of the bond.
- Prepare your own regular financial reports to measure operating surplus.
- Consider having regular external audits of city financial records by reputable accountants to confirm the integrity of your data.
- Maintain and publish a credit rating for your city.
- Invest in high-quality city management (capital budgeting, computerized accounting, program budgeting, public participation).
1. Access to Credit Initiative of USAID/Ukraine: - http://www.atci.com.ua/
Olympic Business Center
72 V.Vasylkivska Street
1st entrance, 5th floor
03150, Kyiv, Ukraine
Telephone: +380(44)5370967, +380(44)5370966
2. Cbonds for detailed information about Ukrainian bond market - http://www.cbonds.info/ua/eng/index.phtml
3. Credit Rating Agencies:
www.credit-rating.com.ua/en/ratingservices/national.html
www.standardandpoors.com
www.fitchratings.com/corporate/sectors/sector.cfm?sector_flag=5&marketsector=1&detail=1&body_content=about
www.moodys.com/cust/default.asp
