Preserving the Value of Municipal Bonds

Preserving the Value of Municipal Bonds

Generalizing about municipalities is a dangerous thing. Cities come in an amazing range of sizes (from those with populations of a few or a few dozens to populations measured in the millions). They also range dramatically in the services they provide and the stability of the resources on which they rely to provide them. And that’s just for starters.

Even so, there are some areas of policy where it can be said that municipalities generally share common interests. One such area, I believe, has to do with their ability to borrow money.

Not all municipal leaders utilize bonding capacity to meet their community’s needs. Some are devoted to a “pay as you go” approach, not wanting to obligate the city for years in the future.

But many mayors, councilmembers, commissioners and trustees believe that there are certain kinds of public investments that are appropriate to finance through bonds and, in many cases, would be nearly impossible without them.

Whichever side of this policy fence one finds more attractive in general, I believe the vast majority of municipal leaders, past and present, would at least want the option of bonding preserved.

If a city is able to maintain a good bond rating, the cost of borrowing can be very low. There are two fundamental reasons for this.

For one, government debt generally is considered to be low-risk debt. While cities do occasionally go bankrupt, those occasions are stunningly rare. A recent Governing magazine report covering local general purpose governments (cities and counties) nationwide found that, on average, barely 1/100th of 1% took this step each year. Proportionately, the annual rate for businesses is considerably more than 10 times that number; for individuals, close to 30 times.

Yup. Municipal bankruptcies are rare.

But the second reason for low borrowing costs is that the interest on these municipal bonds (that is, the interest paid to bondholders) generally is tax exempt. Every dollar returned to the investor is a dollar the investor can keep.

An investment that is low risk and tax free? Sounds like a winner for the purposes of balancing many an investment portfolio.

This low risk and tax-free status of municipal bonds makes them attractive to investors. This, in turn, means that cities are able to attract capital to invest in infrastructure and facilities at a cost that is much lighter on taxpayers’ wallets than it would be if the interest from municipal bonds was taxed. In other words, tax-exempt municipal bonds = lower local taxes than otherwise would be the case.

Despite the fact that the tax-exempt status of municipal bonds benefits city residents across the country, recent years have witnessed proposals in Washington to do away with some or all of the exemption. If such a proposal becomes law, municipalities will have to pay a higher rate of interest on their bonds in order to attract the needed capital. This higher rate of interest, in turn, will be paid through higher taxes or the diversion of tax revenues from other pressing community needs.

Fortunately, there are members of Congress who understand the implications of such proposals for the ability of municipalities to meet the needs of their residents. So far, their efforts to preserve the tax-exempt status of municipal bonds have been successful.

In the end, of course, new and restored infrastructure and facilities must be paid for. None of it comes for free.

But better, I think, that cities retain this powerful and relatively affordable tool for taking on big projects than to lose it in the complex game of federal budget politics.