Municipal bonds are debts issued by local government bodies, principally to fund capital expenditure. Like Government stock, they are traded.
These bonds were used by local authorities in the UK for much of the Twentieth Century but in the 1980s they largely fell out of favour as their interest rates were being undercut by those charged by the Public Works Loans Board which, until October 2010 was able to lend at gilt rate plus 0.2% per annum. In 2010/11 the PWLB had lent £11.1bn.
The Comprehensive Spending Review of October 2010 increased the rate at which the PWLB could lend to local authorities to gilt rate plus 1% and cut back volume of funds available from the PWLB, which is expected to reduce lending to £6bn in real terms by 2014/5. Given these higher interest rates local authorities can potentially borrow directly from the bond markets at a more competitive rate.
Municipal bonds are a liability of the issuing authority but can be secured by a specific cash flow (such as the rental stream from social housing). In theory the holders of municipal bonds have access to council tax proceeds in a default position.
Local Authorities are required by the 2003 Local Finance Act only to undertake “prudential” borrowing.
Examples of Municipal Bonds issued in other countries:
- 1 Sweden: Kommuninvest, part of the Co-operative movement, is triple A rated and borrows using bonds. It lends the funds to 260 local authorities to fund such projects as roads and renewable energy. Its target in 2012 is to lend £17bn
- 2 Finland: Munifin was established in 1990 and is owned by the Government and the body which arranges public sector pensions. It has so far lent £11bn to local authorities and bodies, with 39% of the funds going to provide housing
- 3 New Zealand: The Local Government Funding Agency was set up in 2011 and is owned by 18 local authorities. It already has a better credit rating than any NZ bank
- 4 USA: the municipal bond market here extends to some $2,800bn but has recently been rocked by defaults frequently arising from the problems in the housing sector. Illinois has so far issued over £13bn of bonds to shore up its public sector pension fund. In the USA such bonds are sometimes issued on the basis that no tax will be paid on the interest paid on the bonds – leading to the ability to issue bonds at very low interest rates
- 5 France and Germany are expected to shortly move to this market
A UK case study: Birmingham has the benefit of a triple A rating from Moodys and AA+ from Standard and Poors (a better rating than Germany!). It has recently issued £215 m bonds to refinance its stake in the NEC.
However it plans to borrow £75m from the PWLB to improve energy efficiency in 60,000 council homes. Birmingham has £2.5bn of debt, up from £1bn in 2004, with funds used to remodel the city library, redevelop New Street station, buy the Pallisades shopping centre and to upgrade housing stock.
Meanwhile, Southampton Council is looking to set up a co-operative arrangement to borrow £100m in municipal bonds. It would share the funds with other local authorities and so far has had expressions of interest from Portsmouth, Dudley, Eastleigh and Chesterfield.
Wandsworth and Guildford have recently obtained credit ratings in readiness for the issue of bonds.
Greater Manchester is expected to issue over £500m of bonds via its Transport Authority to fund the cost of its tram network.
Transport for London has issued £600m bonds towards the funding of Crossrail.
In theory funds investing in municipal bonds may consider these as part of their general allocation of investment in bonds. This will include Government stock which carries the finest credit rating.
So municipal bonds should always carry a higher interest rate than gilts. It may be that local authority pension funds could be encouraged to look favourably at investing in municipal bonds but they can only do this as part of their wider prudential approach to investment.
Michael Lister is Chairman of the LFIG Treasury Policy Group