How do municipal bonds work from the city's perspective?

October 3, 2024 10:14 PM

My town has a ballot measure to issue more "General Obligation" bonds. The bonds are for $240M. The city says they'll pay out at $15.4M/year, over I guess around 15 years? I may be wrong about how may years they pay out over; the city says they're assuming 25-year bonds with a 4% interest rate. The bonds are to fund a new city building, where presumably the contractors will need to be paid once the construction is done, not over 15 or 25 years. So what am I missing about how these bonds work. Location is California.

This seems like it should be google-able, but all the results are for investing in bonds, rather than explaining how they work for the city.

posted by matildatakesovertheworld to Law & Government (7 answers total)

From the city's point of view it's exactly like going to the money market for a very big loan: they get the cash upfront, from the people/firms/banks who buy the bonds. The city uses the capital (i.e. cash) they just raised to pay the contractors and builders, and get a city building. The bond part is that they'll pay the bondholders back the principal and interest over a long period of years, out of the regular income they collect in taxes.

Since building projects need a lot of money upfront, the only alternative to borrowing is saving the sum out of the taxes the city collects, which might take a very long time.
posted by Fiasco da Gama at 10:53 PM on October 3

If I understand what you are asking, I believe the idea is that investors will buy the available bonds for $240M, which the city gets all at once. Over the next 25 years they will pay out to investors at the set rate. So it's a way for the city to get cash now and then pay out from other revenues over time.
posted by Carillon at 10:53 PM on October 3

The way municipal bonds work is that the city issues bonds to investors. When investors buy bonds, they give the city money now and in exchange the city promises to pay them back in annual installments plus interest.

The city gets the whole $240M right way (just like you get all of the mortgage so you can pay the seller of your house) and they use that pay the construction costs. Taxpayers then pay an extra $15.4M in taxes for 25 years which is given to the investors until they are fully paid back for their $240M investment plus 4% interest per year.

Because it is such a large amount of money, instead of just getting all from one source (like a simple bank loan) the city will break it down, offering, say 240,0000 bonds that cost the investor $1000 each. In exchange for the giving the city $1000 today, the city promises to pay each of investors about $64 per year for 25 years (for a total of $15.4M across all 240000 bonds.) At the end of 25 years, the investor gets back about $1600 - the $1000 that they paid in plus the 4% interest.

So, for the city it works a lot like getting a mortgage - they get the $$ now and pay it back over time. For the investor, it is a little like a Certificate of Deposit - in exchange for tying up their money they get paid interest except they get a partial return of the money every year instead of having to wait until the end of the contract.

There are lots of special quirks and complications in reality but that is a basic answer.
posted by metahawk at 10:54 PM on October 3

I'd add the reason cities (in the US) and State Governments (in Australia where I am) find it convenient to raise money this way is that they've got a quality financial markets find very attractive: because the economies of cities and States, especially in developed countries, don't usually go bankrupt or disappear, and because they've got an established base of taxpayers who aren't going anywhere, they're extremely secure over a long time, and they offer a way of hedging against other riskier investments.

So long as the economy doesn't collapse, or the government doesn't fall, or the Treasury refuses to pay. Don't buy Russian bonds.
posted by Fiasco da Gama at 11:11 PM on October 3

The reason why an investor would buy a muni bond is generally three fold. One, they are safe because the issuer, the town, has the legal authority to tax the residents. Need more money? Just raise the taxes. It is extremely rare for a municipality to go bankrupt of default on their bonds. Two, the interest income to the lender (the buyers of the bonds) is not taxable. For a high tax rate person, the income net of taxes (zero taxes) is higher than the income net of taxes on a taxable bond. Say 4% on a muni bond. You would net 4%. A bond paying 7% that is taxable may only net the investor 3% after local, state and federal taxes.

An investor would look at the town's existing debt plus new bond debt versus the town's revenue sources and tax base. Risk versus return (reward).

From the city's prespective, it is simply borrowing money to pay for a new building and paying it back over whatever the term of the bond is. While there is no collateral on the building theywill build with the money, the collateral is the tax base and the town's legal ability to raise taxes to pay it off. I am quite sure (maybe legally required) that the use of funds and how they plan to pay it off will be in the bond's perspectus offered by the investment firm leading the offering.
posted by JohnnyGunn at 2:32 AM on October 4

It's often dangerous to compare public finance to private finance, but in this case it's helpful. You shouldn't take out a loan to go on vacation or go out to dinner, but it does make sense to take out a loan to buy a house or in some cases to renovate your home or buy a car. Those purchases provide a stream of value - a place to live, transportation to a job - over a long term. Similarly, if there's an influx of children into a town, they need a place to be educated. If the town taxed the families for a long time, then built a school, there would be years in which there would be no school. So they borrow money, build a school that will last for decades, and tax the families (and other residents) for those decades to be able to repay the loan.

A more detailed answer, from Tax-Exempt Bonds: A Description of State and Local Government Debt:

Why Do State and Local Governments Issue Debt?
Since public capital facilities provide services over a long period of time, it makes financial and economic sense to pay for the facilities over a similarly long period of time. This is particularly true for state and local governments, whose taxpayers lay claim to the benefits from these facilities by dint of residency and relinquish their claim to benefits when they move. Given the demands a market-oriented society places on labor mobility, taxpayers are reluctant to pay today for state and local capital services to be received in the future. The state or local official concerned with satisfying the preferences of constituents may therefore elect to match the timing of the payments to the flow of services, precisely the function served by long-term bond financing. An attempt to pay for capital facilities “up front” is likely to result in a less than optimal rate of public capital formation.
posted by Mr.Know-it-some at 6:44 AM on October 4

At the end of 25 years, the investor gets back about $1600 - the $1000 that they paid in plus the 4% interest.

Municipal bonds are very rarely "zero coupon" where all cash flow occurs at the maturity date of the bond. Notably, this would make the bond income taxed as capital gains or imputed income and prevent the bond from being tax-free.

In that case the more likely scenario is the bond pays a 4% coupon. Most municipal bonds pay twice yearly. For each bond an investor owns (par value of $1000 at maturity), she would receive a $20 payment every six months ($40 per year) for 25 years. Then for the 50th payment at the end of 25 years, she would receive $1020 - the par value of the bond plus the last coupon payment.
posted by saeculorum at 6:51 AM on October 4