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Municipal Bonds 101: A Primer on Issuing General Obligation Bonds

By John Utley

Book cover with a dollar signIf your city needs to make a major capital improvement — such as upgrading its water treatment plant — it may issue general obligation municipal bonds to pay for that project. Issuing municipal bonds is one of the most common ways for cities to finance capital improvements.

When a city issues municipal bonds, it’s equivalent to taking out a loan from one or more lenders. The city must agree to secure and repay the loan. According to the online publication The Bond Buyer, in calendar year 2020, cities and towns in Minnesota sold municipal bonds in an aggregate principal amount of $1.38 billion (via 255 separate bond issues).

Two types of bond sales

Cities don’t sell their municipal bonds directly to the general public. Bonds are sold to underwriters who, in turn, sell the bonds to investors. A competitive sale and a negotiated sale are the two methods by which a city will sell its bonds to an underwriter for reoffering to the public.

In a competitive sale, the terms are set by the city, and underwriters may bid on the bonds at a specific time. The bonds are then awarded to the bidder offering the lowest interest cost to the city.

In a negotiated sale, an underwriter is selected to purchase the bonds, and the terms are negotiated by the underwriter and the city. The underwriter then sells the bonds to its investor customers.

On rare occasions, a city may sell its bonds directly to a financial institution that will hold the bonds indefinitely for investment purposes.

Competitive bond sales offer several advantages over negotiated sales. A competitive sale typically assures the lowest interest rates and the lowest underwriter fees. The Government Finance Officers Association recommends the use of competitive sales whenever feasible. As a result, about 80% of general obligation bond sales in Minnesota are made through competitive sales.

Legal limitations

The state Legislature has granted broad powers to cities to issue general obligation bonds. The most important state law dealing with municipal bonds is Minnesota Statutes, Chapter 475, which authorizes the issuance of general obligation bonds for a broad array of capital improvements.

State law also imposes various limitations on the issuance of general obligation bonds. For example, there are limitations on the purposes for which bonds may be issued. Capital improvements, such as streets, utilities, and municipal buildings and equipment, are authorized, but working capital expenses, such as the payment of salaries, are not authorized.

In addition to statutory limitations, the municipal bond industry is also subject to federal and state income tax laws (for those bonds issued as tax-exempt obligations) and federal and state securities laws.

Outside assistance is key

Most cities don’t issue general obligation bonds very often and, therefore, they usually don’t have staff with expertise in this area. A city obtains this expertise by contracting with a municipal advisor who is knowledgeable about the financial status of the city and the requirements of the municipal bond market. Municipal advisors are required to be registered with the Municipal Securities Rulemaking Board.

Another outside expert the city will need when issuing bonds is a bond counsel — a law firm with expertise in the laws related to municipal bonds. Underwriters require the participation of bond counsel for all publicly offered bond issues.

The function of bond counsel is to provide a legal opinion that (1) the bonds are legal, valid, and binding obligations of the city, enforceable in accordance with their terms, and (2) interest on the bonds is not included in gross income for income tax purposes (as applicable).

In order to be in a position to deliver these opinions, bond counsel prepares the legal documentation under which the bonds are issued. There are a limited number of law firms in Minnesota that are qualified to issue bond counsel opinions. General obligation bonds are not marketable unless their issuance is accompanied by an opinion of qualified bond counsel.

Additional participants commonly involved in general obligation bond issues include rating agencies, paying agents, dissemination agents, and others. Because of the many players involved and the level of expertise required, it’s important for the city to contract with qualified professional service providers for municipal bonding.

John Utley is a bond attorney with the law firm of Kennedy & Graven, Chartered (www.kennedy-graven.com). Kennedy & Graven is a member of the League’s Business Leadership Council (www.lmc.org/sponsors).