Bonds are debt instruments that come traditionally with a fixed interest rate, or coupon and is a loan transaction from an investor to a borrower, usually a larger entity such a government or corporate entity.
Municipal bonds are debt securities issued by cities, states, counties or countries to raise capital for infrastructure projects. The municipalities in need of capital can raise funds in primary markets via primary issuances of bonds. Once bonds are issued, they can be traded in secondary markets. Municipal bonds are associated with low risk and are often tax exempted making them especially attractive to investors (Narayanaswamy et al, 2017). In turn, they usually trade at better credit ratings, which are determined by a credit rating agency. The unit price and the minimum buy-in for municipal bonds are usually high providing a high threshold for potential investors. Municipal bonds are further categorised as General Obligations Bond (repayment via tax revenues) and Revenue Bond (repayment via revenues from the project).
Pooling Municipal debt to issue municipal bonds. In comparison to big cities, the cost of borrowing for smaller municipalities can be particularly high. By pooling municipal debts with other small municipalities, the overall borrowing cost can be drastically reduced. Municipal bonds on the pooled municipal debts are then issued by the local governments and are purchased by a bank specifically authorised by the national or state statute. The bank then pools all the bonds purchased and issues them at the national bond market. Financing authorities can then gain greater access to national and international capital markets with higher credit ratings, and lower credit risk for each individual Municipality (UN Habitat, 2009).
Advantages: These bonds allow the municipality to raise funds for public projects either independently or through coordination with bond agencies. As municipal bonds have very low-interest rates compared to other financings methods, they provide access to finance at a price that is lower than that of commercial debt securities. Comparing bonds and debt instruments such as loans, bonds usually raise larger sums, and the application of proceeds greatly depends on its stipulations. Municipal bonds can be used more independently for the purposes of covering a bigger portfolio, project or range of projects, therefore, permitting the project management to operate the project with more flexibility and independence in decision-making and capital allocations.
Disadvantages: Issuing municipal bonds may require extensive and costly preparation, such as obtaining a credit rating, acquiring approval from national securities authorities, and consulting with investment brokers, making these more suitable to larger municipalities or a collective of smaller ones. For this reason, many countries have municipal bond agencies, which aggregate debt from multiple municipalities, issue bonds, and sell them in the financial markets. With a high credit rating, agencies can raise capital for municipalities at a lower cost than would be possible if the municipalities issued the bonds themselves. Agencies of this kind are located in Sweden, Finland, France, Denmark, Switzerland, UK, and the Netherlands (ManagEnergy, 2017).
Projects that can be financed with this model: Most municipalities with access to a bond agency and a good credit rating can apply this model and use the proceeds according to stipulations for example for large infrastructure projects or a portfolio under a certain topic.
INNOVATIVE TYPES OF BONDS
Mini bonds are General Obligation bonds with a lower unit price as compared to municipal bonds. Mini-bonds are marketed directly to individuals without an underwriter serving as broker-dealer. The municipality assigns a firm to process the sale transaction, maintain the records and execute maturity payments. Mini bonds connect the taxpayers to the public projects, thus engaging citizens, increasing citizens’ access to municipal bonds, increasing the perceived equity of tax-exempt financing, and increasing social capital while funding capital projects. However, the role of mini bonds is often limited in scale as there are limited number of local investors and have high marketing costs (Ely, T. L. and Martell, C.R., 2016).
Green bonds are bonds issued by public entities, such as municipalities or other government bodies, to support climate and environmental investments attracting investors interested in positive social and environmental impacts, thus creating a greener portfolio. Alongside the standard financial characteristics, green bonds are additionally evaluated based on the positive environmental impacts the bond’s use of proceeds intend to be used for. Investor diversification, closer engagement with investors and raising awareness for the projects to be financed, are some of the benefits of green bonds to the issuers (World Bank Group, 2015).
To ensure transparency, alignment, reporting and disclosure, the Green Bond Principles provide guidance and the recent EU Green Bond Standard is the EU's approach to scale green investments and raise environmental ambitions.
Sustainability Linked Bonds
Sustainability linked bonds are bonds where the proceeds support projects with both environmental and social sustainability-related outcomes, such as affordable, energy-efficient housing or sustainable value chain creation. (Vanhuyse, F., et al., 2020). In a sustainability-linked bond, the issuer commits to future improved sustainability outcomes within a predefined time frame. Unlike green, social and sustainability bonds, however, a sustainability-linked bond has no restrictions on how the proceeds can be used (Waltré, N. et al, 2022). Sustainability-linked bonds aim at fostering the role of debt markets in funding and incentivising companies that contribute to sustainability.
The Sustainability-Linked Bond Principles provide guidelines that recommend structuring features, disclosure and reporting. They are intended for use by market participants and are designed to drive the provision of information needed to increase capital allocation to such financial products. The SLBP are applicable to all types of issuers and any type of financial capital market instruments.
ICMA. 2021/2022. "Green Bond Principles. Voluntary Process Guildelines for Issuing Green Bonds."
Narayanaswamy, Meera; Blitzer, Charles; Carvajal, Ana. 2017. The Importance of Local Capital Markets for Financing Development. EMCompass,no. 28;. International Finance Corporation, Washington, DC. © International Finance Corporation. License:CCBY-NC-ND3.0IGO.”
Novikova, A., Stelmakh, K., Hessling, M., Emmrich, J., and Stamo, I. 2017. Guideline on finding a suitable financing model for public lighting investment: Deliverable D.T2.3.3 Best practice guide. Report of the EU-funded project “INTERREG Central Europe CE452 Dynamic Light”, October 2017.
Todd L. Ely and Christine R. Martell. (2016). Costs of raising (social) capital through mini-bonds Municipal finance journal: the state and local financing and municipal securities advisor. - Kingston, NJ : Civil Research Institute, ISSN 0199-6134, ZDB-ID 1359156-3. - Vol. 37.2016, 3, p. 23-43
UN-HABITAT. (2009). Guide to Municipal Finance.
Vanhuyse, F., Chan, S. and Gill, T. (2020). Bonds Beyond Green: Results of the Scoping Study on Sustainable City Bonds. Stockholm Sustainable Finance Centre, Stockholm.
Waltré, N., Sjöström, E., Agerström, M., Vanhuyse, F. and Requena Carrion, A. (2022). The role of private market capital in financing sustainable cities: investor and municipal views in a Swedish context. Stockholm Environment Institute, Stockholm School of Economics, Cleantech Scandinavia.
World Bank Group. (2015). What are green bonds (English). Washington, D.C. : World Bank Group