Municipal Lease-Purchase Obligations: A Different Kind of Tax-Free Investment

The capital markets are constantly introducing a wide array of new investment vehicles. It's important for practitioners to keep up with these changes so they can advise their clients appropriately. This month, Lance L. Dominique, director of municipal general lease placements, Bankers Leasing Association, Inc., Northbrook, Illinois, and Peter D. Fleming, CFP, a senior editor with the Journal, write about municipal lease-purchase obligations. Municipal lease--purchase obligations are a form of short-term, tax-exempt financing often used by municipalities or other government entities to purchase essential equipment. They represent a municipality's promise to pay under installment purchase contracts. These obligations are typically incurred by municipalities when they need to purchase equipment and don't want to issue bonds, buy the equipment for cash or rent it. The types of equipment purchased with municipal lease--purchase obligations range from fire and garbage trucks to computers and telephones.  Municipalities use lease financing for several reasons; they are often issued to avoid state-imposed constitutional Amortization schedule Principal: $35,000 Interest rate: 8% Term: Three years Payment schedule: $1,096.77 monthly Approximate principal balance at Year Principal Interest Total yearend 1 $10,750 $2,411 $13,161 $24,250 2 11,642 1,519 13,161 12,608 3 12,608 553 13,161 (*) * A final payment, usually $1 or less, is sometimes necessary to fully repay principal. and statutory limitations on the issuance of debt. At other times, the cost of the equipment beign financed is not large enough to justify the expense of a bond issue. Or the useful life of the equipment itself is not long enough to match the life of the bond. The term of municipal lease--purchase obligations takes into consideration the particular useful life of the underlying equipment. Municipal lease financing can be completed in a fraction of the time it takes for a full bond issue. This allows municipalities to acquire equipment when they need it. TAX-EXEMPT INVESTMENT As with most state and local government financing arrangements, a municipality's leasing equipment results in creation of a tax-exempt investment, in this case a municipal lease-purchase obligation. A more accurate term is actually "municipal installment purchase agreement," since the transaction is not a true lease but is in fact an installment loan. By making installment payments over a two- to five-year period, the municipality is able to purchase the equipment it needs on more favorable terms. Because of the municipal lease structure, these obligations carry a relatively high tax-exempt yield and have a shorter maturity when compared to more conventional municipal bonds. Currently, municipal lease-purchase obligations are yielding 7.5% to 8.25% and have two- to five-year maturities. Yields on other municipal securities of comparable maturity are only in the range of approximately 5% to 6%. The exhibit above shows the amortization of a typical municipal lease--purchase obligation. Investors in conventional municipal bonds, with maturities of 10,20 or 30 years, receive semiannual interest payments and no principal payments until the bonds mature. Municipal lease-purchase obligations are different. Over the term of the obligation, the investor receives regular payments including both principal and interest. Most leases make montly payments; quarterly, semi-annual or annual payments also exist, at the option of the municipality. After a final payment of $1, the municipality owns the property subject to the lease. Municipal leases typically are originated in amounts ranging from $5,000 to as much as several hundred thousand dollars, depending on the equipment acquired. …

Field of study: Business