44398 noTE no. 33 ­ May 2008GRIDLINES Sharing knowledge, experiences, and innovations in public-private partnerships in infrastructure Asking the right questions Johannesburg completes a groundbreaking municipal bond issue Jason Ngobeni I n 2004 the City of Johannesburg sold two did little to address the needs of the disadvan- municipal bond issues, among the very few taged majority population. Nor did it encourage suchissuesinAfrica.Thebondissuesmarked the development of a viable municipal bond the city's recovery from near bankruptcy in the market. There was virtually no trading of bonds; mid-1990s. They have been followed by several investors simply bought and held the bonds to more--as well as an even more ambitious capi- fulfill their portfolio requirements. tal financing program. Preparing for a first- time bond issuance is complicated and time The prescribed investment regime ended in the consuming. Johannesburg navigated its way early 1990s as government leaders began to with remarkable success by asking the right realize that a perceived sovereign guarantee of questions and insisting on credible answers. Its local government borrowing was creating large path offers guidance and insights to other local contingent liabilities for the national government. governments considering the use of municipal Municipal bond sales stopped entirely after 1993. bonds to finance infrastructure. Private bank lending to municipalities also began to decline after the end of apartheid in 1994, By the mid-1990s the City of Johannesburg was largely because municipalities were expanded to close to bankruptcy. Infrastructure was deterio- incorporate disadvantaged areas and as a result rating, and this city of 4 million residents had became much less attractive to private lenders. a capital budget of less than $50 million. But a visionary municipal management team was put The government used South Africa's Develop- into place, and it promptly began corporatizing ment Bank of Southern Africa (DBSA) to fill utilities, selling off commercial enterprises, and some of the infrastructure investment gap in contracting out services. the late 1990s. But the DBSA could not supply all municipal investment needs, and once the The city had many of its operating problems national government stopped contributing to largely under control by 2003, but it needed huge its operations in the mid-1990s it sometimes amounts of capital investment. Under apartheid, avoided risky investments to maintain its credit capital expenditures had been dealt with through rating. A private, nonbank investment fund, the a government-backed "prescribed investment Infrastructure Finance Corporation (trading as regime": institutional investors were required to INCA), began operation in the mid-1990s, rais- hold 54 percent of their investment portfolios ing money in the capital markets and lending to in a range of government securities, including municipalities at commercial rates. municipal bonds. The high, fixed percentage and an implied sovereign guarantee meant that virtu- ally all municipal securities could be sold quickly through private placement. While the system fed capital to municipalities and Jason Ngobeni is executive director of economic helped to build and maintain western-style urban PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY development, and former city treasurer of the City of infrastructure services for the white minority, it Johannesburg. Helping to eliminate poverty and achieve sustainable development through public-private partnerships in infrastructure PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY The questions Credit issues and interest costs. Bonds can be more expensive than commercial loans if inves- By 2003 Johannesburg city officials were asking tors perceive the credit quality as poor. In 2003 and getting answers to a series of basic questions most investors in South Africa viewed municipal about whether bond financing or bank loans was a debt as inherently risky. Johannesburg would have better way to meet the city's infrastructure financ- to work hard to market bonded debt at attrac- ing needs. These questions and answers were tive interest rates. Credit enhancements, including followed by more as the city navigated its way. financial guarantees or special structuring of the issue, could help reduce interest costs. What were the advantages of bonds? Size. Bond issues can be substantially larger than Market limitations. Early in the 1990s the South typical bank loans, depending on the appetite of African capital market was volatile: interest rates the investing community. were relatively high, investors were not particu- larly knowledgeable, few financial intermediaries Interest rates. Interest rates on bonds depend on had experience with bonds, and rating agencies the creditworthiness of the issuer and the effec- were rarely used. There was virtually no secondary tiveness of marketing the issue to underwriters market, so investors had difficulty selling bonds and investors, not on commercial lending rates. before maturity (an option every investor wants In essence, the interest rates reflect a premium to have when interest rates are volatile). All this over the rate on the most risk-free bond of the promised to make selling bonds with long maturi- same maturity, typically some form of national ties difficult. treasury debt. Most important, interest rates on bonds can be lower than those on bank loans, and Amortization of payments. While municipalities that potential seemed to exist in South Africa. typically use amortizing bank loans to fund their capital programs, South African investors and Maturities. Bonds typically have longer maturities underwriters largely prefer bullet bonds because of than bank loans. That means that debt service their simplicity. Yet while municipalities can repay costs are spread over longer periods, making them a portion of a bank loan (interest and principal) easier to pay. For infrastructure projects, extend- each year, bullet bonds require rigorous financial ing the repayment period also makes good public planning to ensure that they can be repaid when The city policy sense, because it matches the life of the they mature. assets being built with the liability to be paid navigated its back. In effect, longer maturities ensure that the Could the city sell bonds for way through users of the infrastructure are contributing to the infrastructure investment? repayment (through taxes or charges). By 2003 Johannesburg had huge capital invest- a series of ment needs, particularly in the former townships, questions Collateral requirement. In contrast with bonds, which lacked adequate access to water and elec- traditional bank loans require matching collat- tricity. Yet the city was already heavily indebted to eral, increasing their true cost to the municipality. the DBSA, INCA, and most of the major commer- A typical example: In South Africa, nearly 20% cial banks, which had limited appetite for more of every $1 borrowed would have to be invested debt from the city. To compound matters, much in an escrow account, usually with the lender, of this earlier debt was expensive because it had and the return on the account is generally below been secured when the municipal finances were market rates. much more tenuous. Finally, despite significant management reforms, the city still had not earned What were the disadvantages of bonds? unqualified audit reports on its financial state- Issuance costs. Bond issues, particularly first-time ments. issues, can involve higher costs than loans. These costs include advisory and underwriting fees and All these factors together suggested that the city legal due diligence in addition to disclosure costs, would face serious challenges with a standard debt trustee fees, and so on. Most of these costs can be issue. As a result, securing new debt, on top of paid from the proceeds of the issue, so they do not outstanding, expensive obligations, did not seem typically cause cash flow problems for the issuer. possible. But they are burdens for taxpayers or ratepayers. Are brownfield concessions poised for a comeback? Could the city use a bond issue to investors what it was doing to improve financial refinance existing debt? management. Johannesburg already had a domes- After reviewing the situation, city officials and tic credit rating of A- from Fitch and, while not their advisors realized that they might be able exceptionally strong, this was considered adequate to sell a municipal bond to refinance much of given market appetite at the time. the outstanding debt. Ideally, such a bond issue could produce cost savings by lowering the over- Maturity. The longer the maturity of the bond, all interest rate on the city's debt, extending the the more likely that its term would match the The answers maturity on the debt and thereby lowering annual life of the infrastructure being built with the led to a debt service repayments, and freeing assets that proceeds. But South Africa's lack of a strong had been ceded to lenders as collateral for earlier secondary market meant that investors probably decision to loans. Moreover, refinancing presented much less would not favor long maturities restricting their go ahead with credit risk for investors because the city already ability to shift into other investments as market had a successful track record of servicing this debt conditions changed. In addition, investors were a bond issue at a higher cost. still concerned about the potential for default or downgrading of the bond in later years--and they The city hired consultants to examine the were likely to decide that the reward of higher outstanding loan book, to determine the size and interest was not worth the risk of default on a characteristics of outstanding loans and identify longer-term bond. which were backed by redemption instruments or affected by prepayment penalties. The results Method of sale. Bonds can be directly placed were somewhat startling: almost $430 million in with a preselected group of investors or competi- redemption instruments had been ceded to lend- tively sold. Competitive sales normally are more ers, held in reserve in case of default. If structured transparent and, because of the greater competi- correctly, a municipal bond could liberate these tion, result in a better price for the issuer, though municipal assets. The city decided to go ahead they also generally involve higher issuance costs. with a bond issue. Because Johannesburg's issue would involve significant refinancing and many existing lend- What characteristics needed to be ers could require penalties for early redemption clarified before issuance? of debt, the city decided to directly place some Type of bonds. Should the city issue "general obli- of the debt with existing lenders, to replace debt gation" bonds, to be repaid from any and all city being redeemed and avoid some of the potential revenues? Or should it issue revenue bonds, to be penalties. repaid from the revenues of the projects built with the proceeds? Because the city had already created Approach to managing the issue. One approach to semiautonomous utilities, there was a possibility selling bonds is to hire a single firm to manage and for using revenue bonds for much of the infra- coordinate the deal-making process, structure and structure needed. But close review showed that market the transaction, and act as underwriter. the city needed more money than could be raised Another is to hire a specialist firm to act as a by the utilities, which were not yet fully self-suffi- financial advisor, with no possibility of being an cient. Moreover, the city would need to use all underwriter. This firm would manage and coordi- sources of revenue--including taxes, which were nate the issuance and oversee the procurement of not available to the utilities--to support new debt. underwriting services. Because the Johannesburg The city decided to use general obligation bonds. bond was uncomplicated, the city chose the first option, to minimize costs. Credit quality. The better the credit quality of the issuer, the lower the interest costs. This simple Credit enhancements. Did the city need a guarantee rule confronted the city with a question: should or some other form of external credit enhancement it invest in improving its financial accounting and to make the sale successful? Guarantees, typically reporting systems so as to achieve unqualified issued by third parties with higher credit ratings, audit opinions and better credit ratings? Because improve the credit quality of a bond issue and, if credit ratings still played a minor part in investors' structured properly, can reduce the cost of borrow- decision making, the city decided that rather than ing. Several factors, including the city's modest depend solely on credit ratings, it would explain to credit rating and qualified audit reports, argued in favor of a guarantee. Moreover, a guarantee would Conclusion allow the city to increase the size of the bond and extend the maturity. The city therefore began to In 2005 and 2006 the City of Johannesburg sold explore options for credit enhancement. more bond issues, again with a 12-year maturity but this time with no external enhancements. The city now sells debt under the capital market's The deal Domestic Medium-Term Note Program, which allows a series of borrowings without the costs of The city decided to purchase a partial credit guar- new disclosure documentation for each transac- antee from the DBSA and the Municipal Fund tion. And the city has engaged an underwriting of the International Finance Corporation (IFC). consortium under a long-term contract to plan, The guarantee was to be split equally between the structure, and sell future debt. DBSA and IFC, a major lender to the city. But the time needed for due diligence and other process- Most recently the city offered the first municipal ing meant that the guarantee would not be in retail bonds in Africa--again demonstrating its place by the time of the scheduled issuance. The creativity. Retail bonds are sold in modest denomi- city therefore split the bond issue into two parts. nations and offer residents of Johannesburg an opportunity to invest in the city's future. They The first was a R 1 billion ($159 million) issue also carry a return of about 10 percent a year, sold without enhancement in April 2004. The significantly higher than commercial savings rates. issue had a six-year maturity, reflecting the fact The bonds were purchased through the post office, that it carried the city's A- credit rating. Still, a local commercial bank, and the Internet. The the issue was modestly oversubscribed and placed bonds are also listed and actively traded on the with many of the city's existing debt holders. It stock exchange. These "Jozi Bonds" raised more was priced at a respectable 230 basis points over than $22 million in the first month, and the city risk-free government securities. plans to raise more capital through these retail bonds. Two months later the city sold a second R 1 billion issue. IFC and the DBSA guaranteed 40 Overall, the bond issues succeeded beyond the percent, improving the deal's Fitch rating to AA-, city's expectations, establishing a stable foun- three levels above the city's normal rating. The dation of financing that has allowed the city to enhancement allowed a doubling of the maturity, extend its infrastructure investments far into the to 12 years, and a much improved price of 164 future. How Johannesburg tackled the challenges basis points over treasuries. The transaction was involved holds valuable lessons for other local heavily oversubscribed. governments seeking new ways to raise debt in an emerging market. GRIDLINES Gridlines share emerging knowledge on public-private partnership and give an overview of a wide selection of projects from various regions of the world. Past notes can be found at www.ppiaf.org/gridlines. 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