The Real Cost of Money

Money cash

Money cash (Photo credit: @Doug88888)

I have often heard it said that municipal bonds are cheaper than bank loans. This is an argument rolled out by incumbent telephone and cable companies all of the time when they are trying to stave off competition by a municipal provider. Many times I’ve heard the argument that governments have an unfair advantage over commercial firms in that they can raise cheaper money through bonds.

But I have been recently working with some municipal entities and also some public / private partnerships and I think that argument is dead wrong. It looks to me like bond money is some of the most expensive money in the market.

It’s always been easy to make the argument that government money is cheaper due to municipal bonds having lower interest rates. And that is true. Historically municipal bonds have had lower interest rates. There has always been a spread between bond rates and commercial lending rates and bond rates almost always have lower interest rates. But interest rates are not the only cost of money, and so to make a comparison between the two kinds of borrowing based only upon interest rates is not telling the real story.

There are numerous other costs associated with borrowing large amounts of money. It’s easy for the average person to be able to think of loans in terms of interest rates, because when somebody uses a credit card or buys a car there are no additional costs of money other than the interest. But when somebody wants to borrow large amounts of money like what is needed for a major telecom project, then there are extra costs, much in the manner that there are closing costs when you get a mortgage on a house.

The true cost of money is the costs incurred to borrow the money and to administer the payback. Following are examples of some of the extra costs associated with borrowing large amounts of money:

  • Application Fees. For a large borrowing there is typically the requirement for a business plan. But bonds also require an additional document be prepared that is the equivalent of an offering document when a commercial firm sells securities. These documents can come with a significant cost, in the hundreds of thousands.
  • Legal Fees. Both commercial and municipal borrowing include legal fees. But the legal fees associated with bond financing are generally much larger than the costs associated with a commercial loan. Bonds are more complicated, and in some cases can be contested by the public, so there is a lot of additional due diligence done for bonds to make sure they will succeed. And if the bonds are challenged legally there can be a huge legal cost.
  • Referendum Costs. Many kinds of bonds require a vote of the public to be approved and getting a bond question onto a ballot can have a significant cost, particularly if this is not done at the time of a major general election.
  • Capitalized Interest. Bonds generally hand over the entire amount to be borrowed on day one. The bond borrower then has to pay interest on the whole balance from the start of a project. If the revenues associated with a bond don’t start right away (like with telecom projects), then it is typical for the borrower to have to borrow the first two to four years of interest payments. This can significantly increase the cost of the borrowing. For example, on a $50M project, capitalized interest can range from $5M to $10M, which is a 10% to 20% adder to the cost of the project. Commercial loans generally us a construction method where the borrower only draws the loan as it is needed, which greatly reduces the early year interest costs.
  • Debt Service Reserve Fund. Many bonds also require a debt service reserve fund. This is an amount of money set aside to pay bondholders in case the borrower is unable some year to make the full bond payments. It’s not untypical for this to be set at a full year’s interest and principal payment, adding another 3% to 5% to the total cost of the borrowing.
  • Bond Insurance. Some bonds also require bond insurance. This is an amount paid up front at closing to an insurance company that will guarantee some payments to bondholders in case of a default. The insurance rates typically run 1% to 2% of the total project.
  • Escrow Fees. Almost all bonds, and some types of commercial loans require an intermediate escrow company to gather payments monthly in order to make periodic payments to bondholders of lenders. Additionally escrow companies are used to hold money such as the debt service reserve funds or capitalized interest.
  • Reporting and Administration. Most large loans have costs of reporting results to the borrowers in some manner.

When considering all of these costs it is not unusual for a municipal telecom project to have much higher financing costs than an equivalent commercial project. When considering all of these costs it’s not hard to find municipal projects where the total cost of financing is 12% to 18% of the project. It’s rare to find a commercial loan these days where the all-in costs even hit 10%. I’ve recently seen some public / private partnership deals where bringing in commercial money has greatly lowered the cost of borrowing compared to traditional bond financing. So forget interest rates. It’s the whole cost of getting and paying back the money that matters.

Public Private Partnership Financing

Wipe our Debt

Wipe our Debt (Photo credit: Images_of_Money)

Yesterday’s blog talked about finding partners for telecom ventures. Today I want to talk about a specific kind financing. Commercial companies have often complained that municipal telecom ventures get an advantage because they can borrow with bonds instead of normal commercial loans. And this makes me laugh because having worked with a lot of ventures financed in both ways I can’t see any particular advantages to bonds over commercial loans.

It has always been generally assumed that because bonds normally carry a lower interest rate that they are a far better deal than a bank loan. But let’s look at the realities of bonds used for telecom projects:

  • Bonds do generally have lower interest rates. But looking back over the history of commercial versus bond financing, the spread between the two interest rates in has usually not been very big. Certainly when we hit market conditions where there is a big benefit for tax-free bond interest rates then bonds can be a really great deal, but this has generally not been the case.
  • Bonds require that you borrow all of the money up front, meaning that everything you borrow goes into escrow and you begin paying interest on the money from the day you close on the bond. Commercial loans generally start projects with construction financing, meaning that you only take the cash as needed by construction and only pay interest on the money that has been borrowed.
  • It generally takes around three years for a new telecom venture to get a positive margin, and so a normal aspect of bonds financed for this purpose is capitalized interest. This means that the borrowing must include the funds required to make the interest payments, and often principle too, for the first three years of the project.
  • Many bonds have required the borrower to have a debt service reserve fund. This is essentially self-insurance to hedge against a default and normally this would mean doing something like borrowing an extra amount of money equal to a year’s principle and interest and keeping it in escrow against a time when there might be a full or partial default on bond repayment. And this money accrues interest expense for the entire term of the bond.
  • Depending upon the bond credit rate of the borrower, some bonds also require bond insurance. This is similar to the debt service reserve fund and has the borrower taking out an insurance policy that will guarantee one year’s payment on the bond in case of default. These policies are paid in full upfront at the beginning of the bond. I have seen bond issues that have both a debt service reserve fund and bond insurance.
  • Bonds have longer terms. It is not unusual for bonds to have terms of at least twenty years and I have seen bonds as long as thirty years. This is a mixed blessing. While having a longer term lowers the payments a little each year, the new business is saddled with debt for decades. In the long run this keeps the pressure on a bond-funded venture to always perform to a pretty high level. However, once any business is debt free they can perform at a lower level and still be quite successful without having to cover debt payments.
  • There are significant fees to be paid up front to sell bonds. There are bond sellers who specialize in finding buyers for bonds, but they charge a significant fee up front. The legal expenses requires to issue bonds are generally also much higher than the costs needed to borrow commercial debt.
  • When taken as a whole, these various items add costs to a bond issue and it’s not unusual to see the size of a bond issue be 20% to 25% higher than an equivalent commercial loan. That extra borrowing generally more than offsets the savings from interest rates and in reality I think that bond financing is generally more expensive than commercial financing.

Because of this there is a big opportunity for public private financing. If a venture can get funds from both sources through a public private partnerships then you can benefit by the best of both worlds. Consider, for instance a financing that is 1/3 bonds and 2/3 commercial. It would have the following advantages:

  • The bond money could act as equity and mean that no other equity is required for the project.
  • The smaller bond size means relatively small capitalized interest and other bond costs.
  • Some of the project is spread long-term with the bulk being medium-term, making it easier to make debt payments in the early years.
  • The bond can be used to cover the early debt payments on the commercial loan, eliminating the need for capitalized interest.
  • Construction can be done using normal construction debt financing.

I recently looked at a structure like this for a client and this public private financing looked to be superior to both normal bond and normal commercial financing. So there is a strong financial incentive for telecom partnerships between commercial and public entities.

In my next blog I will talk about what it takes to be good partners. It’s not always easy.