Muni Impact | February 9, 2023

Munis 101: Players, capital flows and mechanics in the $4 trillion municipal-bond market

Andrea Riquier

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ImpactAlpha Editor

Andrea Riquier

ImpactAlpha, Feb. 9 – Municipal bonds have been called the original impact investments, the source of much needed capital for highways, bridges, schools and other essential public services. Investors, issuers and communities are increasingly leveraging the $4 trillion municipal bond markets to disrupt systemic inequities. 

As essential as it is, the muni market can feel opaque.

To broaden access to the market and bring newcomers into the conversation, ImpactAlpha offers this basic explainer to sort out the players, capital flows and mechanics that fund our public projects. 

We’ll update it over time with new phrases and concepts (have a suggestion?). Catch up on all of ImpactAlpha’s coverage of Muni Impact, made possible with support from the Robert Wood Johnson Foundation.

What are municipal bonds?

Muni bonds are investment instruments that state and local government entities issue to raise money for expenditures. Investors who buy the bonds get the government entity’s promise to repay that money, along with interest. In most cases –  but not always – investors do not have to pay income tax on the interest they receive for holding the bonds.

In return, the issuer gets money to fund things like schools, roads and bridges, public transit, water and sewer infrastructure, parks, and housing for lower and moderate income residents.

How big is the municipal bond market? 

The municipal bond market has $4 trillion in outstanding debt (for comparison, the corporate bond market totals about $10 trillion). On an average day in 2022, $14 billion worth of “munis” were traded. In recent years, roughly $400-500 billion worth of muni bonds have been issued each year, although that figure will be down sharply in 2022 thanks largely to the spike in interest rates. Estimates of how many issuers there are range from 36,000 to 50,000.

Source: US Municipal Bonds Statistics – SIFMA – US Municipal Bonds Statistics – SIFMA

Who are muni-market issuers?

The municipal market is often considered quirky largely because of the huge number of entities that use it to sell debt. There are tens of thousands of state and local government entities that issue— sometimes on a regular basis, like states and big cities with ongoing capital plans — and sometimes once in a lifetime, like when a small town needs a one-time infusion of funds. 

Municipal bonds are either revenue bonds, which will be paid back with money that flows in from use of the facility – tolls, tickets, or fees – or general obligation, which are paid back with taxes. Issuers typically fall into one of the following categories:

  • Cities, towns, townships, counties, and states
  • Water utilities and water districts; sewer utilities and sewer districts
  • Power utilities
  • Health care, higher education, and some non-profit entities 
  • School systems
  • Authorities governing public transportation, airports, bridges and tunnels, highways, and more
  • Housing authorities
  • “Conduit” issuers and “bond banks,” which are authorities that issue on behalf of several smaller entities

Source: The Fundamentals of Municipal Bonds, Sixth Edition, by the Securities Industry and Financial Markets Association

What is the difference between “tax-exempt” bonds and “municipal bonds”?

If a municipal government or one of the entities noted above issues bonds, they are always considered municipal bonds. But there are specific guidelines that issuers must follow in order to issue bonds that are tax-exempt for the investor. For example, the project or initiative for which the bonds will be used must be for public use, with little of the benefit flowing to private-sector parties. That can make a project like a student center or a senior center with a third-party concessionaire somewhat challenging. 

Another big consideration: continuing disclosure. Municipalities have to report to the investing community every year, and for a few years after, in which their bonds are outstanding. 

Investor demand for tax-exempt bonds is so great that it’s often cheaper to issue bonds that way. But if a municipal entity determines that issuing taxable bonds isn’t that much more expensive, the extra labor involved with ongoing disclosures may make it a better bet to issue taxables, or to structure a private placement with a bank.

How do bonds get issued?

Several steps typically have to happen before an issuer can go to the market and sell bonds. A project or piece of infrastructure is usually considered and budgeted as part of a longer-term spending plan. That’s important because municipal bonds should not be used to fund ongoing expenses like payroll, utilities, office supplies, and so on. 

In some cases, the issuer may need the community’s okay to issue debt. Some municipalities always need voter approval for new bonds, some never need it, some need it when they issue amounts over a certain threshold, and so on. Separately, issuers may sometimes seek community buy-in for more sensitive or controversial projects via meetings or hearings. And in some instances, a new authority may need to be created for the bonds to be issued — say a special taxing district to fund a new building or park. 

Once all the approvals are in place, the issuer will work with a lawyer, known as bond counsel, to make sure the debt structure conforms to all applicable standards. For example, most municipal bonds are exempt from federal taxes, and bond counsel will ensure that the plan meets those standards. 

Issuers are also strongly encouraged to hire a professional called a municipal advisor. Advisors can help determine whether it makes sense to issue tax-exempt municipal bonds, or whether the amount of savings isn’t worth the amount of work it will require. They will also help the municipality obtain a credit rating from an agency like Standard & Poor’s or Moody’s, and choose an underwriter. 

Importantly, the 2010 Dodd-Frank legislation requires that municipal advisors serve as fiduciaries to issuers, and that they register with the Securities and Exchange Commission and the Municipal Securities Rulemaking Board (MSRB).

A municipal advisor can also help the issuer determine whether its bonds should have other features that would make them more attractive to investors: insurance, state credit enhancements, and even intercepts that funnel revenues directly to bondholders. Such enhancements can help investors feel more comfortable lending to more marginal borrowers or for more unusual projects. In a case like this, an issuer may also consider borrowing through state or regional conduit authorities or bond banks, if they are available. 

Once the underwriter is in place and the sale has been advertised to investors, the underwriter and the issuer determine the structure of the debt offering. Municipal bonds are almost always serial bonds — the entire offering is broken up into maturities of increasing length, with longer maturities offering higher interest rates. 

Because of the push-and-pull involved in selling debt: the issuer wants the lowest possible cost of capital while the investor wants the highest rate of return, it’s often suggested that the municipal advisor and the underwriter not work for the same firm.

Source: Sheryl Bailey, professor, Virginia Tech; former director, Virginia state bond bank

Who invests in municipal bonds?

Roughly 40% of outstanding municipal bonds are held by individuals, not funds, which makes them unique among asset classes. The vast majority of muni bond investors simply want a stream of income that’s exempt from taxes— capital preservation, not growth or speculation. 

Munis are attractive for that purpose in large part because they are exceptionally safe. According to Moody’s Investors Service, from 1970 to 2020, the average five-year municipal default rate is 0.08%, compared to 6.9% for corporate bonds. The average rating of municipal issuers is much higher than the average rating of corporates, Moody’s notes. 

Most observers believe that the tax exemption shapes the muni market in critical ways. Among them: the desire to avoid paying taxes means investors “pay more than they should,” says Matt Fabian, a longtime industry stalwart. “People are happy to not price (bonds) too precisely,” Fabian says. “The buying side is not efficient.”

Neither is the selling side: with tens of thousands of issuers, some of whom are in the market very rarely, it’s hard to have the same consistent availability in munis that investors are accustomed to in other asset classes. Also, every issuer has a unique mix of characteristics: demographics, area economy, state laws, internal budgeting practices, local politics, and so on. 

Source: Matt Fabian, partner, Municipal Market Analytics