i.2.3 Decision #3 – Can the municipal market help the public agency meet its capital financing needs?
The final decision for public agencies in this process is to assess whether the municipal market can help finance its capital needs. To this end, publicly offered debt exhibits distinct strengths and weaknesses.
STRENGTHS OF PUBLICLY OFFERED DEBT
- Debt can potentially finance 100% of the cost of the project.
Public agencies are routinely able to finance all of the cost of a particular capital project or acquisition through debt financing. This allows a public agency to maintain cash reserves to deal with contingencies.
- Publicly offered debt is often the cheapest source of funds, especially when interest payments to the lender are exempt from income taxation.
For most public projects, debt financing can be done on a tax exempt basis, which means that there is no income tax paid by the bondholder on the interest income received on the bond. The benefit to some investors is significant and results in a lower cost of financing for the public agency.
- Fixed-rates over a long period are readily available.Unlike many other areas of the capital markets and banking sectors, public agencies frequently issue debt at a fixed rate for 30 years or even longer. This allows a public agency to establish a stable source of financing that can extend over a long planning period without exposure to interest rate fluctuation. It also allows an agency to better match the repayment period to the lifespan of the facility itself.
WEAKNESSES OF PUBLICLY OFFERED DEBT
- Complicated Process
The process of debt financing can be lengthy and difficult and requires the assistance of outside parties, attorneys, consultants, and financial firms. The public agency needs to lead the process as well as assume significant ongoing obligations to investors. - Compliance with Securities Laws
Debt that constitutes a municipal security carries substantial obligations under federal securities laws, including the preparation of offering documents that explain to investors the terms and conditions of the bonds, risks associated with the investment, the finances and operations of the public agency, and any other information that would be important to investors in deciding to purchase the bonds. In addition, an offering of municipal securities requires the public agency to maintain policies and procedures for ensuring that any disclosure to the market is made on a timely basis and is correct and complete, both at the time of the initial transaction and throughout the life of the borrowing. - Transaction Costs
Debt financing usually requires the involvement of consultants, including lawyers, financial advisors, underwriters, trustees, and paying agents, who assist the public agency in the process. For smaller transactions these costs may render bond financing uneconomical. - Market Prefers “Standardized” Structures
Although this is not always the case, the municipal market tends to require debt issued as a municipal security to conform to certain standardized norms. This may force the public agency to adjust its practices. For example, interest payments on long term bonds are typically scheduled at 6 month intervals, and principal is repaid once per year. Long term bond issues generally require a detailed security pledge and operating and financial covenants designed to protect bondholders. These covenants likely will bind an issuer for the length of time the bonds are outstanding. - Requires Ongoing Monitoring of Legal and Financial Commitments
Debt issued as a municipal security requires public agencies to perform certain ongoing activities to ensure compliance with tax laws and bond covenants. - Debt Capacity
The total amount of debt a public agency may incur may be subject to legal limitations and is subject to practical limitations. Over reliance on debt can be a sign of financial weakness.