CREDIT PROBLEMS OF SMALL MUNICIPALITIES*

The Market for Bond Issues of Small Municipalities

Long-term municipal debt outstanding totals in excess of 29 billion dollars.1 In the nine-year period 1957-65, such debt increased by approximately 1.4 billion dollars a year, and there is every indication that municipal debt outstanding will continue to increase at no less a rapid pace in the future.

With few exceptions, the nation's cities, like its citizens, are compelled to borrow in order to obtain funds for the construction and acquisition of capital facilities. However, unlike private citizens who can secure loans with relative ease at fixed interest rates, small municipalities, particularly those having less than 10,000 inhabitants, often are penalized, solely on the basis of their size, in the rate of interest they must pay. This occurs in spite of the fact that the degree of credit risk involved is not an intrinsic characteristic directly attributable to size alone.

The average annual net interest costs of bonds in the "A," "B," and unrated categories for municipalities having less than 10,000 inhabitants and for municipalities having 10, 000 to 250,000 inhabitants are compared for the five-year period 1961-1965 in Table I on the following page. In each year, the average annual interest costs paid by smaller municipalities exceeded the average costs paid by the larger municipalities. Application, on a monthly basis, of the Bond Buyer Index to the various categories of bonds shows that the time of sale is not a significant factor contributing to the consistently lower net interest costs enjoyed by the larger municipalities. Table II shows the difference, expressed in basis points, ** between the average annual interest costs of small and medium sized municipalities as a deviation from the Bond Buyer Index. In each case, the adjusted interest costs for the medium sized municipalities are less than those for the small municipalities. The difference varies from 4.0 to 79.9 basis points depending upon the year and the type of bonds.

*This paper was prepared by David R. Berman and Lawrence A. Williams of the National League of Cities' Urban Studies staff for the Subcommittee on Economic Progress, U.S. Congress Joint Economic Committee, Congressman Wright Patman, Chairman. It appears, slightly abridged, in a Joint Committee Report. See U.S., Congress, Joint Economic Committee, Subcommittee on Economic Progress, State and Local Public Facility Needs and Financing, Vol. 2, 89th Cong., 2d Sess., 1966.

**A "basis point" is one-hundredth of one percent of the bond yield. Each basis point constitutes $0.10 in interest per year on a thousand dollar bond. On a $500,000 bond issue, maturing serially over 20 years, an increase of 25 basis points in the interest rate increases interest payments by $13, 125.

Source: Investment Bankers Association of America very kindly provided the raw data on a monthly basis. The data were converted to an annual basis because the number of issues marketed in some months provided too little material upon which to base conclusions. See Appendix A for a presentation of the data on a monthly basis.

TABLE II

AVERAGE ANNUAL DEVIATION OF NET INTEREST COSTS FROM
BOND BUYER'S INDEX FOR "A," "B," AND UNRATED BONDS
FOR SMALL AND MEDIUM SIZED MUNICIPALITIES

Source: Calculations based upon data provided by the Investment Bankers Association of

America and from the Bond Buyer's Index of 20 Municipal Bonds.

Factors Causing Discriminatory Treatment

Several interrelated factors tend to cause such discriminatory treatment. First, small municipalities market bond issues at infrequent intervals, and these issues usually involve only a limited number of bonds of relatively small total dollar amounts. However, overhead costs incurred in marketing an issue of small dollar amount is not proportionally less than the cost incurred in marketing a sizable issue. As a consequence, market costs per bond are higher for small issues, because the "spread"* is greater for a small issue than it is for a large issue. Major bond buyers, such as insurance companies and commercial banks, usually prefer to purchase bond issues that are large in total dollar amounts because larger issues are generally easier to trade. Thus, bond issues of small municipalities are relatively more costly to market, and less attractive to investors, than are the issues of large municipalities. Second, large municipalities generally can provide quickly and accurately the detailed financial information needed by bond dealers and buyers for an analysis of investment possibilities. Third, small municipalities usually cannot afford to employ the experienced legal and financial advisors necessary to guide the bond issue through the intricacies of the bond market smoothly and effectively. Finally, the influential bond rating services, that evaluate municipal fiscal responsibility, usually will not rate bonds of political subdivisions unless such units have at least a specified minimum amount of debt outstanding. For example, Moody's has followed a policy of not rating debt of governmental subdivisions unless debt outstanding totals $600,000 or more. Standard and Poor's does not rate governmental subdivisions having less than $1,000,000 in debt outstanding. Such policies probably reflect the general lack of interest in the bond issues of small municipalities, and the difficulty in securing detailed financial data from such units. The absence of a rating tends to decrease still further bond buying interest.

The lack of interest by the large, nationwide investors forces small municipalities to seek a market for their bonds in the immediate area, competing for the limited amount of local investment capital with other investments that yield greater returns than do tax-exempt municipals. A large number of small issues are sold to local bankers who feel that their local government should "get at least one decent bid."2 At other times:

A local investor with little expert investment knowledge and considerable
mistrust of the central capital markets may be quite willing to invest in
local municipal obligations even though his use of tax exemption is slight.
3
Local pride and sentiment may support such action.

Usually only a few people in the community are in a high enough income bracket to take advantage of the tax-exempt feature. Thus, issues marketed locally frequently must offer a yield approximating the yield offered by taxable securities.4

*The "spread" is the difference between the amount offered for the issue by the underwriters and the price of the issue to the issuer, and serves as compensation to the underwriters for the costs and risks of floating the issue.