A Brief Description of Municipal Bonds and Analysis of Municipality of Svishtov s Issue

Georgi Belovski

International Activities Director

Municipal Bank AG

No. 3/2000

Lately, the municipalities have demonstrated a great interest in seeking funding sources for their investment plans. The real transactions on the money and capital markets are very few. Bank loans have the largest relative share of municipal funding sources; however, given the significant demand and the municipal needs, they are insufficient by far. It is a well-known fact that lending in Bulgaria is based on loan funds from local sources that are typically very mobile and have a short maturity. Thus, the loan capital of all economic agents in the country is short-term, which impedes the investment process.

Bond issues, which by definition provide long-term financial resources, are an alternative funding source for the Bulgarian municipalities. The belief that a bond issue may be used for short-term re-financing is incorrect. World practice provides various examples but in general, the decisive factor when entering the bond market is the desire to attract long-term resources. This is due to the fact that bond issues exist as an alternative to bank loans that allows accumulation of free funds from a large number of investors who are willing to lend their money for the long-term and at higher yield.

Two Leva denominated bond issues and one Eurobond issue were issued by Bulgarian municipalities over the last ten years. A third one is to be emitted soon.

Experience shows that the bond issues sold at the domestic market are plagued by significant problems and rather have a negative impact on the willingness to invest in such instruments.

Some legislative changes are needed, in order to create a favorable environment for the development and the successful use of bond issues.

There are different opinions on the optimization of the legislation regulating the issue. Some economists want a separate act on municipal financing that would summarize all texts of existing legislation that regulate municipalities financing abilities. They believe that such an act would clarify the principles on which the municipalities will act as borrowers (regardless of whether they are financed through loans, bond issues or in some other way).

Another group of economists propose the municipalities to be treated as an equal business agent, without specific legislative texts that would regulate municipal re-financing. The idea is to have the municipalities in an equal position with the other players on the credit and capital markets.

At present, the second theory has more supporters. To prove this, the newly adopted Public Offering of Securities Act doesn t include any text regulating municipal finance. The Banking Act, despite its multiple amendments and supplements, also doesn t stipulate an individual approach towards the municipalities in their capacity of borrowers.

The issue of having an individual act on municipalities activities with regard to financial relations is controversial and is interpreted differently, depending on the position of the respective economic agent. To solve the issue, the national governments needs to rethink fiscal decentralization and the opportunities to help the municipalities by grants.

The current year will be extremely difficult financially for all municipalities in the country. The privatization plans are running out of steam, the local economy is dysfunctional, there is a lack of interest on behalf of foreign investors, establishing joint-ventures is quite difficult and the national budget grants were significantly reduced. The solution is to seek bank loans or to sell bonds to domestic investors.

This article will try to provide a brief description of the major aspects of a bond issue and to outline the mistakes related to Svishtov s issue.

Features of a Leva denominated bond issue

The table gives a very general information about bond issues and could be useful when comparing the indicators with those of bank loans.

In world practice, the use of bond issues by municipalities for re-financing purposes is allowed, if they can prove that their revenues are stable in terms of amount and regularity. Secondly, the municipalities must have a detailed investment plan to prove the need for funding. In Bulgaria, the application of these principles is limited by the following:

- At present, only the largest municipalities in the country have the ability to successfully issue bonds. This is due to the fact that they have on their territory financial and non-financial institutions, large population and a large number of companies, all of them directly interested in the development of regional infrastructure and potentially willing to invest in bonds.

- Larger municipalities have more stable and regular revenues and are more likely to be trusted by potential investors.

I believe that the above peculiarities were among the factors that explain the failure of Svishtov s issue.

The start of the bond market after the enactment of specific legislation (Securities, Stock Exchanges and Investment Companies Act) was to be marked by an issue of a large Bulgarian municipality.

Nationally, the Municipality of Svishtov is among the less significant municipalities and that also contributed to the low interest in its bond issue. Overall, the issue can be considered unsuccessful as the funds were generated after the subscription as postponed and municipal companies resources were committed. Unfortunately, there was almost no interest in this issue and only the fact that municipal companies that were forced to subscribe generated the minimum amount required in the prospectus. This is definitely not the way to develop the bond market, as by definition bonds are aimed at attracting resources from sources that are external to the municipality.

Another important reason for the failure of this issue is its inadequate marketing strategy:

1. The selected investment intermediary didn t have offices in the country that could advertise the project.

2. The actions of the municipal administration in general, and of the mayor in particular, also didn t contribute to the success of the issue. World practice has demonstrated that the mayor and his team play a key role in convincing potential investors in the effectiveness of the project that is to be funded through the issue. In practice, this promotion process begins with the decision to issue bonds and continues until the beginning of the subscription. There is a key period involving a road show of the project; during this period, the mayor and the municipal expert team meet with hesitant institutional investors to justify their project.

3. The general advertising campaign included irregular announcements in specialized economic editions (The Banker, The Capital) and didn t reach the general audience.

As a result of these mistakes, the issue was promoted only in the Svishtov region and could only rely on local interest and resources. The opportunity to accumulate resources from the whole country was disregarded.

It is recommended that when a decision is made to issue bonds, the investment intermediary should have a well-developed network within the whole country (t best, that would be a bank) which will allow a maximum number of capital market players to learn about the project. It is hardly a secret that the subscription serves only to register the deals that have been contracted beforehand. The use of banks as investment intermediaries is beneficial, as they have both large networks of offices throughout the country and at the same time are represented at highest level in the Association of Commercial Banks and the Association of Investment Intermediaries. The direct, management level contacts with such a large number of financial and non-financial institutions would enhance the promotion and the sale of the issue.

Also, the banks are depositories or provide direct services to the retirement funds, which are the most stable investors in securities. This function of the banks is the most natural link between the bond issue and the retirement funds.

A significant drawback of Svishtov s bond issue was the irrationally selected yield calculation method. The inconsistency of the yield of the proposed issue and the yield of government securities with a similar maturity, as well as the sale of bonds under par, made them an asset of low yield and high risk.

When calculating the yield, it is recommended to consider the fact that investors are more interested in a higher interest (coupon) that that of government securities, as the risk of default for the municipalities is considerably greater than for the Ministry of Finance.

The Bulgarian bond market will develop and will be enriched in terms of the preparation stage, the sale of bonds and debt repayment. To achieve this, however, it would be necessary to:

have the Securities Committee unify its project evaluation criteria;

have the insurance companies develop credit risk insurance practices, which will discourage the practice of mortgaging or pledging municipal assets;

give the municipalities the right to use their future cash flows as a collateral on their debt, etc.

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This article expresses the personal opinion of Georgi Belovski and does not commit the Municipal Bank in any way.