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The Case for Microbonds

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The Case for Microbonds

A financial tool that could help cities achieve a sustainable fiscal recovery June 8, 2020
Covid-19
Cities
Economy, finance, and budgets

The current urban-financing crisis could finally make “community microbonds” a serious alternative to traditional municipal bonds. For several decades, municipal issuers have used minibonds—sold in increments significantly less than $5,000—to access a broader group of potential investors and avoid the fees associated with a standard bond issuance. Microbonds refer to bond denominations of $100 or less, but there is no common industry standard for the term. In fact, some issuers elect to use the term minibond to refer to bonds denominated in increments as low as $25.

Designed to be affordable, microbonds are sold in small denominations, opening the door to what advocates call “community-powered finance.” The community can select and fund local-scale projects, such as parks, public art, local clean energy, and affordable housing, while providing investment opportunities for historically marginalized populations. Low-cost interest-bearing instruments aid wealth creation by turning low-income consumers into investors.

Ben Bartlett, a long-serving city councilmember in Berkeley, California, is one of many local government leaders worried about municipal budget stress. He’s especially concerned about declining city revenues, degrading city infrastructure, and increased capital concentration. Bartlett, however, thinks that Covid-19 has “also accelerated many of the changes people have been discussing for years.” Futuristic innovations like telework and telehealth “have become the new norm.”

Bartlett is convinced that “coronavirus impacts will be felt in the world of money,” especially public budgets. He believes that the “solutions will not come from Washington, D.C. or New York City. We are in virgin territory here, and the innovations we need will only arise through local experimentation.” According to Bartlett, and some of his Berkeley city council colleagues, microbonds “offer a quick, flexible, and targeted mechanism for communities to rebound.” He believes that once the “all clear” is sounded, the “community itself is more likely to respond quickly and intelligently to the opportunity to rebuild than the traditional buyers of municipal bonds.” A significant attraction of microbonds, Bartlett holds, is that they “help communities put the resources where local voters and their local representatives see the most impact now.” Tax exemption has been another main attraction for investors in municipal bonds. Fortunately, the federal government has determined that the tax treatment for microbonds will be the same as the favorable tax treatment received by munis.

When selecting a project to finance through minibonds, issuers tend to focus on smaller, defined projects that have a tangible connection to the local investor base. The objective is to maximize local investor participation by selecting an easily identifiable project that would interest and benefit the community. Minibonds have been used for several decades by municipal issuers to access a broader group of potential investors and avoid the fees associated with a standard bond issuance. In 1990, Mission Viejo, California issued minibonds in denominations of $500 to finance a portion of renovations to the city hall. The minibond issuance had 35 orders, ranging from $500 to $30,000, raising $140,500 toward the project. The city ended up supplementing the financing with traditional municipal bonds sold through a public offering. In 1991, Anaheim issued $3.4 million in minibonds. These were issued as zero-coupon bonds (meaning that the bonds were purchased at a discount and bond owners were paid the face value of the bonds at maturity). Unlike many other minibonds, these were not issued as part of a larger financing. Over the last half-decade, there have been minibond issuances in the cities of Vancouver, Washington; Burlington, Vermont; Lawrence, Kansas; Cambridge and Somerville, Massachusetts; and Madison, Wisconsin. Each of these cities is home, or near, to a major university or college. A key consideration for issuing minibonds is community engagement; one participant in the financing of these minibond issuances remarked, “communities that are innovative and engaged are usually college towns. They are the ones with the most participation.”

Recent minibonds have been sold through two primary channels: either directly from the municipal authority or electronically through an underwriter’s retail-distribution network. Due to the complexity of developing an online ordering system, issuing directly from the municipal authority typically requires mailed-in or physical orders, the physical transfer of the bond certificates, and the submission of certificates by bond holders to the municipal authority to receive payment. The minibonds of the early 1990s were sold through this method. Denver’s minibonds, which made headlines in 2014 for selling $12 million in debt in 20 minutes, were issued directly by the city; orders were delivered online, by mail, and by hand delivery. Denver offered the bonds for sale online two hours before they began accepting mailed-in or hand-delivered orders. As a result, some residents expressed frustration that the bonds sold out before any physical orders were processed.

Until the pandemic hit, the assumption had been that municipal issuers were trustworthy—and that the projects for which they float bonds were worthwhile. Transparency and financial reporting requirements for regular muni bonds are now clearly inadequate. This has led to some very bad kinds of bond offerings, including pension-obligation bonds and capital appreciation bonds. These will haunt municipalities for many years to come. Some will ask whether, and how, financial transparency will be any better for microbonds, and who, if anyone, would rate them or oversee them. So far, nothing has been determined. Microbonds are a new category of borrowing, with no special rules (voluntary or mandatory) applying to them, yet.

In order to maximize community engagement, cities can restrict the bond sale to city or county residents, though this increases the chance of failing to raise enough money. To mitigate the risk of a funding shortfall, a city could consider a priority-sale period for city residents followed by a broader sale period to the general public—statewide or nationwide—to ensure that the full amount is sold. It’s worth noting that if a city seeks to limit the maximum amount of the minibonds that can be purchased by any one investor—to avoid a situation where a trust or other institutional fund buys the bonds through a retail account—there is an increased risk of a funding shortfall.

At a moment when many cities face extraordinary fiscal pressures, microbonds can offer a creative means of raising money from local stakeholders, who are already invested emotionally and physically in the community.

Photo: gregobagel/iStock

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