The widespread financial troubles facing state and local governments, and their growing budget deficits, have brought the municipal market under increased scrutiny.

Government finance officers must fund infrastructure projects and provide essential services with less federal aid and lower tax receipts. Even some municipal bond investors are questioning the safety of their investments.

As government finance officers manage their way through this current fiscal crisis, several key questions have emerged. How will the tax-backed market change? What new financing techniques will appear? How will issuers tap limited insurance capacity? How will investors view the market at the end of the decade?

To answer these issues, here are several predictions of how government finance officers will come to grips with their growing capital needs in the years ahead:

* We will see a boom in lease and special tax structures.

The tax-backed market will diversify away from plain-vanilla general obligation bonds to more exotic lease structures and special tax pledges. Leasing capital projects such as schools or prisons will grow in popularity as finance officers maximize their financial flexibility and take advantage of structures more likely to match the useful life of the assets that are being financed.

Look for a proliferation of special tax issues as well, as municipalities restructure their GO debt to improve market access and increase their ability to obtain bond insurance. More and more issuers will structure special tax issues by either carving out user fees or an income tax from the general fund (i.e, Massachusetts) or pledging a sales tax first to bondholders before it becomes part of the general fund.

Over the next few years, this diversification and restructuring of security features will become an even greater necessity for frequent municipal issuers. The market has only so much appetite for any one credit. For example, the heavy slate of new-issue California debt may cause a rise in yields for California issuers, despite the reaffirmation of their triple-A ratings.

* There will be a greater demand for bond insurance.

Accelerating retail investor demand for insured securities, financial difficulties of many municipalities, and the use of new financing vehicles will drive demand for municipal bond insurance to record levels. Rising credit concerns will continue to stimulate investor preference for insured issues. For the first quarter of 1991, insurance reached 27% of the market. It could rise to over 30% in a few years.

The increasing complexity of municipal financings, even GO issues, will also produce an increased use of insurance. By simplifying the story, insurance makes securities more marketable to retail investors, the dominant buyers of municipal bonds. This is particularly true for more unusual structures such as lease and special tax issues.

Special Tax Structures

In addition, issuers will utilize special tax structures to qualify for insurance. Since special tax issues can be rated higher than an issuer's GO debt, this structure helps improve the credit rating of lower-rated issuers so they can become eligible for insurance.

Larger issuers will also use special tax structures to maximize available insurance capacity. Since insurers may consider pledging a particular revenue tax stream to be a different credit, financial guarantors might be willing to take on more capacity of that issuer.

* Major states and cities will seek credit management.

Forced to tighten their belts another notch, financially squeezed municipal issuers will use bond insurance to pare borrowing costs. In addition, faced with widening budget gaps, more highly rated issuers will be downgraded into the "insurable" range.

As a result, major cities and states will seek bond insurance for the first time. For example, Pennsylvania has recently benefited from the use of such insurance, and Washington State recently sought insurance for its government office lease issue. Even triple-A rated Dallas used insurance on its civic center issue. Other likely prospects include Connecticut and Boston.

* New levels of credit enhancement will develop.

Not only will there be a greater use of bond insurance, but other levels of credit enhancement will continue to grow. The Texas Permanent School Fund, rated triple-A, and existing school and intercept funds in such states as Michigan will be copied in states as conservative as South Dakota.

Even though many of South Dakota's programs may receive only an A rating, municipal issuers will reduce their interest cost expense and investors will receive a better level of security. Similar developments are taking place in Georgia. It may not be long before many states use their credit strength to help achieve educational goals and to equalize and redistribute sate aid among school districts.

* "Investor relations" will become an important factor for municipalities.

The 1990s will bring increased responsibilities for government finance officers as investor relations, traditionally associated with public held companies, are added to their job description.

Municipalities will develop comprehensive programs to educate and communicate with investors to ensure strong demand for their debt offerings. Government finance officers not only have to be more savvy about municipal finance matters, but also be able to work effectively with Wall Street and potential investors.

* The inherent strength of the municipal market will be reaffirmed.

All recessions end, and the current one will be no exception. Eventually, an improving economy and tight budget controls will result in surpluses and improving credits.

Within the next few years, most bond buyers will realize what most municipal analysts already know -- municipal bonds maintain a remarkably strong track record of repayment. As the recession ends and credits recover, it will be clearer than ever that the only security better than a quality municipal bond is the full faith and credit of the United States government.

Mr. Budnick is senior vice president and director of tax-backed utilities and structured finance products at Municipal Bond Investors Assurance Corp.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.