City of Johannesburg Johannesburg Innovation and Knowledge Exchange (JIKE)

Transcription

1 City of Johannesburg Johannesburg Innovation and Knowledge Exchange (JIKE) Best Practice Case Study: The Municipal Bond Issue Final Draft March 2005

2 Contact Details Contact Michael Goldblatt Postal address Postnet Suite #259, Private Bag X30500, Houghton, 2041 Physical address 7 St Davids Place, Parktown, Johannesburg Telephone (011) Facsimile (011) Cell phone mike@pdg.co.za

3 Best Practice Case Studies: The Municipal Bond Issue i Preface Palmer Development Group was commissioned by the Johannesburg Innovation and Knowledge Exchange (JIKE) to carry out three case studies: on an innovation, an example of best practice and a challenging project where particular lessons have been learnt by the municipality. The purpose of the case studies is to document experience in the City of Johannesburg and share approaches to service delivery both internally as well as with other municipalities. The case study that follows focuses on the process and impact on the City of Johannesburg of instituting an international best practice approach to accessing funding - the issuing of two municipal bonds.

4 Best Practice Case Studies: The Municipal Bond Issue ii Contents 1 Introduction 1 2 Baseline Financial crisis Institutional arrangements Investor confidence 2 3 The idea Objectives What is a municipal bond? Institutional bond Retail bond First bond - COJ Second bond - COJ Implementation Planning Establishing Treasury Study tour of international best practice Political support year funding plan Implementation Appoint advisors Appoint underwriters and guarantors Road shows Book building 6 5 Impact Bond performance Over subscription Creation of a market Bond performance in secondary markets Financial performance Finances stabilise Capital expenditure Decreasing the infrastructure backlog 9 6 Conclusion 10 References 11

5 Best Practice Case Study: The Municipal Bond Issue 1 1 Introduction When Jason Ngobeni first joined the City of Johannesburg as the first Treasurer he was excited about starting to play a role in confronting the large infrastructure backlogs he knew the City faced. He was surprised, however, to discover that one of the major problems for Treasury was that they were finding it increasingly difficult to raise the kind of funding necessary to start making inroads into providing basic services to all residents. Putting in place a strategy to ensure that financing could be accessed by the City became the baton the new Treasurer would pick up from his seniors with the enthusiasm and determination necessary to lead the team to victory. This involved establishing two municipal bonds that would ensure access for the municipality to large funding sources. Many municipal role players describe the drive of the Treasury team as being pivotal to establishing this international best practice approach to providing options for selecting funding strategies (Interview, Member of the Mayoral Committee - Finance, Strategy and Economic Development (FSED), 2005). 2 Baseline 2.1 Financial crisis The financial environment between 1996 and 2002, prior to the establishment of the two municipal bonds, was characterised by crisis. Poor financial planning, inefficiencies and overspending had by 1997, thrust the City into bankruptcy. Capital expenditure decreased from over R1.2 billion in 1997 to less than R220 million in 2000 (Peter Honey, Financial Mail, 2005). There was an R8 billion capital expenditure backlog over and above annual spending requirements. This meant that, for example, bulk electricity infrastructure, surfacing of roads and provision of water could not receive the investment required to maintain or extend services. While it was still possible to raise bank loans this funding source alone could not cover the capital investments required. Each of the seven financial institutions had a loan facility available to the City but all of these were at thei maximum limit. The lack of choice in funding strategies available to the City was proving to be a serious obstacle to improving service delivery (Interview, Treasurer, COJ, 2005). At this stage National Treasury intervened and bailed the City out of the crisis with a R525 million grant, on condition that spending patterns were made more efficient. 2.2 Institutional arrangements Prior to 2002 the City Treasury as it stands today, was not in place. There was a Treasury section in existence that formed part of the Expenditure Department. It however had limited functions and capacity in proactively managing the finances of the City. It could not, for example, confront issues related to attracting investment to the City, retiring inefficient loans and taking on new loans. It relied heavily on consultants that were appointed by the City on a fee basis to advice on financial management. This was an expensive undertaking that resulted in minimal skills transfer to municipal staff. The capacity in the City to begin addressing the financial crisis and developing alternative funding strategies was therefore severely limited (Interview, Treasurer, COJ, 2005).

6 Best Practice Case Study: The Municipal Bond Issue Investor confidence As a result of the financial crisis and low profile of the Treasury investor confidence in the City was low. A credit rating agency, Fitch, had been brought in to assess the financial stability of the City and provide a rating that would reflect to potential investors the relative attractiveness of the municipality for investment. Credit rating agencies generally assess borrowing and how well linked this is to capital investment. Initially, for reasons described in section 2.1, these ratings were low and did not assist with attracting investment. This early assessment did however serve to provide a baseline against which improvements in financial stability could later be measured (Interview, Treasurer, 2005). 3 The idea 3.1 Objectives The objective of establishing the municipal bond was to provide the City with an alternative funding strategy to bank loans for sourcing finances. This flexibility offered by having options for finance available would enable the City to assess its needs and the conditions, such as interest rates, attached to the alternative sources of funding and then to decide on the most appropriate source to use (Interview, Treasurer, 2005). 3.2 What is a municipal bond? A municipal bond is a security issued by a state or local government entity. The bond is meant to raise money for local projects or to retire more expensive debt. Ordinarily, the interest or income from municipal bonds is to some extent tax-free.. In this way the buyers of the bond, who may be an institution or an individual, invest funds in the municipality and will receive interest at an established rate at fixed intervals according to what is generally referred to as a coupon. This may be compared to a bond on a house whereby the bank provides funds to a homeowner who in return pays interest back to the bank. With the funds raised from the issuing of the bond the municipality is able to embark on capital expenditure projects or upgrading and maintaining existing infrastructure., Together with operational surpluses from, for example, electricity and water revenues, the City will set up a fund to pay out interest and capital when it is due to customers who invested in the bond thereby increasing investor confidence that the CoJ will be able to meet its debt obligations. Such investor confidence also ensures that they will participate in any forthcoming bond issues.. Two important types of bonds that have been considered by the City are institutional bonds and retail bonds: Institutional bond An institutional bond is one that is made available to large financial institutions such as banks, insurance companies, mutual funds, asset funds and specific investment institutions. The two bonds issued by the City in 2004 were of this nature. The reason for the City issuing bonds in the institutional market was that it needed access to large quantities of funds that only institutions such as pension funds and asset managers are able to provide. The institutional investors in turn are also looking for additional sources of investments to diversify their portfolios and a municipal bond with a different credit profile is an alternative means of investment for the instutional investors. The City also wanted to create the market for municipal bonds, since these were a first in the

7 Best Practice Case Study: The Municipal Bond Issue 3 country. An institutional bond can also consolidate investor confidence before approaching citizens to consider investing in retail bonds directly as discussed below Retail bond A retail bond is made available to the citizens of a city (or country), who may then invest in the municipality by purchasing bonds. According to the Treasurer (Interview, COJ, 2005) the mayor then has direct accountability to citizens. He believes this is a useful mechanism to keep the city in check. Since residents have directly invested funds in the municipality they are more likely to question why, for example, a robot is not working or electricity is gone down. While the CoJ has not yet issued this type of bond, investor confidence has been established so it is now under serious consideration. 3.3 First bond - COJ 1 The first bond issued by the City was for R1 billion and will mature in It was issued un-enhanced or without a guarantee. An un-enhanced bond provides a true reflection of market appetite for municipal issues and the pricing is a reflection of the way the investors view the City s credit. The first bond has a single bullet redemption in 2010 and pays out interest on a six monthly basis (Interview, Head of Operations, Treasury, COJ, 2005). 3.4 Second bond - COJ 2 The second bond issued by the City in 2004 was also for R1 billion and will mature in It has a complex redemption structure with six repayments in the last three years. It also pays out interest on a six monthly basis. This bond was partially guaranteed, for 40% of the total issue. The Development Bank of Southern Africa (DBSA) guaranteed 20% of the bond and the other 20% was guaranteed by the International Finance Corporation (IFC) (Interview, Head of Operations, and COJ, 2005). 4 Implementation According to the Treasurer (Interview, COJ, 2005) there was a series of important steps in planning that preceded the establishment of the bonds. There was then also a specific process that needed to be followed in issuing the bonds. These two processes are presented below: 4.1 Planning Key preparatory steps followed in planning to issue the bonds were: establishing the City Treasury, doing a study tour to learn about best international practice in municipal bonds, eliciting political support for the move and developing a 10 year financial plan Establishing Treasury A campaign to develop the capacity of the Treasury and market it to investors was embarked upon. A fully-fledged City Treasury was established by the CoJ in December of The Treasurer (Interview, COJ, 2005) emphasised the importance of putting in place a dedicated unit. It was essential for investor confidence, he believes, for the City to have a Treasury in its own right, with competence and qualifications in financial management and economic development. Experience and qualifications needed to

8 Best Practice Case Study: The Municipal Bond Issue 4 equal to those in the private financial and economic sectors. He highlighted further how impeccable, as Treasurer, his own image had to be. People don t buy what you sell, they buy you first. Your commitment has to be undoubted. You have to show confidence and you have to have done your homework. The ground work and research we did was thorough. Some of the key research undertaken by the City, is described below Study tour of international best practice All managers interviewed emphasised the importance of getting first hand knowledge of international best practice in the issuing of municipal bonds (Interviews, Treasurer, Head of Operations, Chairman Mayoral Committee FSED, 2005). A study tour was arranged to Mexico City because Mexico was at the time the fastest growing municipal bond issuing country in the world. Other countries have focussed more on corporate bonds. Also because the CoJ has a twinning arrangement with Mexico City, the visit there was easily facilitated. Information relating to the issue of bonds is generally treated with serious confidentiality. However, because municipalities are not in competition there is open sharing of information. Benefits from the trip included getting a better understanding of the risks involved in issuing a bond, and an understanding of the experiences and lessons that have been learnt by other cities. According to the Treasurer, Mexico City was particularly interesting because they issue retail as opposed to institutional bonds and the bonds are fully subscribed. This means that the full amount for which the bond is issued, which can be as much as R1 billion, is taken up by residents of the City. The Treasurer highlighted that the team came back from Mexico even more confident. We had a better understanding of the risks and believed even more that they were manageable. He indicated that a concern prior to the trip had been the Auditor General s refusal to give an opinion on the possibility of the CoJ issuing bonds. They, however, decided on return that all the concerns related to political instability of management in the City, and the need for full transparency and accountability, were surmountable and that systems could be put in place to address these obstacles Political support Challenges eliciting political support for the issue of bonds needed to be tackled at a range of different levels. Internally the Mayor, councillors and managers had to be convinced of the move. Support from other municipalities and spheres of government were also needed given that there was widespread anxiety about the readiness of the City to issue the first bond. National Treasury and the Department of Provincial and Local Government (DPLG) had been integrally involved in the process from an early stage so were less of a concern (Councillor and Member of the Mayoral Committee FSED, 2005). Paramount was the need to sell the idea of the bonds internally. Several role players interviewed (Councillor and Member of the Mayoral Committee FSED, Treasurer, 2005), emphasised the challenge involved in conveying the risks and capacity of Treasury to deal with these risks, in a way that was accessible to the Mayor, councillors and non-financial managers. Financial information can be highly jargonised and technical and the Treasury team had to ensure they were able to articulate concepts clearly and convincingly. There was also an issue regarding confidentiality of information. Details surrounding the emerging market offering were at a very sensitive stage and could not be distributed widely. At the same time it was essential that politicians, and the Mayor in particular, had access to all key information and were confident that the process had been fully transparent. Managing the balance in both of the above areas was generally considered to be one of the bigger challenges leading up to the first bond issue.

9 Best Practice Case Study: The Municipal Bond Issue 5 The prospect of eliciting support from other municipalities and spheres of government had issues of its own. According to the Councillor and Member of the Mayoral Committee FSED (Interview, COJ, 2005), this was an area that should have been given more attention earlier in the process. There was anxiety among these role players that if bonds were issued by CoJ and undersubscribed, this would deflate investor confidence and sabotage the opportunity for all municipalities to issue bonds. To ease these concerns the Councillor believes the CoJ should have communicated the processes they were involved in earlier, to manage this risk. This would include the ongoing interaction with investors that was taking place and possibilities of bringing on board underwriters to guarantee the bonds should this have been required for the first bond year funding plan As part of the overall planning process a ten-year funding strategy was developed for the City. The strategy considered issues such as inflation, interest rates, tariff increases for municipal services and mechanisms to secure cheap capital. The strategy served to inform Treasury whether the City would be to afford to repay bonds as they became due, should a bond be issued. This plan provided the basis for the arguments made by Treasury that the risks to the municipality were manageable and given that certain measures were put in place, the City would be able to repay bonds with interest. 4.2 Implementation An official guideline for the issuing of municipal bonds was followed by Treasury and entailed implementing the following steps outlined below (Head of Operations, Treasury, COJ, 2005). Many of these have already been referred to above: Appoint advisors Financial advisors were appointed whose role was to advise on the type and structure of the bond; the timing and the size of the issuance; and the design and structure of the bonds. The advisors also provided advice on the underwriting levels; the preliminary offering price and price range and the Offering Circular. The number of bonds to be sold per instrument, the credit appetite from investors and other relevant issues were also addressed by external financial advisors. Drafting of documents, such as the programme memorandum and all the agreements relating to the bond programme were undertaken by appointed advisors under th oversight of the CoJ Appoint underwriters and guarantors Since the municipality had decided to underwrite the bond it was necessary to bring on board financial institutions that were prepared underwrite the bond. In underwriting the bond the City is guaranteed the success of the issue as the underwriter agrees to buy the entire issue if for some unforeseen reason, the market does not want take up the full allotment. The bank or the selected underwriter bears the risk of underwriting offerings. In other words the CoJ would have still received the anticipated proceeds irrespective of whether investors took up the issue or not. The function of the underwriter is to ensure that the issue is underwritten for any portion that might not be taken up by investors thereby ensuring that the issue is 100 percent subscribed on the date of issue. Depending on the structure and appetite of the instrument and the way the investors view the credit profile of the City and the market conditions on the day there may be no need for underwriting. Underwriting is however, a prudent risk management measure..

10 Best Practice Case Study: The Municipal Bond Issue 6 Absa bank was chosen as the City s underwriters. Because the COJ 01 and COJ 02 bonds were oversubscribed, meaning that they were extremely well received by the market, it transpired that there was actually no need for underwriting. Nevertheless, the appointment of underwriters was still seen by the Treasury as a sensible measure to reduce risk to the CoJ. Guarantors As already indicated, the Development Bank of Southern Africa (DBSA) and the International Finance Corporation (IFC) guaranteed 40 percent of the second bond issued, the COJ 02. The purpose of guaranteeing the bond was three fold. 1. Investors were new to the City, they did not understand the City s creditworthiness and therefore it was difficult to tell how they would price the City. It therefore made economic sense to guarantee the bond at that time. 2. Guaranting the bond meant that the bond would have to be rated by a Credit Rating Agency which meant the bond could carry a higher rating than the City s Rating which at that point was an A-. The purpose of rating COJ 02 would be to enhance the credit quality of the bond thereby ensuring that the bond was rated at an A+ giving investors increased confidence that the quality of paper that they would purchase was A graded paper. 3. Having the bond guaranteed ensured increased participation in the issue as it opened interest to more investors Road shows In an effort to optimise investor confidence road shows were carried out, and continue to be undertaken on a regular basis, whereby potential investors were taken to key infrastructure projects in the City. According to the Treasurer (Interview, COJ, 2005), investors are exposed to as wide a variety of priority infrastructure projects as possible. In the last road show they were taken, for example, to a housing development project in Kliptown. It is a presidential project where roads are being constructed and basic services such as water and electricity established. They were also taken to Constitution Hill, a project funded jointly by national, provincial and local government. Mandela Bridge and the Alexandra Renewal Project also featured prominently on the programme of projects to show case. Councillor Tau emphasised (Interview, Member of the Mayoral Committee FSED, COJ, 2005) the importance of demonstrating to potential investors firstly, that the City had a good understanding of it priorities and challenges for infrastructure development and also that the utilities and departments have the capacity to spend the funds raised through a bond issue Book building A final step in the process of issuing the bond, which took place the day before the bond was put on the market, was book building. This involves taking orders from investors on the phone, usually through a bank s dealing room, for units of the bond. This process provides a firm indication of the price and the quantity of the bond, which enabled the bond to be traded the following day.

11 Best Practice Case Study: The Municipal Bond Issue 7 5 Impact 5.1 Bond performance Over subscription As it turns out both bonds were extremely well received by the market. The first bond, COJ 1, was 1.5 times oversubscribed. In other words there were orders for R1.5 billion on the R1 billion bond issue. COJ 2 was received by the market even better than COJ 1, with orders for R2.3 billion being made on the second R1 billion bond issue. In this second scenario the Treasurer considered using a Dutch Auction to distribute the bond to investors. In a Dutch Auction all winning bidders pay the same price per item, which is the lowest successful bid, and specify the quantity of items they want. Early bidders are awarded first so some bidders may not be successful in participating in the bond issue. Treasury decided against this approach because investors were putting in all or nothing bids. This meant that if bidders were not issued the quantity they ordered they could withdraw completely. This could result ultimately in undersubscription and in the case COJ 2 would have resulted in R of the bond being unsold. As mentioned above this is a legitimate part of a Dutch Auction process but was likely to result in disillusionment in the market. So instead of using the Dutch Auction, to ensure that the full R1 billion was sold, the Treasurer decided to cut all bids by 33%, which covered the full issue. This approach meant that all bidders would ultimately be able to purchase bonds though in smaller quantities than preferred. Investors were satisfied with this solution and all bidders were included (Interview, Treasurer, COJ, 2005) Creation of a market An important impact of the CoJ being first to market in issuing of the bonds has been the creation of a platform for further municipal bond issues, by the CoJ or other municipalities. After a period of prolonged uncertainty for many municipalities as to whether investors will be interested in bonds, the CoJ has established market appetite. This means that investors now have a good understanding of the credit risk related to municipal bonds and are likely to look at other municipalities differently (Treasurer, COJ, 2005) Bond performance in secondary markets Another important impact of the successful bond issue is improved performance of the bonds in the secondary market. The secondary market refers to selling of the bond from one bank or institution to another whereas the primary market refers to selling directly from the CoJ to investors. At the time that COJ 1 was issued it was sold at 2.3% above the R153, a government bond used by Treasury to benchmark the CoJ bonds because it has the closest terms. If the bond were sold today it would sell at 1.5% above the R153. This means that investors are becoming more confident of the CoJ and have a better understanding of the credit risk as well as the leadership, vision, and mission of the CoJ. 5.2 Financial performance Finances stabilise Due to the range of mechanisms put in place by the City to improve its financial standing, key among which has been the issuing of bonds, the financial position of City improved dramatically between 1996/7 and According to the Treasurer

12 Best Practice Case Study: The Municipal Bond Issue 8 (Interview, COJ, 2005) the finances of the City moved from being in overdraft of R466 million in1996/7 to a positive balance of R481 million in 2003/4, shown in the graph below. Table 1 City of Joburg Overdrafts and call bonds Overdraft & call bonds (ZAR million) /6 1996/7 1997/8 1998/9 1999/0 2000/1 2001/2 2002/3 2003/4 Source: Presentation by Roland Hunter to IADF Conference, 2004 The improved financial stability of the City was reflected in an improved credit rating by Fitch. The credit rating agency that had initially given the City a BBB- in 1999 increased the rating to A- in This in turn has had very positive impact on investor confidence (Interview, Treasurer, 2005) Capital expenditure According to the Treasurer, money is no longer the issue for the municipality. Rather ensuring ongoing capacity to spend it has become the focus. He indicated that tables have been turned around. In the past the City could not fund projects, now we can. Over and above this there has been major acceleration in capital investment, capital spending is really on track. Everyone in the municipality knows we have to spend, and if we do not this is how we will be measured. So everyone is pulling their weight (Interview, COJ, 2005). The table below shows CoJ projections for capital expenditure to increase by 53% from R0.95 billion in 1995/6 to R1.98 billion in 2004/5.

13 Best Practice Case Study: The Municipal Bond Issue 9 Table 2 City of Johannesburg, Capital Expenditure current and projected: 1995/6 2006/7 Capital expenditure (ZAR m) ,978 2,019 2, ,280 1,346 1, , /6 1996/7 1997/8 1998/9 1999/0 2000/1 2001/2 2002/3 2003/4 2004/5 2005/6 2006/7 Source: Presentation by Roland Hunter to IADF Conference, 2004 According to interviews with the City carried out by the Financial Mail, these projections for capital expenditure are now being realised (Peter Honey, Financial Mail, 2005). It is further evident from the above table that in 2006 capital expenditure will top R2 billion. While the significant increase in capital expenditure reported in 2005 has been accessed from a range of sources, the bonds have contributed substantially to availability of funding for capital projects (Peter Honey, Financial Mail, 2005). 5.3 Decreasing the infrastructure backlog It is evident that efforts are focussed on using capital raised through the bonds to reduce infrastructure backlogs. According to the Councillor and member of the Mayoral Committee FSED (Interview, COJ, 2005), the CoJ is now investing extensively in meeting service needs. He reports that 40% of the capital budget in the last year went to repairing and replacing electricity infrastructure, in an attempt to reduce power outages and improve bulk infrastructure. Other priorities are developing infrastructure for the new strategic public transport network with the intension of creating a bias towards public transport. The tarring of roads in Soweto by Johannesburg Roads Agency has also been given attention with the target for tarring all roads in Soweto expected to be achieved by the end of In addition, managers of the large utilities including City Power and Johannesburg Water have indicated that they will be able to use the additional capital available without any problem, given the extent of the need for development. Johannesburg Water for example is spending R450 million on a three-year programme to completely replace water and sewerage networks in Soweto. It is reported that 70% of water is lost because the system is so dilapidated. Savings on unaccounted for water alone will ensure that investments are returned to them (Peter Honey, Financial Mail, 2005).

14 Best Practice Case Study: The Municipal Bond Issue 10 6 Conclusion The municipal bonds issued by the CoJ demonstrate well a bold step taken by the City in instituting a best practice mechanism to introduce more options in the funding strategies available to the City. While the process of issuing the bonds took place amidst a range of initiatives to overcome the financial crisis faced by the City, such as major commercialisation of services, the project has clearly contributed significantly to the renewed financial stability of the City.

15 Best Practice Case Study: The Municipal Bond Issue 11 References Honey, Peter, 2005: City Gets Cracking, Financial Mail, 11 February Hunter, Peter, 2004: Presentation to the IADF Conference, Joburg Innovation and Knowledge Management (JIKE), 2004/5: Joburg Innovations, City Treasury: Issuing of Pilot Municipal Bond Interviews Councillor Tau, 2005: Member of the Mayoral Committee Finance, Strategy and Economic Development Ngobeni, Jason, 2005: Treasurer, City of Johannesburg Botes, Helen, 2005: Head of Operations, City Treasury, City of Johannesburg