Municipal Bondage

More Than You Ever Wanted To Know About How Bonds Work.
By Mari Wadsworth 

IN THE LAST bond election in 1986, the voters approved just over $219 million for various capital improvements in Pima County; $23 million of that prior authorization remains to be sold ($15 million in general obligation bonds, $8 million in revenue bonds for sewer improvements), according to the county administrator's office.

On the ballot for the May 20 special bond election is nearly $362 million in additional general obligation and revenue bonds, bringing the county's grand total for current bond expenditure, if voters approve all eight measures on the ballot, to $385 million.

So how does all that money get from the ballot to the county budget? Jim Barry, chief assistant to County Administrator Chuck Huckelberry, and Kurt Freund, one of the managing directors of the Phoenix branch of Rauscher, Pierce, Refsnes, Inc., the county's financial advisor for bond sales, helped to translate the process into laymen's terms:

What is a bond? It's a debt, in the form of a series of promissory notes sold to investors. Typically, these notes may be sold in lots of $5,000 or $10,000. Essentially, a bond is an IOU.

How do bonds work? If county residents vote to approve a bond proposal of $362 million, that authorizes the Pima County Board of Supervisors to sell that amount in bonds over an unspecified period of years. The county administrator's office makes a public announcement, with a deadline to receive sealed bids from interested investment-banking firms (like, say, Merrill Lynch or Dean Witter). These investment firms are the middle-man: They buy the bonds from the county, then turn around and sell them to private investors, which might be individuals or institutional entities like a pension or mutual fund.

What the investment firms bid on is the interest rate at which the county will pay back its IOU (called the "bond award"). County officials say the maximum interest rate they would approve would be 12 percent; although currently the going interest rate seems to be running between 5 and 6 percent, determined by fluctuations in the bond market. An investment firm wins the bond award by bidding the lowest interest rate to the county. This interest rate remains fixed through the bond's maturation period.

The investment firm then turns around and sets its stock brokers to finding interested investors willing to buy the bonds at a slightly lower interest rate than the investment firm paid. That's how Wall Street makes money.

So who pays the county for the bonds? The money comes directly from the investment-banking firm, and indirectly from the investors to whom that firm sells the bonds. The assumption is that, say three weeks later when the deal actually closes and the money changes hands, the firm will have secured investors to pay that lump sum. If they haven't secured investors, the investment firm is obligated to pay the issuer (the county) out-of-pocket for the remaining balance.

What's the relationship between the county and the firm that actually sells the bonds to investors?

The "underwriter" is the investment-banking firm. They're the go-between for the issuer (the county) and investor. "Underwriting" means being the bond's sponsor, or guarantor.

How do interest rates affect the worth of a bond over the long term? The interest rate the county pays on the bonds is fixed at the point of sale (that is, at the award of the bond to the low bidder). The risk the investment bankers take is this: to bid as low as possible to win the bonds, while guessing at what rate they can turn around and sell them to investors. If the market pushes interests rates too high, the firm might take the bonds into inventory, meaning they'll cough up the money to the county in the short term, and sell the bonds later, when the interest rates in the bond market are more favorable to the firm (investors will want to buy when the interest rates are highest, but the firm will want to sell them at the lowest possible market rate). There's a huge market for municipal bonds, so the risks for investment bankers seem relatively low.

When does the county actually sell the bonds approved by the voters? The county doesn't sell all of its bonds to the low-bidding investment firm immediately after the election. There are federal guidelines, called "arbitrage rules," for bond expenditures, one of which states that, because the bonds have federal tax-exempt status, a county can rake in only as much bond money as it can reasonably spend in a two-year period. So in the first year after the bond election, the supervisors may only award $30 million of the $362 million total. If the county were to earn more from bond sales than it could actually spend in that two-year period, they'd have to pay a penalty to the IRS. That's how it happens that we're still selling bonds in 1997 that were approved by the voters in 1984.

What are "tax-free" bonds? Municipal bonds are tax free to investors: This means they won't have to pay income tax on the money earned from the accrued interest on the bonds they've purchased.

Say you buy a single bond for $5,000, and it pays a 6 percent rate of interest. You pay $5,000 to the investment firm, which in turn pays your $5,000 to the county. In return, you're going to get your $5,000 back when the bond matures, let's say 10 years from now. In between, you might receive a check twice annually for the interest earned on that bond. Six percent of $5,000 is $300. So that $300 a year is what's tax exempt.

What's the difference between a general obligation bond and a revenue bond? A general obligation bond is repaid through property taxes. The county pledges to the investors that it will raise whatever property taxes are necessary to meet the annual debt service until the principal and interest are paid. Items one through seven on the May 20 ballot are general obligation bonds.

A revenue bond, on the other hand, is paid by a defined revenue stream, specified by the county. Item eight on the ballot, dealing with sewer improvements, would be covered by connection fees--what you pay when you first connect to the county sewer system--as well as monthly user fees, which are included in your monthly water and sewer bill.

What do we need to be mindful of in selling bonds? Each bond sale is approved individually by the supervisors, with input by financial advisors, who assess how the county's tax base is growing and what the market is demanding in interest rates. TW

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