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Agriculture

Economic

Research

Service

Rural

Development

Research Report

Number 35

The Cost of Metro and

Nonmetro Government

Borrowing

Patrick J. Sullivan
THE COST OF METRO AND NONMETRO GOVERNMENT BORROWING. By

Patrick J. Sullivan, Economic Development Division, Economic

Research Service, U.S. Department of Agriculture. RDRR-35

ABSTRACT Nonmetro governments paid about the same interest rates on

municipal bonds sold in 1977 as metro governments, even though

po1ic)miakers commonly believed that rural governments had more

limited access to regional and national bond markets. The

movement toward State taxing limitations and the tightening of

Federal budgets may make the bond market a more important

source of local government construction funds. This study

indicates that rural governments in general should have as much

(or as little) access to the bond market as urban governments.

Keywords: Municipal bonds, local government finance, rural

government borrowing, tax-exempt securities.

ACKNOWLEDGMENTS The author wishes to thank Eleanor Whitehead for her assistance

in preparing the data; William Fox, Thomas Hady, James Mikesell,

Daniel Milkove, Richard Reeder, and Thomas Stinson for many

useful comments; Linda Hatcher for editorial assistance; and

Lucy Marshall for preparation of the report.

Washington, D.C. 20250 January 1983
SALES INFORMATION Additional copies of this report—The Cost of Metro and Nonmetro

Government Borrowing (RDRR-35)—may be ordered from:

National Technical Information Service

5285 Port Royal Road

Springfield, VA 22161

Order this report by using PB83-143610, and indicate whether

you want paper copies or microfiche. Cost per paper copy

is $8.50; cost per microfiche is $4.50 (prices subject to

change).

The Economic Research Service has no copies for free

distribution.

ALSO AVAILABLE Examining the Rural Municipal Bond Market, RDRR-34.

Nonmetro governments have increased reliance on long-term

borrowing faster over the last two decades than metro governments

have. However, outstanding per capita debt for nonmetro areas

is still lower than it is for metro areas. Current budget cuts

are making Federal assistance to local governments scarce.

Therefore, the municipal bond market may become a more important

method for rural governments to finance the construction of

public facilities.

For information on ordering this report, write to:

Information Division, EMS, USDA

Room 1664, South Building

Washington, D.C. 20250
CONTENTS Page

SUMMARY, • , iii

INTRODUCTION. 1

CHARAGTERISTIGS OF RURAL GOVERNMENT BONDS 2

Issue Characteristics 2

Marketing Methods 5

THE COST OF RURAL GOVERNMENT BONDS 6

Interest Cost. 6

Underwriter and Investor Compensation 11

Marketing Costs 15

POLICY IMPLICATIONS 16

Federal Policy. .... . . 17

State Policy. 18

REFERENCES .. .. , .. 21

APPENDIX A—THE DETERMINANTS OF NET INTEREST COST. 23

Problems With a Single—Stage Regression Approach 27

APPENDIX B—MUNICIPAL BOND PREPARATION COSTS 30

11
SUMMARY Nonmetro governments paid about the same interest rates on

municipal bonds sold in 1977 as metro governments, even though

policymakers commonly believed that rural governments had more

limited access to regional and national bond markets. The

movement toward State taxing limitations and the tightening of

Federal budgets may make the bond market a more important

source of local government construction funds. This study

indicates that rural governments in general should have as much

(or as little) access to the bond market as urban governments.

In 1977, borrowing costs of most nonmetro governments were

roughly equivalent to those of metro governments; however,

nonmetro governments sold bonds with characteristics which

normally would have added to the costs, Nonmetro governments

generally sold small bond issues, sold them noncompetitively,

sold revenue bonds (bonds backed by revenues from a specific

and limited source such as highway tolls), and sold unrated or

unfavorably rated bonds. The demand for rural government bonds

was evidently high enough to keep interest rates down despite

these characteristics.

Rural governments rely heavily on noncompetitive marketing

techniques (bonds are sold to preselected underwriters at

negotiated prices or bonds are sold directly to investors).

This reliance on noncompetitive sales with their relatively

high borrowing costs may come from a lack of technical expertise

in marketing bonds or from a lack of underwriter interest in

many rural bond issues. However, several State governments are

helping to lower borrowing costs for small governments.

Although the need for such programs was evidently not widespread

in 1977, they may be more important for the attainment of rural

development goals, given current bond market conditions. The

following programs already have been adopted in one or more

States in an attempt to lower the cost of borrowing for small

towns and rural areas:

o Technical assistance programs can improve local

government understanding and evaluation of the

alternatives in issuing bonds.

o The sale of several small bonds at one convenient

location can increase underwriter interest in small

bonds. Such a plan would reduce the costs to underwriters when submitting bids on bonds and heighten

underwriter competition for rural bonds, making

competitive sales a viable marketing method for more

rural borrowers.

Ill
State supervision programs which increase the perceived investment quality of rural bonds by major

investors can broaden the market for these bonds.

Investors may come to accept the judgment of State

officials on the local government's ability to pay

back its debts effectively. However, such programs

reduce local government autonomy and, therefore, may

meet considerable resistance from local government

officials. To some extent, the autonomy factor

can be avoided by making local participation in these

programs optional.

IV
The Cost of Metro and Nonmetro

Government Borrowing

Patrick J. Sullivan^

INTRODUCTION Tighteiiing Federal budgets and a continuing tax-limitation

movement at the State level are forcing local governments to

rely on their own revenues for a greater share of the construction and rehabilitation costs of public facilities. For many

local governments, the only practical means of financing

major capital projects is through the sale of long-term municipal bonds, \J Governments serving the many rural areas which

continue to experience population and economic growth can be

expected to rely heavily on bond financing as they cope with

increased demands for new schools, roads, water and sewer

lines, and other public facilities.

Many of the Federal and State loan and loan guarantee programs

currently affected by budget constraints originally were

instituted to overcome the borrowing problems and high interest

rates rural governments were believed to face. Nevertheless,

little empirical work has been done to determine whether

borrowing problems were widespread among rural governments or

whether the municipal bond market discriminated between metro

and nonmetro borrowers,

This report summarizes an analysis of the borrowing costs of

metro and nonmetro governments in 1977, The available evidence

suggests that nonmetro areas have been remarkably successful in

marketing their long-term bonds.

Based on bond sales reported in the financial press, the

interest rate for nonmetro bonds is roughly equivalent to that

paid by governments in metro areas selling similar types of

bonds and using similar marketing methods.

* The author is an economist with the Economic Development

Division, Economic Research Service, U.S. Department of Agriculture.

\J The terms "municipal bonds" and "tax-exempt bonds" will be

used interchangeably throughout this report. All securities

issued or guaranteed by States, their political subdivisions,

agencies, or instrumentalities are referred to as municipal

bonds if their interest is exempt from Federal income tax.
CHARACTERISTICS OF

RURAL GOVERNllENT

BONDS

The characteristics of local government bonds and how they are

marketed help determine the cost of bond financing. Such

characteristics as the dollar amount of the bond issue and

its security backing, maturity structure, credit rating, and

method of sale affect borrowing costs. Ij For many of these

characteristics 5 the bonds of nonmetro governments are different

from those of metro governments.

Data on bond sales reported in 1977 are the basis for the

description and analysis to follow. Information on individual

bond sales is collected from reports in the financial press

(primarily The Bond Buyer) and from bond dealers by the Public

Securities Association (PSA), However, the PSA does not

geographically locate bond issuers beyond identifying the State

in which they are located. Location and debt information from

the census of governments' individual governments files vjere

used to ease the task of geographically locating the government

responsible for each bond issue and to supplement the information reported by the PSA. As a result, 1977~the latest year a

census of local governments was taken—was chosen as the sample

period for this analysis. The resulting data base, merging

information from the PSA with information from the Bureau of

the Census, is the only nationwide data set available for

assessing bond market conditions in nometro areas.

However, the PSA/census data base does not report information

on all bonds sold during any given time period. Nor do

reported sales constitute a representative sample of all bond

sales. The PSA is more likely to report information on larger

bond issues, on the bond issues of frequent borrowers, and on

bonds sold through traditional marketing channels. Because

many rural bond issues fall outside this set, many of them

likely go unreported and, therefore, are excluded from our data

set. Nonetheless, information should be recorded on most of

the dollar volume of bonds issued by both metro and nonmetro

governments. As a result, in describing the characteristics of

rural bonds, we will look at the dollar volume issued by

metro and nonmetro governments instead of at the "average" bond

issue.

j^ssue

Characteristics

Local government bonds are categorized in numerous ways. The

source of funds pledged toward repayment, the use for which the

bonds were issued, their maturity, and their credit ratings are

used to differentiate one bond issue from another. To some

extent, each of these characteristics affects the cost of

borrowing. An examination of bonds issued by metro and nonmetro

governments during 1977 reveals many prominent differences and

some surprising similarities.

IJ A bond is a written promise to pay a specified sum of

money on a specific date in the future, together with periodic

interest at a specified rate. A bond issue is a group of bonds

sold at one time as a package.
Local governments sell two broad types of long-temi bonds•

General obligation bonds are backed unconditionally by the

issuing government's general revenues or, if these prove

insufficient 5 by the full taxing power of the jurisdiction.

Revenue bonds are not backed by the issuing government's general

revenues but depend on a specific revenue source, such as highway tolls, for the funds needed to repay principal and interest

Borrowing costs tend to be slightly higher for revenue bonds

than for comparable general obligation bonds (3). _3/.

In 1977, roughly two-thirds of the bond issues sold by nonmetro

governments were of the general obligation type. However, over

two-thirds of the dollar amount of bonds sold was accounted for

by revenue bonds. This apparent contradiction resulted because

the general obligation bond issues of nonmetro governments

tended to be small—averaging $1.5 million compared with

$6,1 million for revenue bond issues. 4_/ Thus, for most of

their borrowings nonmetro governments favored the more costly

type of bond. Metro governments, in comparison, relied on

revenue bonds for a much smaller percentage of their borrowing.

A second characteristic of rural government borrowing was that

the bond issues tended to be smaller than those of metro governments. The average size of nonmetro revenue bond issues was

roughly half the average size of those sold by metro governments; for general obligation bonds, the average size of nonmetro

issues was less than one-third that of metro issues. Small

bond issues tend to cost more on a *'per"'dollar-borrowed" basis

because of economies of size in marketing and trading ( 14).

A third characteristic of nonmetro government bonds was a

comparative absence of credit ratings. The investing public

uses the judgments of the two major rating agencies--Moody's

Investors Service, Inc., and Standard and Poor's Corp.—to

categorize municipal bonds. The rating agencies' decisions on

the creditworthiness of a bond are a major component in

the market's judgment of a bond's credit quality. Favorable

ratings tend to reduce the cost of issuing a bond.

The issuing government generally decides on whether to have a

bond rated by either or both agencies; both will rate most

bonds for a fee. _5/ In 1977, the agencies rated only 57

percent of the nonmetro bond issues sold, compared with

70 percent of the metro bond issues. This pattern is not too

3/ Underscored numbers in parentheses refer to items in the

References section of this report,

^/ All of the nonmetro figures referred to in this section

exclude five Alaskan oil pipeline industrial revenue bonds sold

by the city of Valdez, Alaska. These bonds had little in

common with other local government issues because of their

large size and the nature of the facility being built.

5J The rating agencies refuse to evaluate certain types of

debt and may withhold publishing a rating on any bond for which

insufficient information has been made available.
surprising given the small size of maay nonraetro bond issues

and the localized markets within which the bonds tend to

be sold. Small bond issues being sold to local investors

usually do not need a published credit rating (21), Credit

ratings are more important for larger bond issues being marketed

regionally or nationally.

When only bonds with ratings are considered, a smaller percentage of nonmetro area bonds are rated favorably compared with

those of metro areas* General obligation bonds have an especially pronounced difference in rating distributions.

Although only 19 percent of the nonraetro bonds were rated "Aa"

or better, 37 percent of the metro bonds were rated as high

(fig. 1). Whether this pattern was the result of the rating

agencies' belief that most rural governments do not merit high

grades for creditworthiness or was simply a reflection of a

decision by rural officials to purchase ratings on only their

"hard-to-sell" bonds is difficult to say. The result in either

case should be a tendency for nonraetro issuers to pay higher

borrowing costs vis-a-vis metro issuers.

A final characteristic of municipal bonds that is noteworthy

because of the similarity between metro and nonmetro areas is

the maturity structure. Most municipal bond issues are comprised

of bonds that come due at different times over the life of the

issue (y:_). The ability to stretch bond maturity, and therefore,

Figure 1

Distribution of Rated Bonds Among Major Rating Groups by Type of Bond and

IVIetropolitan Status, 1977

Percent

100

/;

Air bonds

General obligation bonds

Revenue bonds

High

Medium

Low

All local

governments

Metro Nonmetro Urban Less urban Rural

'Ratings by Moody's Investors Service are used wheiiever possible. Otherwise ratings by Standards and Poor's

Corp., are used. "Aaa" and "Aa" are high; "A-1" and "A," medium; and "Baa-1," "Baa," and "Ba," low.

Source: Calculated from unpublished data from the Pub I re Securities Association long-term municipal

bond file and Moody's Municipal and Government Manual.
debt retirement, over 20 to 30 years may be as important in

determining the project's financial feasibility as the ability

to raise sufficient funds to cover construction costs.

Generally, however, investor demand for the longer term bonds

tends to be lower than demand for short- to medium-term bonds

(5).

An examination of the average maturity of the bonds issued by

metro and nonraetro governments during 1977 shows little difference between the two. The average maturity of nonmetro general

obligation bonds is within 1 year of the metro average. For

revenue bonds, the average maturity is 2 years longer than the

metro average. Both differences represent less than 10 percent

of the average maturity of bonds in each group. Apparently

nonmetro areas can issue longer termed bonds when necessary.

Marketing Methods In addition to a bond's characteristics, how it is marketed and

how it is received by the underwriting industry also help

determine the cost of borrowing. Local governments usually do

not sell bonds directly to the public. In a typical sale, the

issuing government sells the entire bond issue to an underwriter

or to a group of underwriters which then resells the bonds

to investors. The two methods of choosing an underwriter are:

(1) selling the bond issue at a public auction to the underwriter

submitting the lowest bid and (2) selling the bonds to a

preselected underwriter at a negotiated price. Occasionally,

local governments sell the bonds directly to the investors

themselves. In 1977, however, less than 2 percent of the

dollar volume was sold in this manner.

Each type of sale has advantages and disadvantages, and under

the right circumstances, each may be the cheapest method of

marketing bonds (12). Nonetheless, competitive sales tend to

be less costly than either negotiated or direcj sales. For

this reason, State law often requires local governments

to attempt to sell their general obligation bonds through a

competitive auction. Since revenue bonds generally fall

outside the purview of State regulation, local officials have

more latitude in choosing their method of sale. As a result,

noncompetitive sales are much more prevalent in marketing

revenue bonds.

An examination of the methods used by nonmetro governments to

market their long-term bonds reveals a sharp contrast between

general obligation and revenue bond sales. Roughly 78 percent

of nonmetro general obligation bonds were sold competitively—a

slightly higher proportion than for those of metro issuers.

Only 12 percent of nonmetro revenue bonds were sold competitively—a much lower proportion than for those of metro issuers.

Overall, only 33 percent of the total bonds issued by nonmetro

governments were sold competitively in 1977, compared with 48

percent of metro bonds. To some extent this pattern is to be

expected. For many of the bonds sold by nonmetro governments,

negotiated sales may be the best way (and in some cases,

the only way) of marketing them. Nonetheless, such a heavy
reliance on noncompetitive sales by nonmetro governments likely

adds to the cost of bond financing.

The major reason a negotiated sale may be cheaper than a

competitive sale is underwriter apathy toward certain types of

bonds. Small bond i&sues sold at remote locations may not

attract many bids. As the number of bids falls, the cost of

competitive sales tends to rise. 6^/ Nonetheless, an examination

of the average number of bids received on metro and nonmetro

competitively sold bond issues fails to reveal lower underwriter

competition for the issues of rural governments.

In sum, the borrowing cost for nonmetro bonds should be higher

than that for metro bonds. This expectation results from

nonmetro governments' heavy reliance on revenue bonds and

noncompetitive sales, the small size of nonmetro bond issues,

and a small proportion of favorable ratings for nonmetro bonds.

We will now examine the cost of rural government bond financing

to see if this hypothesis is supported.

THE COST OF RURAL

GOVERNMENT BONDS

If the market facing nonmetro issuers is distinct from the

national bond market, the cost of borrowing still may be low

vis-a-vis the national average. This section examines some of

the costs that local governments incur when issuing bonds. Of

particular concern is the interest rate paid on the bond

issues. Variations in the net interest cost (NIC) associated

with bonds sold during 1977 will be examined as will the two

components of the NIC--underwriter compensation and reoffering

yields, Ij ^ brief discussion of some of the other costs

associated with selling a bond issue closes this section.

Interest Cost The net interest cost of a bond issue is not only a measure of

the government's interest cost. It also reflects the underwriter's assessment of investor demand for the bonds and the

risk involved in handling the bond issue. The NIC will be high

if the underwriting firms feel that investors will demand high

6/ Sorensen (18) found that for lower rated bonds, negotiated

sales are cheaper than competitive sales that attract only one

bid. For a discussion of the potential benefits of marketing

risky securities through a preselected underwriter, see (19).

V The net interest cost (NIG) measure of municipal bond rates

is a weighted average of the undiscounted interest payments made

on a bond issue. Because the NIC measure doesn't take the time

of payment into account, it is not a very good measure of the

true cost associated with a bond issue. Nonetheless, the NIC

is the only measure currently reported for most bond issues (8^).

The underwriter compensation rate is the margin of gross profit

per $1,000 of bond proceeds which the underwriters receive for

distributing the securities. The measure of reoffering yields

used is the rate offered by the underwriters to the investing

public on bonds maturing in 10 years.
yields for purchasing the bonds or that incurring losses in

purchasing and reselling the bonds is a high risk.

The interest cost of a bond issue is sensitive to a number of

factors which reflect the bond's attractiveness as an investment.

General money market conditions and the bond issue's credit

rating, maturity structure, and size help determine its interest

cost. Obviously, not all of these factors can be accounted for

in a tabular presentation of interest costs. Table 1 reports

the NIC for metro and nonraetro bonds grouped into two categories

based on the type of bond and the type of sale local governments

used to raise funds. These two aspects of municipal bonds are

directly controlled by the issuing government and represent

areas where metro and nonmetro bonds differ.

Previous studies of the determinants of municipal borrowing

costs have shown consistently that revenue bonds and bonds sold

through negotiation tend to have higher interest costs. The

interest rates reported for general obligation and revenue

bonds awarded through competitive and noncompetitive sales

support these conclusions. For each type of bond, the interest

cost of competitively sold bonds was consistently lower than

that for negotiated or directly sold bonds. Furthermore, the

interest cost of revenue bonds is nearly always higher than the

corresponding cost of general obligation bonds.

The type of bond and the type of sale explain much of the

metro-nonmetro variation in interest rates. Overall, nonmetro

governments paid slightly lower rates on bonds issued in 1977

than did governments in metro areas. Given the heavy reliance

nonmetro governments placed on revenue bonds and noncompetitive

sales, a lower overall interest cost is surprising.

An interesting set of patterns emerges when general obligation

and revenue bonds are examined separately. Nonmetro governments

paid a lower rate on their general obligation bonds than did

metro governments regardless of the type of sale. For competitively sold bonds, the rate charged for nonmetro bonds sold in

1977 was 20 basis points lower than the rate charged for metro

bonds. (A basis point is one-hundredth of 1 percent.) Within

nonmetro areas, the cost of competitively sold general obligation bonds remained remarkably stable as the area became less

urbanized. For bonds sold through negotiation, metro governments

paid a rate 134 basis points higher than the rate paid by

nonmetro governments. Unlike competitively sold bonds, however,

the rate paid by nonmetro governments tended to increase as the

area became less urbanized.

For revenue bonds, a different pattern is evident. Nonmetro

governments paid slightly higher rates on bonds issued in 1977

than did metro governments. Among nonmetro areas, the more

rural areas appeared to pay a lower rate on their competitively

sold revenue bonds than their urbanized counterparts; no clear

pattern emerged for revenue bonds sold through negotiation.
Table 1—Net interest rates of long-term bonds issued by type of bond, method of sale, and

metropolitan status, 1977

Government ! All long-term bonds IJ General obligation bonds V Revenue boneIs

category Total *

Competitive :Noncompetitive Total : Competitive: Noncompet itive Total : Competitive: Noncompet itive

sale : sale : sale : sale : sale : sale

Percent

Local govermnents Z_l 5.83 5.33 6.29 5.61 5.22 6.92 6.01 5.62 6.13

Metropolitan 4/ ' 5.84 5.36 6.38 5.68 5.25 7.04 5.99 5.63 6.15

Nonmetropolitan 5/ 5.79 5,18 6.15 5.15 5.05 5.70 6.11 5.60 6.19

Urbanized 6J 5.72 5.15 6.07 5.10 5.02 5.63 6.03 5.60 6.10

Less Urbanized l_l' 5.85 5.21 6.23 5.14 5.07 5.69 6,18 5.62 6.26

Rural 5_/ , ^/ 5.81 5.11 6.11 5.33 5.05 5.80 6.14 5.45 6.19

yj This table is based upon 3,998 local government bond issues for which interest rate information is available.

The dollar Volume of these bonds amoürltéd to 87.6 percent of the volume of all local government bonds sold in 1977.

The interest rates reported represent an average of all the bond issues in each category weighted by issue size.

2J Includes limited-tax bonds not classified as "full faith and credit" obligations.

3J Includes governments that could not be classified as either metropolitan or nonmetropolitan.

hj Metropolitan status is determined according to whether or not the issuing government was located in a

Standard Metropolitan Statistical Area (SMSA) as defined in 1974.

5J Excludes five Alaskan oil pipeline industrial revenue bonds for comparison purposes.

J6/ Issuers located in nonmetro counties which had 20,000 or more people residing in urban places in 1970,

_7/ Issuers located in nonmetro counties which had between 2,500 and 19,999 people residing in urban places

in 1970.

8^/ Issuers located in nonmetro counties which had no urban places in 1970.

Source: Calculated from unpublished data from the Public Securities Association's long-term municipal bond file.
Thus, despite low credit ratings and small-sized bond issues,

the interest rate on nonmetro bonds is remarkably low. Even

with their heavier usage of revenue bonds and noncompetitive

sales, the overall nonmetro rate was 5 basis points lower

than the metro rate.

Variations in market conditions throughout the year or unique

differences in government financial conditions might possibly

explain this interest rate pattern. To determine whether the

interest cost associated with nonmetro bonds seems reasonable

when bond characteristics are taken into account, a simple

model of the determinants of NIC on newly issued bonds sold in

1977 is developed and estimated in appendix A of this report.

A single-equation regression approach is used to hold constant

the effects of bond issue size, maturity structure, national

bond market conditions, credit rating, and regional location

when comparing the interest cost of metro and nonmetro government bonds. To further clarify the comparison, only competitively awarded bonds issued by general-purpose governments and

school districts were examined. Bonds with these characteristics

are easier to compare with one another since they are subject

to fewer measurement and reporting problems than are noncompetitively sold bonds.

The parameters of the model are reported in appendix table 1

for samples comprised of general obligation and revenue bonds

grouped together and estimated separately. Nonmetro governments

paid a lower rate for their general obligation bonds and

roughly the same rate as did metro governments for their

revenue bonds once various bond issue, issuer, and market

conditions were taken into account. When these characteristics

were held constant, metro governments paid an additional

6 basis points over the nonmetro rate on their competitively

sold general obligation bonds; there was no statistically

significant difference in the rates paid on revenue bonds.

There are several possible explanations for this interest

differential. One is that the data base is biased in favor of

the more marketable (and therefore less costly) rural bonds,

although it includes the full range of metro bonds. To minimize

this problem, the comparison was restricted to competitively

sold bonds, which by their nature (and in many cases, by law)

are widely advertised. However, for bonds which can be sold

either competitively or through negotiation—a group which

includes most revenue bonds—a built-in bias leading to underestimation of nonmetro borrowing rates is still possible. This

possibility will be discussed in more detail shortly.

Another possible explanation for the interest cost differential

between metro and nonmetro bonds is that underwriters and

investors are adjusting for what they consider to be unrealistically low credit ratings for nonmetro bonds. Although no

attempt has been made to determine whether published ratings of

nonmetro governments are based on the same objective criteria

as those of metro governments, the general belief is that

nonmetro governments find it more difficult to acquire favorable
credit ratings. The market may adjust for this rating pattern

in such a way that a nonmetro bond with an "A" rating is

accepted as being more secure than a metro bond with the same

rating. If so, then a slightly lower interest cost for nonmetro

bonds with a given credit rating would be expected.

Still another possible explanation for the interest cost

differential is that local market conditions were not the same

in metro and nonmetro areas in 197 7. Very little is known

about the effect local markets have on the borrowing costs of

local governments. The local supply of tax-exempt bonds

and the demand for these bonds by local investors may be

important determinants of the borrowing costs of small governments O5 20). Because most local governments serving nonmetro

areas are small, their borrowing costs may be sensitive to

changes in the demand for tax-exempt bonds by local investors

and to changes in the local supply of tax-exempt bonds. If

demand for municipal bonds by rural investors was high relative

to the local supply of tax-exempt securities in 1977, rural

governments would have found issuing bonds slightly less

expensive than would otherwise be the case. The investment

behavior of at least one major group of investors differed

regionally—commercial banks. Relative to bank assets and the

local supply of tax-exempt securities, rural banks purchased

more municipal bonds than metro banks in 1977 (19) . Thus, the

average nonmetro government could have enjoyed a slightly lower

interest cost on the bonds it sold in 1977 because of the

support of the rural commercial banking system.

The regression results reinforce the interest cost patterns

reported in table 1, The results indicate that the bond market

favors competitively sold nonmetro issues over comparable

issues sold by metro governments. Nonetheless, this comparison

of interest rates is based on the premise that "all other

things are equal." Hox^ever, as illustrated in the last section,

metro and nonmetro bonds are not equal, Nonmetro bond issues

still have lower credit ratings and tend to be smaller than

metro bond issues—characteristics which add to the interest

rate nonmetro governments have to pay. In addition, the

regression approach ignores the effect that the method of sale

has on borrowing costs.

As discussed in the previous section, two-thirds of the dollar

amount of bonds issued by nonmetro governments in 1977 were not

competitively sold. The NIC analysis based on competitively

sold bonds may or may not be relevant for nonmetro bonds in

general, depending on the reason so many nonmetro bonds were

sold noncompetitively.

If nonmetro governments choose to sell their bonds through a

preselected underwriter because experience has shown this to be

the cheapest way of marketing bonds, then the NIC analysis

discussed above underestimates the cost of debt financing for

nonmetro areas vis-a-vis metro areas. On the other hand, if

nonmetro governments rely on negotiated bond sales for convenience or for taking advantage of the underwriting industry's

10
expertise in preparing bond issues for sale, then the NIC

analysis based on competitive sales should be a fairly accurate

reflection of the "true" market acceptance of nonmetro bonds.

Both causes for choosing a preselected underwriter over a

competitive sale are probably important to nonmetro issuers.

The reasons for this conclusion are presented in appendix A.

The implication of this is that the competitive sale model

of the determinants of NIC probably underestimates the true

interest cost of nonmetro bonds to some extent. The degree of

underestimation remains unknown, but the underlying conclusion

of this section remains valid: interest costs paid by nonmetro

borrowers are not unreasonably high, nor does the market seem

to be discriminating against nonmetro bonds.

Underwriter and The NIC is a measure of the underwriter's judgment of the

Investor marketability of the bond issue. The NIC includes both the

Compensation underwriter's profit (or loss) and the yield payable to the

initial purchasers of the bonds as they are resold by the

underwriting firm. Information on each of these cost components

is sketchy. Although NIC information is available on a large

portion of the reported bond sales, information on underwriter

compensation rates and yield information on reoffered bonds is

available for only 25 percent of the local government bond

issues. Thus, data reported in this section do not necessarily

represent market conditions in either metro or nonmetro areas.

In determining their bids on competitively sold bonds and their

profit margins on negotiated sales, underwriters attempt to

structure their proposed interest rate schedule to compensate

themselves for the operating costs of doing business and the

risk they undertake in purchasing the bonds for resale.

Underwriter compensation is the difference between what the

underwriting firm pays for a bond issue and what it receives

upon resale of the bonds. In a world of perfect knowledge,

this difference represents the value of the underwriter's

services.

Table 2 presents the underwriter compensation rates reported

for general obligation and revenue bonds by type of sale. The

figures represent the cost per $1,000 of gross proceeds from

all bond sales for which data are available. As expected, the

compensation rates for negotiated sales were higher than

those for competitive sales. Furthermore, with the exception

of the most rural areas, underwriter compensation rates on

revenue bonds were higher than the corresponding rates on

general obligation bonds. These two cost patterns account for

the overall higher compensation rate paid by nonmetro governments. Compensation paid on nonmetro bonds for which underwriter

"spreads" were available was $1.37 (per $1,000 borrowed)

higher than that on metro bonds.

The other pattern evident from table 2 is that underwriter

compensation rates on reported general obligation bonds sold

through competitive auction were lower for nonmetro areas than

11
Table 2—Underwriter compensation: Cost per $1,000 of gross proceeds by type of bond, method of sale, and

metropolitan status, 1977

Government All long-term bonds IJ General obligation bonds 2/ Revenue bonds

category Total ;

Competitive

sale

:Noncompet it ive

: sale Total : Competitive:: sale :

Noncompetitive

sale Total :Compet it ive:Noncompet it ive

sale : sale

Dollars

Local governments 3/ 15.16 12.01 17.56 12.98 11.92 16.02 16.61 12.19 17.91

Metropolitan 14.84 12.02 17.72 12.93 12.00 15.51 16.48 12.06 18.44

Nonmetropolitan kj 16.21 11.92 17.73 13.37 11.42 20.53 17.20 13.64 17.51

Urbanized 15.93 11.30 17.33 12.02 10.76 16.55 17.08 13.03 17.39

Less urbanized 16.39 12.21 18.50 12.82 11.53 19.33 18.06 14.80 18.43

Rural 4/ : 17.61 15.19 18,27 23.87 15-95 35.58 15,33 12.88 15.52

1_/ This table is based upon 1,241 local government bond issues for which underwriter spread information is available.

The dollar volume of these bonds amounted to 37.8 percent of the volume of all local government bonds sold in 1977.

The compensation rates reported represent an average of all the bond issues in each category weighted by issue size.

2^/ Includes limited-tax bonds not classified as "full faith and credit" obligations.

3^/ Includes governments that could not be classified as either metropolitan or nonmetropolitan.

à_/ Excludes five Alaskan oil pipeline industrial development bonds for comparison purposes.

Source: Calculated from unpublished data from the Public Securities Association's long-term municipal bond file.
for metro governments while nonmetro areas paid a higher

compensation rate on their competitively sold revenue bonds.

Interestingly, underwriter compensation rates for the general

obligation bonds of the most rural areas were much higher than

the rates paid by governments in other categories, while their

rates for revenue bonds were lower.

Studies have found that underwriter compensation rates tend to

be higher for small, unrated, and unfavorably rated issues.

Revenue bonds and bonds sold through negotiation tend to have

higher underwriter compensation rates than do general obligation

bonds and competitively sold issues. For competitive sales,

underwriter compensation rates decline as the number of

bids increases (10, 17, 22). All these tendencies should put

many nonmetro issuers at a disadvantage and should lead to

higher overall underwriter compensation rates for nonmetro

areas. Nonetheless, underwriting firms do not seem to favor

either metro or nonmetro areas once the bond issue characteristics have been taken into account—metro and nonmetro governments

appear to pay roughly the same rate for underwriting services. 8^/

The other component of NIC is the yield which investors receive

when they purchase the bonds. Given the term structure of

interest rates, the yield that investors expect to receive on a

bond is related directly to the length of time before the bond

matures. Since each bond issue usually is comprised of bonds

with a range of maturity dates, only the yield on bonds

maturing in 10 years (that is, 1987) will be examined to insure

comparability. Table 3 presents information on the yields

offered by underwriters on 10-year bonds sold by metro and

nonmetro governments during 1977. As with NIC, these yields

should be higher for revenue bonds and for bonds sold through

negotiation, other things being equal. Because these two

factors predominate in the nonmetro bond market, the overall

yield on nonmetro 10-year bonds was slightly higher than the

yield on metro bonds.

For the most part, yield patterns were consistent with the NIC

patterns discussed previously. Yields on competitively sold

nonmetro general obligations were lower than metro yields,

while the reverse was true for revenue bonds. Nonetheless, as

with underwriter compensation rates, when national market

effects, bond issue characteristics, and issuer financial

conditions are held constant, the difference between metro and

nonmetro bond yields was not substantial.

8/ A single-equation model similar to that estimated for NIC

in appendix A was used to explain variations in the underwriter

compensation rates of general-purpose government and school

district bonds sold competitively during 1977, The metro dummy

variable was not significantly different frottiizeto for either

general obligation or revenue bonds at the 5-percent level of

confidence.

13
Table 3—Reoffer yields for bonds maturing in 10 years by type of bond, method of sale,

and metropolitan status, 1977

Government

category

Local governments 3_l

Metropolitan

Nonmetropolitan ¿^/

Urbanized

Less Urbanized

Rural 4/

All long-term bonds 1/ General obligation bonds 2/

^ ^ ^ : CompetítLverNoncompetLtive: lotai , ,

: sale : sale :

: Competitive:Noneompetitive

^_ :_ sale : sale

Percent

Revenue bonds

„, ^ , : Competitive: Noncompet It IV e

lotai - ,

: sale : sale

5.00

4.99

5.08

5.05

5.12

5.16

4.84

4.85

4.73

4.71

4.74

4.78

5.20 4.88 4.86 4.99 5.13 4.78 5.26

5.18 4.89 4.88 4.95 5.10 4.77 5,26

5.28 4.80 4.70 5.28 5,24 4.88 5.28

5.22 4.71 4.66 5.04 5.21 4.95 5.23

5.39 4.76 4.73 5.20 5.33 4,79 5.39

5.33 5.19 4.76 5.49 5.08 4.90 5.10

ly This table is based upon 1,178 local government bond issues for which yield information is available. The dollar

volume of these bonds amounted to 41 percent of the volume of all local government bonds sold in 1977.

The re-offer yields reported represent an average of all the bond issues in each category weighted by issue size.

_2/ Includes limited-tax bonds not classified as "full faith and credit" obligations.

V Includes governments that could not be classified as either metropolitan or nonmetropolitan.

4^/ Excludes five Alaskan oil pipeline industrial development bonds for comparison purposes.

Source: Calculated from unpublished data from the Public Securities Association's long-term municipal bond file.
Marketing Costs Interest payments, usually the largest cost item, are not the

only expenses associated with selling a bond issue. In the

majority of cases, the issuer must pay a number of *'out-ofpocket** costs to prepare a bond issue for eventual sale. These

costs may include obtaining voter approval of a bond sale when

a referendum is required, purchasing a credit rating and an

independent audit, and hiring a fiscal advisor to help with the

sale. Although these expenses are not incurred for all bond

sales, and some may not require any of them, nearly all have

associated expenses for legal counsel and for preparing and

printing legal notices, the bond prospectus, and the bonds

themselves.

Information on these preparation costs is not reported in the

financial press with the other information about each bond

sale. For this reason, a comparison of actual preparation

costs borne by nonmetro and metro governments cannot be presented. However, two special surveys were undertaken to

determine the amount local governments spend in preparing bonds

for sale (6_, 13). Although these surveys were not oriented

geographically, the cost patterns revealed have implications

for nonmetro areas. In particular, preparation costs for small

bond issues are quite large in relation to the amount of funds

being raised. In addition, costs of preparing revenue bonds

for sale are higher than those for general obligation bonds.

Since nonmetro areas tend to sell smaller bond issues and rely

more heavily on revenue bond financing, the preparation costs

(per dollar borrowed) borne by nonmetro governments likely

would tend to be higher than those of metro governments.

If one assumes that the cost of services needed to prepare a

bond of given size and security type for sale does not vary

geographically or by type of sale, very rough estimates of the

preparation costs for bonds sold in 1977 can be calculated.

Based on the size of the bond issue, the type of security,

and the reported marketing costs corrected for price level

changes, appendix B of this report calculates these cost

estimates for 1977, The geographic distribution of estimated

preparation costs is reported in appendix table 3, If the

assumption of constant service costs is correct, local governments paid approximately $4.57 per $1,000 of gross proceeds for

bonds sold during 1977. Nonmetro governments, because of the

smaller size of their bond issues, paid a much higher rate than

did metro governments. Overall, nonmetro governments paid

$5.94 per $1,000 to prepare bonds for sale compared with

$4.30 per $1,000 for metro governments. The disparity between

rates paid by governments in metro and nonmetro areas was

greatest for general obligation bonds, again because of the

smaller average size of the nonmetro bond issues.

These preparation cost estimates may be high for nonmetro areas

for two reasons. First, many nonmetro bonds probably do not

require the preparation services expected of metro bonds. For

example, investors who purchase nonmetro bonds may not expect

them to be rated, thus relieving many nonmetro governments of

the need to purchase a rating. Second, the preparation costs

15
for negotiated or directly sold bonds are probably lower than

those for bonds sold competitively. Often these services are

performed by the underwriting firm or by the investors themselves ^ with the costs being reflected in higher interest

costs. Because nonmetro governments rely on these noncompetitive

methods of marketing their bonds to a larger extent than do

metro governments, the nonmetro cost estimates may be too high.

Nonetheless, the small average size of nonmetro bonds issues is

likely to lead to higher preparation costs per $1,000 of gross

proceeds on balance.

In suray the full cost of issuing bonds—-the interest cost plus

the incidental costs of marketing the bonds—is roughly the

same per dollar borrowed for metro and nonmetro governments\

Investors seem willing to purchase nonmetro bonds at remarkably

low rates given the characteristics of these bonds. Sampling

error may make nonmetro borrowing costs appear lower than they

actually are, but any cost differences that may exist are

small, and are due entirely to the types of bonds issued and to

the marketing techniques relied upon by nonmetro governments.

These choices suggest areas where State and local government

policy could yield significant cost savings for small borrowers

in both metro and nonmetro areas.

POLICY IMPLICATIONS An examination of interest and related costs suggests that

nonmetro governments are able to issue bonds at moderate rates

given the type of debt and marketing methods used. At least

for 1977, the market did not appear reluctant to purchase the

bonds of rural governments at reasonable cost. Evidently,

tax-exempt investors found most nonmetro bonds to be of acceptable investment quality and roughly on a par with the bonds of

metro governments.

The success many nonmetro governments enjoyed in marketing

their long-term bonds during 1977 suggests that, given favorable

bond market conditions in the eighties, rural development can

continue in the face of cutbacks in Federal and State intergovernmental grant and loan programs. However, these Government

grant, loan, and loan guarantee programs will continue to

improve the prospects for continued rural development. Programs

which make the State or Federal Government the "lender of last

resort" for local governments unable to obtain conventional

financing may be critical for many rural governments. 9_/

Furthermore, given current financial market conditions, few

local governments can afford to rely on debt financing for any

but the most critical projects. Nonetheless, if bond market

conditions improve and if recent changes in tax laws have not

altered the relative demand for rural government bonds, bond

issuance should be a viable method of financing public investment in rural development.

9_/ No attempt has been made to estimate the number of local

governments unable to issue bonds because they were rationed

out of the market.

16
Although more research is required to determine the effect

recent changes in tax laws and regulations have had on the

demand for rural government bondsj the implications our historical view of the market has for Federal and State rural development policy can be specified. The caveat attached to the

following discussion is that, even with an improved economy,

the relative position of rural governments in the eighties may

be radically different from that which prevailed in 1977.

Federal Policy Given the prevailing political climate, funding for new or

expanded Federal assistance to local governments is likely to

' be scarce in the near future (_1_) . Nonetheless, as coinmunit ies

grow and as existing infrastructures age, funding for capital

projects will have to be found. In the absence of intergovernmental aid, local governments historically have relied on the

municipal bond market for a sizeable portion of their capital

needs. The result of our analysis suggest that, other things

being equal, rural governments have access to the long-term

bond markets at costs roughly equivalent to those facing metro

governments. Thus, from a rural versus urban perspective,

rural governments do not appear to require further special

assistance in raising funds for needed capital projects.

However, rural governments, together with urban and State

governments, could benefit from Federal actions which reduce

yields on tax-exempt securities in general.

Tax-exempt bond yields are interrelated with interest rates

paid by other borrowers and are dependent on general money

market conditions. Thus, any change in national economic

policy which results in an across-the-board reduction in

interest rates would benefit local governments in both urban

and rural settings. Short of that, actions which lower the

relative yield on long-term borrowing for essential public

services would help local governments adjust to cuts in the

size of intergovernmental grant and loan programs.

From a local government's perspective, current bond m.arket

conditions are troublesome for two reasons. Not only are

yields high, but the yields currently being paid on tax-exempt

securities are high relative to the yields being paid on

taxable securities. The reduced Federal income tax liability,

the increased availability of other tax shelters, and the use

of municipal bonds for a wide range of nontraditional purposes

have all narrowed the gap between the borrowing costs of local

governments and those of the Federal government and the corporate

sector. Historically, tax-exempt rates for long-term bonds

have been approximately 65 to 70 percent of the cost of

comparably rated taxable corporate bonds; today the ratio is in

the neighborhood of 80 percent (2_) , As a result, public sector

borrowing for traditional purposes is costlier than it would be

if current tax-exempt yields were at their historical level in

relation to other interest rates.

One approach open to the Federal Government to reverse the

upward trend in tax-exempt yields would be to reduce the use of

17
the tax exemption. Such devices as the all-savers certificate,

the industrial revenue bond, the pollution control bond, and

the mortgage revenue bond use the tax exemption to lower the

direct cost of financing private sector investment. What is

often overlooked is that these uses of the tax exemption

increase the cost of government borrowing for the construction

and rehabilitation of essential public facilities such as water

systems, highways, and schools. By restricting the use of

tax-exempt bonds, the supply of these securities could be

reduced, resulting in relative tax-exempt yields more in line

with historical trends. The cost of public sector borrowing

could be lowered while at the same time Federal income tax

losses could be reduced.

State Policy State governments are less likely to find restricting the use

of the tax exemption politically feasible. Interstate competition for new business and for plant retention and expansion may

make unilateral restrictions on the issuance of industrial

revenue and pollution control bonds difficult to accept.

Restrictions give the appearance of placing the State in a

noncompetitive position with neighboring States which encourage

the use of tax-exempt financing to attract and hold business

firms. Furthermore, the interest rate effect associated with

such restrictions is diffused throughout the Nation. Benefits

to the State's borrowers appear to be small. 10/

In general, although efforts to lower yields on tax-exempt

securities would be more successful if made at the Federal

level, State governments can take steps to help lower the cost

of borrowing for small governments and governments cut off from

regional bond markets. The discussion which follows is concerned with State policy in fairly broad terms.

One of the major differences between metro and nonmetro borrowing is the heavier reliance placed on noncompetitive sales by

rural governments. The cost of bond-financed rural development

will be higher than necessary if this pattern results from a

lack of rural government technical expertise in marketing bonds

or from a lack of underwriter interest in small-sized bond

issues offered for competitive sale by isolated rural governments. State governments are in the best position to initiate

programs to correct these problems.

Some States have started technical assistance programs to

improve local government debt management practices (15). To

the extent that such programs improve local government understanding and evaluation of debt issuance alternatives, the cost

of borrowing can be minimized. However, in many areas of the

10/ Evidence suggests that heavy Statewide issuance of

tax-exempt bonds may raise small government borrowing costs

while leaving large governments unaffected O, 20). Thus,

there still may be sufficient reason for the State to unilaterally place restrictions on the use of tax-exempt borrowing,
country, rural borrowers may find their alternatives limited by

geographic isolation from regional financial centers. For such

governments, the opportunity to request more extensive State

involvement in the marketing process may be needed to obtain

lower borrowing costs. Centralized marketing is one example of

how the State could increase underwriter interest in small

bond issues. By offering several small bond issues for sale at

one convenient location, the State can reduce bid submission

costs and heighten underwriter competition for rural bonds,

making competitive sales a viable marketing method for more

rural borrowers.

Based on conditions in 1977, the localized markets in which

most rural government bonds are sold were able to absorb the

supply of rural bonds at reasonable interest rates--a condition

that may not exist in the future. Although there is no a priori

reason to expect the recent changes in tax law to affect the

demand for rural bonds more adversely than metro bonds,

neither is there empirical evidence to suggest that this has

not been the case. If it turns out that relative demand for

rural bonds has fallen significantly, States with large and

growing rural populations may wish to consider policies which

could enlarge the market for the bonds of their rural governments .

The characteristics of most rural bonds make them unlikely

investments for large investors oriented toward the national

bond market. Rural bond issues are small, tend to be unrated

or unfavorably rated, and seldom have a viable secondary

market—all characteristics which discourage serious consideration from investors who are not familiar with the issuing

government. Programs which increase the investment quality of

rural bonds, as perceived by major investors, will broaden the

market for these bonds.

Over time, State supervision of local government borrowing or

State présale approval of local bonds can increase the perceived

quality of vSmall government bonds. Investors may come to

accept the judgment of State officials on the local government's

ability to support debt burdens and manage debt retirement

effectively. However, to the extent that such programs

are meaningful, they reduce local autonomy and, therefore, may

meet considerable resistance from local government officials.

To some extent, the autonomy factor can be avoided by making

local participation in the program optional. Optional State

guarantees of local bonds or the creation of a State municipal

bond bank are examples of State participation in local government

bond issuance requiring mutual agreement. The State government

is obligated to participate only if some specific set of

safeguards has been met by the local government. Local officials

can choose, if their bonds meet the requirements, to take part

in the program if it seems economically advantageous.

19
Each of these programs has been adopted already in one or more

States in an attempt to lower the cost of borrowing for small

towns and rural areas. Although the evidence from 197 7 does

not suggest any widespread need for such programs, they may

become more important for the attainment of rural development

goals if current bond market conditions do not improve in the

years ahead.

20
REFEEŒNCES (1) Broder, David S. "Reagan Sees Little Fiscal Help For

State, Local Governments," The Washington Post. Nov. 22,

1981, p. A-1.

(2) "Borrowing Gets Harder As the Demands Intensify," Business

Week. Oct. 26, 1981, pp. 134-58.

(3) Fischer, P. P., R. W. Forbes, and J. E. Petersen. "Risk

and Return in the Choice of Revenue Bond Financing,"

Governmental Finance, Vol. 9 (1980), 9-13.

(4) Forbes, Ronald W., and John E. Petersen. "Costs of Credit

Erosion in the Municipal Bond Market," Study No, 1.

Chicago: Municipal Finance Officers Association, 1975,

(5) _. Building a Broader Market: Report of the

Twentieth Century Fund Task Force on the Municipal Bond

Market. New York: McGraw-Hill Book Co., 1976.

(6) Camello, Thomas P., and Stephen W. Streets. "Dramatic

Increases in Bond Marketing Costs Noted for Counsel,

Rating Services and Printing," The Weekly Bond Buyer:

MFOA Supplement No. 1. May 12, 1980, p. 6.

(7) Hendershott, Patrie H., and David S. Kidwell. "The Impact

of Relative Security Supplies: A Test with Data from a

Regional Tax-Exempt Bond Market," Journal of Money,

Credit, and Banking, Vol. 10 (1978), 337-47.

(8) Hopewell, Michael H., and George G. Kaufman. "Costs to

Municipalities of Selling Bonds By NIC," National Tax

Journal, Vol. 27 (1974), 531-41.

(9) . Commercial Bank Bidding on Municipal Revenue

Bonds: New Evidence. Eugene, Oregon: Center for Capital

Market Research, Univ. of Oreg. 1975.

(10) Kessel, Reuben. "A Study of the Effects of Competition in

the Tax-Exerapt Bond Market," Journal of Political Economy,

Vol. 79 (1971), 706-38.

(11) Lubov, Andrea. Issuing Municipal Bonds: A Primer for

Local Officials. AIB-429. U.S. Dept. Agr., Econ. Stat.

Coop. Serv., July 1979.

(12) Moak, Lennox L. Administration of Local Government Debt.

Chicago: Municipal Finance Officers Association, 1970.

(13) Municipal Finance Officers Association. Costs Involved in

Marketing State/Local Bonds. Sept. 1973.

(14) Petersen, John. "Small Borrowers in the Municipal Bond

Market: Does Size Matter." National Conference on Nonmetropolitan Community Services Research. Prepared for the

Committee on Agriculture, Nutrition, and Forestry, U.S.

Senate, July 12, 1977.

21
(15) __, L. A. Cole, and M. L. Petrillo. Watching and

Counting. Chicago: Municipal Finance Officers Association,

1977.

(16) Salomon Brothers: 1977 Annual Review of the Bond Market.

New York: Salomon Brothers, 1978.

(17) Sorensen, Eric H. Negotiated Municipal Bond Underwriting:

Implications for Efficiency. Eugene, Oreg.: Center for

Capital Market Research, Univ. of Oregon, 1977.

(18) . "Negotiated Municipal Bond Underwriting:

Implications for Efficiency,'* Journal of Money, Credit,

and Banking, Vol. 11 (1979), 366-70.

(19) Sullivan, Patrick J. "Bank Support of Municipal Bonds

Critical to RD," Rural Development Perspectives, Vol. 3.

U.S. Dept. Agr., Econ. Stat. Serv., Oct. 1980, pp.

32-5.

(20) . "The Effect of Local Municipal Bond Markets on

Local Government Borrowing Costs." Paper presented at

Southern Economic Association meeting, Washington, D.C.,

Nov. 5, 1980.

(21) . "Municipal Bond Ratings: Are They Worthwhile

for Rural Governments?" Journal of the Northeast

Agricultural Economics Council, Vol. 11 (1982), 67-73.

(22) West, Richard. "Determinants of Underwriters' Spreads on

Tax-Exempt Bond Issues," Journal of Financial and Quantitative Analysis, Vol. 2 (1967), 241-63.

22
APPENDIX A~THE

DETERMINANTS OF

NET INTEREST COST

Considering the narrowness of the topic^ a rather extensive

literature exists on the determinants of interest rates payable

on tax-exempt bonds. The typical study adopts a linear multiple

regression approach to analyze variation in the net interest

cost of some sample of municipal bonds. This technique is

applied here, with the selection of independent or explanatory variables drawing heavily on the results of previous

studies (4^5 2.5 î^i ^^^ jO) ^

A total of 2,134 bond issues sold during 1977 is included in

the analysis. Only bonds of general-purpose governments

(county5 citys village, and town governments) and school

districts are included to make comparisons as simple as

possible. Special district governments vary too much in degree

of governing autonomy and taxing power to easily interpret the

results of an analysis which includes their bonds. For much

the same reason, industrial development and pollution control

bond issues are excluded from the sample* Furthermore, bond

issues underwritten by the Farmers Home Administration have

been excluded since the interest cost for these issues does not

vary among borrowers.

The NIC is assumed to be dependent upon the bond issue's

characteristics, certain characteristics of the issuing government, and bond market conditions at the time of sale. Based on

previous work, the bond issue characteristics included in the

equation are dollar amount of the issue; average maturity;

callability of bonds prior to the stated maturity date; bond

type, general obligation or revenue; use of the proceeds;

insurance provisions; and credit rating. All but the dollar

amount variable, which enters the equation in natural log form,

and the average maturity variable are dummy variables taking on

a value of either zero or one. For example, the call provision

variable is equal to one if any of the bonds in the issue are

callable before their stated maturity date; if none are callable,

the variable is equal to zero. JA/

The credit rating variable is based on the ratings assigned by

Moody's Investors Service and Standard and Poor's Corp. Their

rating schemes were collapsed into the four major rating

classes—''Aaa," "Aa," "A," and "Baa'*-=-with Moody ^ s rating being

used whenever possible. The use-of-proceeds variable attempts to

capture the effect of "risky'* uses of revenue bonds as defined

by Hopewell and Kaufman (9^). Our data set excludes bonds which

fall into the Hopewell-Kaufman high-risk category (university

facilities). The low-risk category includes bonds sold to

finance construction of sewer, water, and nonuniversity school

facilities and bonds sold to refinance outstanding issues.

The issuer characteristics are long-term bonds outstanding at

the end of fiscal year 1977, outstanding short-term per capita

bonds, the census region in which the jurisdiction is located.

11/ For an explanation of the terms used in this appendix,

the reader is referred to (11, 12).

23
and government location in a Standard Metropolitan Statistical

Area (SMSA). The long-term bonds variable enters the equation

in natural log form while the regional and metropolitan indicators are dummy variables.

Variables measuring the condition of the bond market at the

time each bond issue was sold include the number of bids

submitted by underwriting firms, the general level of tax-exempt

bond yields, and the term structure of tax-exempt bond yields

(that is, the yield curve). The market rate of interest used

is a simple average of the Salomon Brothers' weekly indices

for prime grade 1-year notes, 10-year bonds, and 25-year bonds

for the week in which the bond was sold (16). The slope of the

yield curve is measured by the difference between the Salomon

Brothers' weekly indices for prime grade 25-year bonds and

prime grade 1-year notes. It enters the regression equation

as an interaction term with the natural log of the final

maturity of the issue.

In general, NIC is expected to decline at a decreasing rate as

the size of the bond issue increases and as the dollar amount

of the issuer's outstanding long-term bonds increases.

Economies of size for underwriters and investors make larger

bond issues (up to a point) less costly to handle, while the

existence of a secondary market for a government's bonds—

measured by the existence of outstanding bonds--reduces investor

and underwriter uncertainty regarding the bond issue's market

acceptance. In the wake of New York City's fiscal problems,

the hypothesis is that higher levels of short-term bonds are

associated with potential credit problems and therefore increase

borrowing costs. The NIC is also expected to decline as the

number of bids increases because a high degree of underwriter

competition should result in lower borrowing costs. The NIC is

expected to rise as the bond issue's average term ts) maturity

increases because longer termed bonds are usually more difficult

to sell. Revenue bonds, bonds callable before their maturity

date, and bonds with low credit ratings, because of the higher

risk associated with these characteristics, are expected to

have higher NIC's than general obligation, noncallable, higher

rated bonds. Because some types of revenue bonds are evidently

less risky than othersj the low-risk uses of revenue bonds

should be associated with lower NIC's than are expected of

other revenue bonds.

National market conditions are measured by the market rate of

interest and structure of interest rates, Higher market rates

should be associated with higher NIC's. In addition, the

higher the long-term rates are relative to the short-term

rates, the greater the borrowing cost on bonds with long-term

maturities should be. During 1977, the rate on long-term bonds

was always higher than the rate on short-term bonds. Therefore,

the product of the "yield curve" and the natural logarithm of

the bond issue's longest term to maturity should be related

positively to borrowing costs.

24
To refine the effect of metropolitan status, a series of

regional dummy variables is included in the equation to account

for regional variation in interest rates. Previous research

found that governments in the Northeast and North Central

States tended to pay higher NIC's on their bonds than did

governments in the Southern and VJestern States (_4) .

The results of the regression analysis are reported in appendix

table 1 for general obligation bonds, revenue bonds, and a

Appendix table I--Regress ion equations for estimating new-issue net interest cost for

competitively sold tax-exempt bonds by type of security, 1977

Independent

variables

All bon<Is : General obl"

: bonds

Lgat ion ] Revenue

¡Coefficient :i

bonds

Coefficient :(:-value : Coefficient :t-value :-value

Constant : -1.6721 4.39 -1.5225 3.95 1.29 .87

Issue size in logs . - .0075 1.10 - .0098 1.44 -.0027 .10

Long-term debt outstanding in logs .0088 4.36 .0091 4.57 .0107 1.27

Short-term debt

per capita .0002 3.62 .0002 3.60 .0006 .71

Number of bids - .0194 7.11 - .0178 6.59 -.0389 3.22

Average maturity .0630 22.98 .0680 23.12 .0495 6.34

Market interest rate 1.2343 14.74 1.1889 13.98 .7399 2.33

Yield curve x final

maturity in logs .1255 17.06 .1262 16.82 .0440 1.52

Call provision dummy .0758 4.59 .0633 3.89 .2036 2.53

R evenu e bond dummy .1773 5.40 na na na na

Low-risk revenue bond

dummy - .0662 1.61 na na -.0565 1.03

Insured issue dummy - .1128 3.21 - .1193 3.32 -.0763 .63

Credit rating dummy

Aaa - .6671 14.49 - .6784 15.12 -.2365 .98

Aa - .5553 19.60 - .5504 19.47 -.5642 4.77

Â - .3249 15.50 - .3322 15.67 -.2684 3.54

Unrated - .1191 4.80 - .1547 6.19 .2110 2.28

Regional dummy

Northeast .4863 18.51 .5101 19.53 .1236 .77

North Central .1536 8.08 .1781 9.15 -.0406 .63

West .1954 8.36 .2271 9.34 .0646 .90

Metropolitan dummy .0618 4.02 .0608 3.94 .0698 1.17

R2 .692 .711 508

F-ratio 250.4 271 1 ] 2.8

Number of observations 2134 1892 242

NIC (mean) 5 .033 4.984 5. 410

na = Not applicable.

Sources: Calculated from unpublished data from the Public Securities Association's

long-term municipal bond file and the U.S. Bureau of the Census, 1977 Census of

Governments.

25
combination of both. Each coefficient can be interpreted as

the incremental cost (in NIC3 measured as a percent) associated

with the characteristic measured by the independent variable.

For the continuous variables—such as bond issue size, debt

outstanding, and number of bids—the regression coefficient

measures the expected change in NIC, given a one-unit change in

the independent variable. For example, receiving one additional

bid on the sale of a general obligation bond issue is expected

to lower the issuer's NIC by 0.018 of 1 percent (or 1.8 basis

points).

The interpretation placed on coefficients of dummy variables is

slightly different since these variables can only take on

values of zero or one. For dummy variables that are not part

of a series (the call provision, revenue bond, low-risk use,

and metropolitan dummy variables), the coefficient indicates

the incremental cost associated with the characteristic. For

example, adding a call provision to a general obligation bond

adds 6.3 basis points to the NIC. For dummy varibles that are

part of a series (the credit rating and regional dummy

variables), the coefficients indicate the incremental costs

associated with the bonds of a given characteristic in relation

to bonds with the characteristic that has been excluded from

the series. The excluded category in the credit rating series

is the "Baa" rating while the South is excluded from the census

regions. The -.33 coefficient for general obligation bonds

with an "A" rating means that governments selling general

obligation bonds with "Á" ratings can expect to pay an NIC 33

basis points lower than that paid on comparable bond issues

with "Baa" ratings.

The results indicate all relevant independent variables have a

statistically significant impact on the NIC of general obligation bonds. The equation "explains" roughly 69 percent of the

variation in the NIC of these bonds. Increasing the size of

the bond issue, increasing the number of bids received, and

raising the bond issue's credit rating reduce the NIC on

general obligation bonds. Interestingly, unrated bonds cost

less than bonds with a "Baa" or lower rating. High amounts of

outstanding debt, long maturities, high market rates, and steep

yield curves are associated with high NIC's. In addition,

bonds with call provisions and bonds of governments located in

SMSA^'s and outside of the South cost more to sell.

Far fewer coefficients are statistically significant (at the

0,05 level) in the revenue bond equation. Nonetheless, those

that are statistically significant have the anticipated signs

and are roughly equivalent to the coefficients in the general

obligation equation. Of importance, for our purposes, is the

lack of statistical significance associated with the positive

coefficient for the metropolitan dummy variable. Holding the

other explanatory variables constant, governments in SMSA's pay

roughly the same NIC "^or their revenue bonds as do governments in

nonmetro areas.

26
Problems With a

Single-stage

Regression Approach

Using a single-equation model to estimate the market's acceptance

of nonmetro bonds has three potential sources of bias. Our

single-stage regression approach fails to model the rating

process, the underwriting industry's bid decision process, and

the decision on how the bond issue is to be sold. By ignoring

the importance of the issuer's rurality in each of these

decisions, the single-equation model may yield a biased estimate

of the coefficient for the metropolitan dummy variable.

If a local government has a lower probability of receiving a

favorable rating on its bonds when it is located outside of an

SMSA, then the degree of market acceptance of rural bonds will

be overestimated to some extent. Because of data requirements,

no attempt has been made to model the rating process as part of

this analysis, and attempts by others have not examined the

influence rurality has on the rating process. Thus, the degree

to which ratings are a function of geographic location remains

open to speculation. Nonetheless, that this relationship would

seriously bias our regression results seems unlikely. In

relation to large metropolitan issues, ratings tend to have a

smaller influence on the cost of rural government borrowing (21).

To the extent that underwriter competition is affected adversely

by geographic isolation, rural issuers will receive fewer bids

on their publicly sold bond issues. Preliminary analyses do

not suggest that competitively sold rural bond issues receive

fewer bids; thus, the single-equation approach may not be

biased. Furthermore, according to the coefficients reported in

appendix table 1, one less bid only adds 2 basis points to the

NIC on general obligation bonds and 4 basis points to the NIC

on revenue bonds so any bias would be small* The underwriter

industry's bid decision process can have a powerful influence

on borrowing costs if it affects the issuing government's

marketing technique, however.

The failure of our single-equation approach to address the

decision on how bonds are sold is the model's most serious

shortcoming. To make the NIC analysis as straightforward as

possible, only competitively sold bond issues were analyzed.

Nonetheless, the same basic result emerges when the analysis

includes both competitive and negotiated sales—other things

being equal, nonmetro bond issues have significantly lower

NIC's. The problem is not with the sample frame; the problem

emerges because a single-equation approach fails to explain the

heavy usage of noncompetitive sales by rural governments. If

rural governments are forced to rely more heavily on noncompetitive sales because of their rurality, then our estimate of the

market's acceptance of rural bonds will be biased.

Unfortunately, the information needed to adequately model the

issuer's decision on how to sell each bond issue is not available. Nonetheless, the underwriter compensation and reoffer

information presented in this paper, as sketchy as it is, does

provide a few clues on the choice between using competitive and

noncompetitive marketing techniques. A look at table 2

27
reveals that underwriter compensation rates were high for bonds

sold through negotiation while table 3 reveals that their

reoffer yields were also high. To the extent that these cost

differentials are a function of the bonds' marketability, they

suggest that the cost of issuing bonds may be higher for

nonmetro governments than our single-equation regression

analysis of NIC indicates.

Underwriter compensation rates are higher for negotiated bond

offerings for several reasons. Noncompetitive sales could

result in inefficient levels of compensation for underwriting

services. Because no market test of the negotiated cost

exists, local governments, especially small governments which

do not issue bonds often, could easily overpay. But higher

compensation rates on negotiated sales simply could reflect the

cost of purchasing a more comprehensive package of services

from the underwriter. If either of these reasons adds to the

level of compensation received by the underwriter, the NIC of

negotiated bonds will be higher, but for reasons unrelated to

the bond's marketability. If such is the case, the higher NIC

of negotiated bonds merely reflects costs due to errors in

judgment and costs that the issuer would have had to pay

separately had the bonds been sold competitively. Since total

marketing costs are not higher, the analysis of variations in

NIC for competitive sales is a reasonably accurate measure of

market conditions facing urban and rural bond offerings.

Higher underwriter compensation rates paid for bonds sold

through negotiation also may be due to factors which make these

bonds difficult to market. If the risk associated with holding

the bonds is high, then underwriter compensation will be high.

To the extent this explains the higher compensation rate paid

on negotiated bonds, the analysis of NIC for competitive sales

underestimates the true cost of nonmetro debt. While all three

explanations are probably relevant for nonmetro areas, the last

possibility is most consistent with the patterns reported in

table 3.

The reoffer yields reported in table 3 are invariably higher

for negotiated bond offerings. Although this condition does

not prove that the bonds themselves are less attractive to

investors than competitively sold bonds, it is one explanation.

If investors do not like something about a bond, the bond issue

will be difficult to sell. Under such a circumstance, the

issuing government may find it cheaper to work closely with a

preselected underwriter. Thus, the bonds offer a higher yield,

not because they are sold through negotiation but because they

are difficult to market. An alternative explanation is that

underwriters of negotiated bonds lack the incentive to find

investors that would accept a lower yield. Either intentionally

or for lack of more complete knowledge of potential investors,

preselected underwriters may underprice their bonds (select too

high an interest rate), thus needlessly adding to the cost of

selling bonds.

28
Again, neither explanation can be accepted or rejected on the

basis of currently available information. Both factors probably

play a role in raising the reoffer yields and the NIC on

negotiated bond offerings. As a result, the interest cost of

bonds is probably higher for nonmetro areas than our single-stage

regression analysis indicates.

29
APPENDIX B—

MUNICIPAL BOND

PREPARATION COSTS

In 1973, the Municipal Finance Officers Association (MFOA)

circulated a questionnaire to its members requesting information

on the preparation costs of recently sold bonds. Information

on 496 bond issues, amounting to nearly $3.1 billion (mostly

sold during the 1971-72 period), was summarized in a special

MFOA publication (13). The survey collected data on the costs

of holding special elections; the costs of purchasing the

services of special bond attorneys, fiscal advisors, and local

attorneys; and the costs of preparing bond notices and bond

prospectuses, printing bonds, and having bonds rated. While

these figures did not include the cost of services performed

in-house by the issuing government's own personnel, they did

provide a rough estimate of the preparation costs local governments could expect to pay during the early seventies.

In the wake of New York City's fiscal problems in 1975, however,

investors and underwriters began demanding much more information

on the fiscal and economic bases supporting a government's

debt. These information requirements changed the nature of the

services provided by fiscal advisors, bond counsel, and the

rating agencies. To capture the effects of inflation and

stricter disclosure requirements, the MFOA recently resurveyed

its members. A preliminary report summarizes the responses of

279 governmental units which issued bonds during 1979 (_6) .

These data, reported b^ size and type of bond issue, are the

basis for the estimates for general obligation and revenue

bonds reported in appendix table 2. To obtain dollar amounts

consistent with the other cost data reported for 1977, the 1979

figures were deflated to 1977 dollar figures by use of the

consumer price index for services other than rent. However,

the 1980 survey had an insufficient number of responses to

estimate the preparation costs of special assessment and

limited-tax bonds confidently. Therefore, the estimates from

the 1973 survey were inflated to 1977 dollars for this category

of bonds. Appendix table 2 presents estimates of the total

preparation cost per $1,000 of gross proceeds for general

obligation bonds, revenue bonds, and special assessment bonds

by the size of the bond issue. 12/

Based on these estimates, calculation of the preparation costs

local governments in metro and nonmetro areas might have paid,

given the size and type of bond issues they sold during 1977,

is possible. The bond issues sold by governments in each of

the government categories were stratified by size and type;

these strata were then used to weight the cost figures reported

in appendix table 2, The weighted average preparation costs

for the general obligation and revenue bonds of local governments

by metropolitan status are reported in appendix table 3,

12/ The 1979 figures were deflated by a factor of 1,215 while

the 1971-72 figures were deflated by a factor of .661 to arrive

at 197 7 estimates.

30
Appendix table 2—Estimated bond preparation costs per $1,000 of gross

proceeds by type of security and bond issue size, 1977

size of Type of security

issue : General obligat ion : Revenue bonds ' Special assessment

; bonds : bonds

Million dollars : Dollars

0 to 0.5 : 15.70 24.29 22.87

0.5 to 1 : 9.83 16.53 14.98

1 to 2 : 7.08 12.86 8.14

2 to 3 : 7.15 15.34 5.39

3 to 5 : 3.88 11.20 5.79

5 to 10 : 4.04 7.71 4.75

10 to 25 : 3.65 5.08 1/ 3.65

25 and up : 2.75 3.01 1/ 2.75

1/ The average cost of general obligation bonds was applied to special

assessment bonds exceeding $10 million.

Source: Calculated from data reported in (6^, 13).

Appendix table 3—Estimated bond preparation costs per $1,000 of gross

proceeds by type of security and metropolitan status, 1977 1/

Government All long-term \ General obi igation Revenue bonds

category bonds \ bonds 2/

Dollars

Local governments 3/ : 4.57 4.27 4.78

Metropolitan 4.30 3.93 4.62

Nonmetropolitan 4/ : 5.94 6.19 5.82

Urbanized 5.53 5.41 5.58

Less urbanized 6.37 6.96 6.10

Rural 4/ 5.86 6.25 5.57

\J The bond preparation costs reported represent an average of all the bond

issues in each category weighted by issue size.

2J Includes limited-tax bonds not classified as "full faith and credit"

obligations.

3J Includes governments that could not be classified as either metropolitan

or nonmetropolitan.

4_/ Excludes five Alaskan oil pipeline industrial development bonds

for comparison purposes.

Sources: Calculated from data reported in appendix table 2 and from

unpublished data from the Public Securities Association's long-term

municipal bond file.

31
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