The Cost of Bond Financing

ppp_logoI have worked on fiber projects where the project has a choice to finance something through municipal bonds or through commercial loans. Such projects involve a government entity as well as a commercial partner. These public private partnerships are becoming more common as cities are looking for fiber and commercial companies are looking for help getting projects financed.

I have always told people that financing through municipal bonds is the most expense kind of debt possible. People at first don’t believe this until I show them. Afterall, the interest rates on municipal bonds is generally a lot lower, and in today’s market, and depending upon the rating of the bonds involved, you see 4% or 4.5% interest on bonds versus 7.0% – 10% interest on the equivalent commercial debt. And so people assume that municipal financing is a better deal.

In fact, around the country when the large incumbents try to pass laws that make it hard for municipalities to get into the fiber business they generally list the ability to obtain municipal financing as one of the big benefits that municipalities have over commercial firms. However, as the following numbers show, this is not true. Consider a project that is going to build a $30 million dollar fiber network. The project is also going to ask for $2.3 million in working cash to cover operating expenses. Following shows the financing using a revenue bond and using commercial debt.

Revenue Bond  Commercial Loan
Assets to be Built $30,000,000 $30,000,000
Fees $900,000 $100,000
DSRF $2,700,000 $      –
Bond Insurance $300,000 $      –
Capitalized Interest $6,500,000 $      –
Construction Interest $1,600,000
Working Capital $2,300,000 $2,300,000
Loan $42,700,000 $34,000,000
Interest Rate 4.50% 7.00%
Term 30 15
Annual Payment $2,621,419 $3,733,017
Total Outlay $78,642,566 $55,995,259

The first obvious difference is that you have to borrow a lot more money with a bond. Here are some of the reasons:
• Bonds require you to take the money in a lump sum and then pay interest on the full amount of borrowing during the time the project is being constructed. Further, bonds generally require the project to capitalize interest, that is borrow the amount up front to make the first three years of bond payments. In contrast, a commercial loan generally uses construction financing, meaning you draw the money as needed and only pay on what you have borrowed.
• Revenue bonds generally require a Debt Service Reserve Fund (DSRF) which puts one year of debt payment into escrow as a hedge against the project having trouble making the bond payments.
• Bonds often also require bond insurance, which is a policy that will make a full annual payment to bond holders should the bonds default.
• Finally, there are huge fees associated with floating bonds. There are many attorneys involved as well as substantial payments to bond trading desks for selling the bonds.

In this example, the bond debt is $8.7 million higher than the equivalent commercial debt. Bonds typically have lower interest rates and longer terms than commercial debt, and in this example mean that the annual payments are $1.1 million less per year. But there is a penalty to be paid for financing anything over a long term (like your home mortgage) and that is that you pay a lot more out over the life of the loan. In this example, the total cash outlay is $22.6 million higher for the bond debt, which is a 40% cash premium to pay for using bonds.

Municipal entities generally use bonds for several reasons. First, bonds rarely require any equity and the borrower can borrow 100% of the cost of the project. But the main reason that municipalities use bonds is that they are comfortable with this kind of financing and they don’t know anything else.

The problem this causes is that everything that the government builds in this manner costs more than if a commercial entity built the same project. I said the above example was for a fiber network, but it could just as well been for a water processing plant, a new high school, a new court house or any other municipal project.

We have an infrastructure crisis in this country and all of governments added together are capable of only borrowing a small percentage of the money needed to build and fix everything that is needed. So we need to abandon the bond model of financing a lot more often and start looking at public private partnerships as a way to get things done.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s