Bonds & Development Finance

Overview

Bonds are the bedrock of public development finance. Bond finance dates back to the 19th century, with the deferral tax exemption included in the country's first federal tax code. In its simplest form, a bond is a debt or a loan incurred by a governmental entity. Bonds are issued and sold to the investing public, and the proceeds are typically made available to finance the costs of a capital project. If the bonds are being issued for the benefit of a non-governmental borrower, the proceeds are often loaned to such a borrower, and the borrower then makes loan payments corresponding to when principal and interest are due on the bonds. Bondholders receive interest over the term of the bonds, and such interest is often exempt from federal, state, and local income taxes. The tax-exempt status of certain bonds makes them an attractive investment option for investors.

There are two types of tax-exempt bonds: Government Bonds (GOs) and Qualified Private Activity Bonds (PABs). Government Bonds are intended to address the traditional infrastructure needs of the nation. GOs may be used for many public purposes (e.g., highways, schools, bridges, sewers, jails, parks, government equipment and buildings, etc.), and their debt service requirements are met by levying taxes on the general public. Facilities financed by GOs are not permitted to be significantly used, operated, controlled or owned by private entities. Conversely, PABs permit a larger degree of private sector involvement, and are used to address numerous development finance needs identified by Congress and state and local governments. PABs drive projects involving both the public and private sector by passing along the low-cost interest benefit - generated by the tax-exempt status of PABs - to private borrowers. While the language governing the usage of GOs is fairly straightforward, the language governing PAB regulations and uses is far more complicated. The Internal Revenue Code (IRC) permits the financing of several types of projects using qualified PABs, although they may be used partially or entirely for private purposes.

Qualified PABS generally include:

Industrial Development Bonds
501(c)(3) Bonds
Exempt Facility Bonds
Qualified Redevelopment Bonds
Aggie Bonds
Green Bonds

Types of Qualified Private Activity Bonds

PABs may be used to address numerous economic development finance needs. They are issued for the benefit of private entities or individuals. The IRC permits the financing of several types of facilities using qualified PABs, although they may be used partially or entirely for private purposes.

Industrial Development Bonds
Small Issue Industrial Development Bonds (IDBs) are also referred to as Small Issue Manufacturing Bonds or Industrial Development Bonds. These bonds are the single most actively used bond tool for financing the manufacturing sector and are a key economic development tool for many states. IDBs are issued for qualified manufacturing projects, with a total bond issuance limit of ten million dollars. These bonds can support expansion and investment in existing manufacturing facilities, as well as the development of new facilities and the purchase of new machinery and equipment.

View Industrial Development Bond (IDBs) Resources

501(c)(3) Bonds
501(c)(3) Bonds finance projects owned and used by not-for-profit corporations that qualify for exemption under Section 501(c)(3) of the IRC. Due to the relative affordability of this type of financing, 501(c)(3) bonds have gained in popularity over the past several years. Organizations using 501(c)(3) bonds may include: universities and private colleges, continuing care facilities, independent and charter schools, cultural organizations, hospitals, religious or charitable groups, scientific organizations and others.

View 501(c)(3) Bonds Resources

Exempt Facility Bonds
Exempt Facility Bonds finance a wide variety of projects, including airports, docks, mass-commuting facilities (such as high-speed rail), water and sewage facilities, solid waste disposal facilities, qualified low-income residential rental projects, facilities for the furnishing of electric energy or gas, qualified public educational facilities and qualified highway or surface freight transfer facilities. Exempt Facility Bonds have a wide scope of use, and implementation varies by state or local government.

View Exempt Facility Bond Resources

Qualified Redevelopment Bonds
Infrastructure projects that do not qualify for Government Bonds may qualify for tax-exempt financing if they meet several tests. For instance, in many cases, the proceeds must fund redevelopment in designated areas of blight. These bonds are typically issued for projects that involve special district financing, such as Tax Increment Financing (TIF).

View Qualified Redevelopment Bond Resources

Aggie Bonds
These bonds are small issue bonds and exist in many states to support agricultural investment. Aggie bonds provide an attractive, affordable source of capital for first-time farmers looking to invest in a new business venture. These programs are often managed by the state agriculture department or similar authority.

View Aggie Bond Resources

Green Bonds
Businesses and governments issue green bonds to raise funds for a range of environmental projects. The issuer has to ensure that the proceeds from the sale of the bond are invested in green projects, such as renewable energy, energy efficiency, projects leading to reduced carbon emissions, etc.

View Green Bond Resources

The Bond Players

The bond finance process is complex and requires considerable oversight. In each transaction, there are variety of players critical to ensuring that the process is effective, efficient and conducted within the scope of the law. Almost all bonds that are issued by state and local political subdivisions are accompanied by the approving legal opinion of a recognized bond counsel law firm. Some of the key bond players are:

Bond Issuer: An organization that registers, distributes and sells a bond on the primary bond market. A bond issuer can be a private organization or a government.
Bond Counsel: An attorney or law firm retained by the issuer to give a legal opinion. The bond counsel's approving legal opinion gives investors assurance as to the validity, security, and tax-exempt status of the bond.
Underwriter: An investment bank or group which agrees to purchase an entire security issue for a specific price, usually for resale to others.
Trustee: A bank designated by an issuer of bonds to act as the custodian of funds and official representative of the bondholders.
Municipal Advisor: A consultant who advises the issuer on matters pertinent to the issue, such as structure, timing, marketing, fairness of pricing, terms and bond ratings.
Rating Organization: A rating organization provides a rating which gives indications of credit quality.

Understanding Bond Ratings

Bond ratings are determined by nationally recognized rating agencies such as Standard & Poor's, Moody's and Fitch to indicate an issuer's credit strength in a particular financing. The rating in effect speaks to the probability that bond investors will be paid in full and on time by the borrower. Bond ratings play a very important role in the issuance process because they determine the levels and interest rates at which bonds may be issued. Although each of the three major credit rating services may weigh each of the following general categories of credit analysis somewhat differently, they all rely on these basic criteria:

Debt Factors
Economic Factors
Administrative/Governmental Factors
Fiscal/Financial Performance Factors

These fundamental factors apply to all types of bonds, including both Government and PABs. Although bonds do not legally require a rating, market circumstances compel most issuers to have their large debt issues rated. Investors use the bond ratings to analyze the degree of risk that is associated with purchasing various public securities.

How Bonds are Sold

New issues of municipal bonds are sold by one of three methods: (1) competitive; (2) negotiated; or (3) private placement. After bonds are sold, most municipal bonds are traded in the secondary market. Unlike the corporate and stock markets, the municipal bond secondary market(s) are not formal. There is no institution like the New York State Exchange where sale offerings are publicly listed. Rather, the municipal secondary market rests on hundreds of broker dealers nationwide, who serve as agents for the buying and selling of perviously sold bonds, an over the counter market.

Summary

In relation to economic development efforts, the bonds outlined above represent the most concrete, readily available source of public finance. When issuing bonds, coordination among and between the appropriate bond players throughout the process is critical to a project's success. Moreover, PAB use has increased exponentially over the past two decades, and today, they serve as the primary source for financing many types of projects, including infrastructure, industrial development and urban development.