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SEPTEMBER 1 96 9

IN TH IS ISSUE

Corporate Bonds
1960-1968 ....................3

The Municipal Bond Market,
1960-1968 ....................17

FEDERAL

RESERVE

BANK

CLEVELAND

Additional copies of the ECONOMIC REVIEW may
be obtained from the Research Department, Federal
Reserve Bank of Cleveland, P. O. Box 6387,
Cleveland, Ohio 44101. Permission is granted to
reproduce any material in this publication providing
credit is given.

SEPTEMBER 1969

CORPORATE BONDS, I 9 6 0 — 1968
Corporations first issued bonds in the United
States early

in the

Nineteenth Century. The

experienced its longest economic expansion in
history, w ith the Gross National Product increas

popularity of these debt instruments as a source of

ing more than 70 percent. Nevertheless, about

capital increased rapidly, particularly with rail

seven years of price stability ended in inflation in

roads.

late 1965. Throughout the article, reference is

1900, corporate bonds outstanding

amounted to $5.9 billion

(par amount).1 By

made

the

preinflationary

period

and the

yearend 1968, the volume of outstandings had

1965-1968 inflationary period, because the behav

increased

ior

nearly

$167

billion.

Currently,

the

corporate

bond

market

differed

corporate bonds play an integral role in the capital

noticeably during the two periods. As shown in

markets by representing a major source of funds

Charts 1 and 2, during the inflationary period,

for businesses, as well as an important media for

market rates of interest soared to postwar high

investors.

levels, and borrowers demanded record volumes of

This article examines the nature and use of

funds.

corporate bonds during the 1960-1968 period. The
article describes some

basic characteristics of

corporate bonds, and then discusses the demand

BASIC CHARACTERISTICS OF
CORPORATE BONDS

for funds and the issuers of bonds, as well as the

Bonds are credit instruments that represent a

suppliers of funds or investors. With the exception

promise by the issuer to repay a specified amount

of a mild recession in 1960-1961, this article was

of money on a stated date, as well as a promise to

w ritten

economic

pay interest at fixed intervals. Although the term

expansion. Since 1961, the United States has

"corporate bond" is generic, the form and nature

against

background

of corporate bonds vary widely. Denominations,
for example, range from $100 to $10,000 or more,

W. Braddock Hickman, The Volume o f Corporate Bond

Financing

Since

1900

(Princeton,

J.:

Princeton

University Press for the National Bureau of Economic
Research, 1953).

with $1,000 being the most common face value.
Security. Corporate bonds may be secured by
specific collateral or unsecured. The types of
3

ECONOMIC REVIEW

C h a r t 1.

CAPITAL MARKET YIELDS
Percent

Last e nt r y :

D e c e m b e r 196 8

S o u r ce o f d a t a :

B o a r d of G o v e r n o r s o f the F e d e r a l Re se rv e Sys tem

property pledged for security include real estate,

during

rolling stock (i.e., freight cars), and marketable

generally had higher default rates than unsecured

securities. Bonds backed by these assets are called

issues.

mortgage

bonds,

equipment

obligations,

the

1900-1943

period, secured

issues

and

collateral trust bonds, respectively.2 Bonds that

There are some hybrid bonds that are usually

are unsecured by property are called debentures.

the result of bankruptcies and railroad reorganiza

Debentures are generally issued by high quality

tions. For example, "incom e" bonds promise to

industrial companies and public utilities and are

pay the principal, but not the interest unless it is

backed by the general

credit of the issuing

earned by the borrowing corporation. Income

corporation. Care should be used when comparing

bonds are sometimes called "adjustm ent" bonds.

the "q u a lity " of a bond w ith the security behind

Two

it. For example, the quality of a debenture issued

"guaranteed" bonds. Typically, these bonds are

by a corporation w ith a high credit rating may be

outgrowths of railroad mergers where the acquir

better than that of a first mortgage bond issued by

ing company assumes or guarantees the obligations

a corporation with a low credit rating. In fact,

of the acquired company.

Detailed definitions of the various types of corporate

bonds

may

found

corporation finance.

4 FRASER
Digitized for

in a standard

textbook

additional

hybrids

are

"assumed"

and

W. Braddock Hickman, Corporate B ond Q u a lity and

Investor Experience

(Princeton,

search, 1958), pp. 431-465.

N. J.: Princeton Re

SEPTEMBER 1969

bonds are

As suggested above, many corporate bonds

generally issued w ith maturities of 10 to 30 years

contain a "c a ll" feature that allows the issuing

or longer,

bonds are redeemed before

corporation to call fo r the redemption of bonds

m aturity. Bonds can be retired in several ways.

before final m aturity. The corporation may call

The basic method is the lump-sum payment,

either all or part of a bond issue to eliminate some

whereby the bond is paid o ff in its entirety at final

unfavorable provision in the indenture, or to be

m aturity. A second method uses a "sinking fu nd ,"

able to refund the issue at lower coupon rates if

that is, the corporation sets aside a certain amount

market interest rates have declined. Many bonds

of money each year to be invested in or to

cannot be called for 5 years, 10 years, or longer.

repurchase some of its outstanding bonds. Another

This

Retirement.

Although

many

corporate

noncallable feature protects investors by

method is through serial retirement, whereby a

enabling them to hold bonds w ith high coupon

specified series of bonds covered under the same

yields when market rates decline. When bonds are

indenture or borrowing agreement are retired each

called, the bondholders or investors receive a

year.

modest premium above the par value of the bond

C h a r t 2.

GROSS PROCEEDS of NEW CORPORATE BOND ISSUES
Billions of dollars

1960
Last entry;

'61

’62

’63

’64

'65

’66

’67

’68

’69

’70

4 Q 1968

So ur ces o f d a t a :

Secu ri tie s a n d E x c h a n g e Co m m is s io n a n d B o a r d o f G o v e r n o r s o f th e F e d e r a l Reserve Sys tem

ECONOMIC REVIEW
for their inconvenience. The value of the premium

converted,

generally diminishes as the bonds move closer to

outstanding debt and interest costs are reduced.

the

amount

the

corporations'

Quality. Basically, the quality of corporate

m aturity.
Finally, some bonds can be converted at the

bonds depends on the earning power o f the issuing

option o f the bondholder into other types of

corporation. Several advisory services and govern

securities, typically common stock. The conver

ment agencies provide quality ratings of bonds

sion rate is based on a formula stated in the

based on their appraisals of the issuer's ability to

indenture. For example, a $1,000 par value bond

pay o ff the debt, among other factors. The ratings

may be convertible into 10 or 20 shares of the

range from Aaa rated “ gilt edge" bonds to DDD-D

common

rated defaulted bonds, and "legal" to "nonlegal"

stock

Convertible

the

issuing

corporation.

bonds are popular w ith

investors

investments in some states. Some corporate bonds

because such issues offer the security of a bond as

are not assigned ratings; however, the absence of a

well as some of the benefits of common stock

rating may or may not reflect the quality of a

ownership. Moreover, the coupon rates paid on

bond. For example, one advisory service does not

convertible bonds, while lower than equivalent

rate corporate bonds when the outstanding issue is

nonconvertible bond yields, are frequently higher

less than $600,000, regardless of the issuer. This

than the dividend yields on the common stocks

truncation

into which the bonds are convertible.

excludes some high

quality bonds

issued by small corporations. In any case, bond
ratings are meant to be investment guides, not

As shown in the lower panel of Chart 2, the
dollar volume

absolutes. A

study

of the

1900-1943 period

of convertible bond issues has

revealed that some high quality corporate bonds

increased appreciably in recent years and has

went into default, but significantly less often than

accounted fo r a larger proportion of total bond

lower rated corporate bonds.4 A study of the

offerings. The dollar volume of convertible bond

post-war period (1944-1965) revealed that corpor

offerings reached a peak in 1967 and accounted

ate bond defaults amounted to about 0.1 percent

for 20 percent of total bond offerings, in contrast

of the volume of outstandings, compared w ith 1.7

to an annual average of 5 percent during the

percent in the 1900-1943 period.5 Bond defaults

1960-1966 period. In 1968, the dollar volume of

were generally at their lowest level near peak years

convertible bond offerings contracted somewhat,

of business cycles. However, the largest number of

but still amounted to about 19 percent of total

defaults occurred in bonds offered about one year

bond offerings. The increases in dollar volume of

before the peak of business cycles.

convertible bond offerings that have occurred
since

1964

represent

an attempt by

issuing

4lb id ., pp. 141-197.

corporations to hold down interest costs and may
have the ultimate effect of raising additional

^Thomas R. Atkinson, Trends in Corporate B ond Q uality

equity capital. Because o f potential capital gains

(New York: Columbia University Press for the National

opportunities, convertible bonds generally carry

Bureau of Economic Research, 1967), p. 43.

lower interest rates than equivalent nonconvertible
issues. In addition, as some of the bonds are
Digitized for
6 FRASER

5I b i d p. 47.

SEPTEMBER 1969
Investors' appraisal of the quality of corporate
bonds is reflected in the bonds' prices, or in their
market yields. As shown in Chart 1, market yields

inflation, rising interest rates, and sharp changes in
credit availability.
Sources

Funds.

During the

1960-1968

on Aaa rated corporate bonds were substantially

period, internal sources of funds (i.e., depreciation

higher than market yields on U. S. Government

and

bonds, which are considered virtually default free,

accounted fo r the bulk of total funds raised by

but much lower than market yields on mortgages.

corporations. Nevertheless, corporations increased

In addition, Aaa rated corporate bonds had lower

their use of external sources of funds during this

yields than Baa rated corporate bonds, which have

time (see Table I), borrowing through stocks,

a higher default risk. As shown in the chart, the

bonds, mortgages, bank and other loans, trade

yield spread between Aaa and Baa rated bonds was

debt, profits tax liabilities, and other liabilities. It

not constant from

is beyond the scope of this article to discuss the

periods

1960 through 1968. During

uncertainty

in the economy, for

example, during the 1960-1961
during

recession and

1967-1968, a period of inflation, yield

spreads tended to be wider than during periods of
relatively

stable

economic

growth

such

retained

advantages

earnings)

and

increased sharply

disadvantages

the

and

various

sources of funds. Instead, the focus w ill be on the
relationship between corporate bonds and both
external and total sources of corporate funds.

The data in Table I reveal that bonds accounted

1964-1965. For example, in 1968, the yield spread

for a substantially larger share of the total sources

between Aaa and Baa rated bonds averaged 76

of funds raised by nonfinancial corporations after

basis points, more than double the spread in 1965.

1965 than during the earlier years under review,

In addition, the yield spreads between corporate

reflecting an increased use of external funds in

bonds and U. S. Government long-term bonds and

general. In addition, corporate bonds' share of all
external sources of funds increased sharply in

mortgages moved in roughly the same fashion.
This movement suggests that investors may have

1966-1967, and then contracted again in the

believed that the risk of holding lower quality

following year. On the whole, corporations have

securities was greater during periods o f rising

financed a small, but increasing share of their

prices and economic

credit needs through bonds in recent years.

uncertainty

than during

By issuing bonds, corporations have obtained

periods of stable economic growth.

long-term funds at nominally high interest costs in
recent years. However, interest payments on bonds

DEMAND FOR FUNDS
In 1968, governments, corporations, individ

are paid before taxes and because of inflation,

uals, and foreigners raised $98 billion, net, in the

both principal and interest are currently paid back

United States credit markets, nearly triple the

in depreciated dollars. Consequently, the "re a l"

volume in 1960. Corporate securities, principally

cost to a borrowing corporation is substantially

bonds of nonfinancial corporations, on average

reduced.

accounted for 8 percent of total funds raised in

sufficiently, issuing corporations can "c a ll" the

credit markets during the 1960-1964 period, and

bonds w ith that privilege and refund them at lower

13 percent during

rates. There is some evidence that when long-term

1965-1968.

As mentioned

earlier, the 1965-1968 period was marked by

Moreover,

interest rates were high

interest

rates

decline

previous periods,
7

ECONOMIC REVIEW

TABLE I
Net Sources of Funds fo r Nonfinancial Corporations
1960-1968

1960
1961
1962
1963
1964
1965
1966
1967
1968p

Total
Sources*

External
Sourcest

Bonds

(bil. of $)

$ 47.3
54.7
63.3
65.9
70.2
88.4
99.2
94.1
111.1

$12.9
19.1
21.5
22.0
19.7
32.7
38.1
32.5
47.0

$ 3.5
4.6
4.6
3.9
4.0
5.4
10.2
15.1
13.0

Bonds
As Percent of
Total Sources

Bonds
As Percent of
External Sources

7.4%
8.4
7.3
5.9
5.7
6.1
10.3
16.0
11.7

27.1%
24.1
21.4
17.7
20.3
16.5
26.8
46.5
27.7

* External and internal sources of funds.
t External sources of funds include: stocks, bonds, mortgages, bank and other
loans, trade debt, profits tax liability, and other liabilities.
Source: Board of Governors of the Federal Reserve System, Flow of Funds
Accounts

corporations increased their short-term financing
and then refunded with

long-term debt when

interest rates declined.7
in the

II)

because many bonds that are

redeemed at m aturity or called are not replaced,
while others are converted into stocks. Thus, the

As shown in Chart 2, there was a gradual
increase

(see Table

gross dollar volume of

new

dollar volume of gross proceeds of new corporate
bond

issues exaggerates the

impact o f these

corporate bond offerings (SEC data) until 1964.

offerings on the bond market. For convenience,

A fter

offerings accelerated,

the difference between gross proceeds and the net

reaching a peak in 1967 after the severe credit

change in outstandings is called "a ttritio n " and is

restraint of 1966. Despite some moderation in the

expressed as a percent o f gross proceeds (see Table

rate of increase, new bond offerings remained at a

III). The data show that the a ttritio n tends to vary

high level in 1968.

inversely w ith the level of corporate bond yields.

1964, total

bond

There is a substantial difference between the

That is, attrition was largest in 1963, when bond

gross proceeds from new corporate bond offerings

yields

and the net change in outstanding corporate bonds

retirement was high, and smallest in 1968, when

were

their

lowest level, and debt

bond yields were at their highest level.
Uses of Funds. Data on the proposed uses of
7See,

Hyman

P. Minsky,

"Financial

Crisis, Financial

funds raised through corporate debt and equity

Systems, and The Performance of the Economy," Private

securities show that only a small fraction of the

Capital Markets, Prepared for the Commission on Money
and Credit (Englewood Cliffs, N. J.: Prentice Hall, Inc.,
1964), pp. 311-314.

8 FRASER
Digitized for

net proceeds was used to retire existing securities
(see Table IV ). Moreover, the volume of funds

SEPTEMBER 1969
TABLE II

TABLE III

Net Change in Outstanding
Corporate Bonds
1960—1968*
(Bil. o f $)

A ttritio n as a Percent of Gross
Proceeds and Corporate Bond Yields*
1960-1968

1960
1961
1962
1963
1964
1965
1966
1967
1968

$ 5.0
5.2
4.9
5.6
6.6

8.1
11.1
16.0
14.0

* Totals in this table are not strictly comparable with
totals in Table V II.

1960
1961
1962
1963
1964
1965
1966
1967
1968

Attrition

Bond
Yields

38.27%
44.68
46.15
48.14
38.88
41.30
28.84
18.18
17.24

4.41%
4.35
4.33
4.26
4.40
4.49
5.13
5.51
6.18

* Moody's Aaa rated corporate bonds.
Source: Securities and Exchange Commission
Sources: Moody’s Investor Service and Federal Reserve
Bank of Cleveland

TABLE IV
Proposed Uses of Corporate Funds
1960-1968
(Bil. of $)

Total Net
Proceeds*
1960
1961
1962
1963
1964
1965
1966
1967
1968

$ 9.9
12.9
10.5
12.0
13.8
15.8
17.8
24.4
n.a.

New Money
--------------------------------Working
Plant and
Equipment
Capital
$ 5.7
7.4
5.7
5.3
7.0
7.7
12.4
16.2

$3.1
3.3
2.6
3.6
4.2
5.4
3.4
6.1

_ .
Retirement
of
Securities

Other
Purposes

$0.3
0.9
0.8
1.5
0.8
1.0
0.2
0.3

$0.9
1.3
1.5
1.6
1.8
1.7
1.8
1.9

n.a. Not available.
* Gross proceeds of stocks, bonds, and notes issued less compensation to
distributors and other costs of flotation.
Source: Securities and Exchange Commission

ECONOMIC REVIEW
O

used fo r that purpose tended to vary inversely

one or a small group of institutional investors.

w ith the level of interest rates. Thus, when interest

Borrower and lender negotiate terms and condi

rates

tions of the offering, w ith the exchange of funds

were

relatively

high,

as in

1960 and

1967-1968, corporations retained their lower rate

and securities taking place directly.

coupon issues as long as possible. Conversely,

As shown in Chart 2, the dollar volume of

relatively low interest periods gave corporations an

directly placed corporate bonds expanded irregu

opportunity to refinance outstanding debt and

larly through the first quarter of 1966 and then

thus to reduce their interest costs.

dropped o ff to a level that was maintained through

The bulk of the total net proceeds raised

1968. Directly placed corporate bonds accounted

(primarily from the sale of bonds) was used for

for 67 percent of total corporate bond offerings in

plant and equipment, particularly in recent years.

1964 but only 38 percent in 1968.

Working capital absorbed the next largest share of

There are several explanations fo r the reduced

funds. During the period under review, the amount

dollar volume of directly placed corporate bonds

of funds used for working capital increased at a

in recent years. Because of monetary restraint and

much slower rate than the amount used for plant

reduced liqu id ity at financial institutions in 1966,

and equipment.

some institutional investors, such as life insurance

Public Offerings and Direct Placements. Total

companies (principal buyers of directly placed

bond offerings consist of both publicly offered

issues), cut back sharply on their volume of new

and privately or directly placed issues. Public

commitments to acquire corporate securities. To

offerings o f securities

are

some extent, the cutback in commitments in 1966

investment bankers who act as

contributed to the reduced volume of corporate

intermediaries between issuing corporations and

bonds directly placed in 1966, 1967, and possibly

investors. Specifically, offerings are handled by a

1968. Moreover, institutional investors put a larger

syndicate o f underwriters that, either through

competitive

corporate bonds because they are more readily

arranged

(debt and equity)

bidding or

negotiation, purchases

securities from a borrowing company and, in turn,

their

funds

into

publicly

offered

marketable than directly placed issues.
In addition, yields on directly placed corporate

sells the securities to individual and institutional
investors. Underwriters assume all of the market

bonds have been less attractive to investors than

ing risk in return fo r a fee, which is represented by

yields on publicly offered bonds. As shown in

the

Chart 3, the spread between the yields on directly

spread

between

the

price

paid

the

borrowing corporation and the price paid by the

placed

corporate

bonds

and

new

Baa rated

investor, minus underwriting expenses.
The alternative to a public offering is the direct

An agent (usually a securities underwriter) will often

placement of securities w ith large institutional

bring

investors that involves direct negotiation between

negotiating terms and conditions of the offering. The

borrower and lender and eliminates the under

agent receives a fee for these services (usually paid by the

w riting

function.

direct

placement,

borrower

borrower).

For

and

lender

detailed

together

and

examination

assist

direct

placements, see “ Direct Placement of Corporate Debt,"

prospective borrower, often w ith the aid of an

Econom ic Review, Federal Reserve Bank of Cleveland,

agent, investigates the possible sale of securities to

March 1965.

Digitized for
10FRASER

SEPTEMBER 1969
rapidly
C h a r t 3.

growing

industrial

firms

have

been

accounting fo r an increasing share of capital

SPREAD BETWEEN AVERAGE YIELD
on DIRECTLY-PLACED BONDS and
AVERAGE YIELD on NEW Baa
PUBLICLY-OFFERED BONDS

market borrowing.
As shown in Table V, during the 1960-1968
period, manufacturing corporations

issued the

largest dollar volume of bonds. A t the peak in
1967, fo r example, manufacturing corporations
accounted fo r 45 percent o f the total bond
offerings, or 20 percentage points more than
public utilities—the second largest issuer. In the
last four years, the dollar volume of bonds issued
by manufacturing corporations increased sharply.
The data in Table IV suggest that the strong
demand

for funds stemmed from

plant and

equipment expenditures, as well as the desire to
replenish
-----1
-----1----- 1
-----1----- 1
-----1-----1
----- 1
----- 1
---Q ----- 1

1960
Last entry:

'62

'64

’66

'68

'70

after

the

extreme

credit

anticipated rising borrowing costs and wanted to
obtain long-term funds at what they believed to be

19 6 8

S ources o f d a t a :

liqu id ity

tightness in 1966. In addition, borrowers probably

M o o d y ' s In vestors S er v ic e , Inc. a n d

favorable terms.

F e d e r a l Re ser ve Bank o f C l e v e l a n d

Public utilities issued the second largest dollar
volume o f corporate bonds. From 1960 through
publicly offered bonds declined sharply in 1966

1965, the annual dollar volume of bond offerings

and remained relatively narrow fo r the next two

by public utilities remained virtually unchanged,

years.

reflecting the relatively mild growth in capital
spending programs of the utilities industries. In the

ISSUERS

next three years, however, the dollar volume of

In broad terms, the composition of corporate

their bond offerings increased in response to

bond issuers reflects different phases of economic

stepped-up investment in plant and equipment.

development. As an industry's financial needs

Nevertheless, during the period as a whole, the

exceed its capacity to generate internal funds, or

public

its willingness or ability to issue capital stock, debt

declined noticeably.

utilities' share o f total bond offerings

financing becomes more important. Thus, the

Financial and real estate corporations, princi

railroads in the 1800's and the utilities in the early

pally finance companies, were the third most

part of this century turned to the bond markets

important issuers of corporate bonds. The dollar

for capital to help finance their growth.9 Today,

volume of their offerings was influenced by the

level of consumer instalment debt and credit

For more information on the changed composition of

corporate bond issuers, see W. Braddock Hickman, The

market conditions. During the 1960-1968 period,

Volume o f Corporate B ond Financing Since 1900, op. cit.

the

level

instalment

credit

financial
11

ECONOMIC REVIEW

TABLE V
Gross Proceeds of New Corporate Bond Issues*
By Type of Issuer
1960-1968
(Bil. of $)

1960
1961
1962
1963
1964
1965
1966
1967
1968

Total

Manufacturing

Commercial
and Other

Transportation

Public
Utilities

Communication

Financial and
Real Estatet

$ 8.1
9.4
9.1
10.8
10.8
13.8
15.6
22.0
17.4

$1.5
3.4
2.9
3.2
2.8
4.7
5.9
9.9
5.7

$0.6
0.8
0.6
0.7
0.9
1.2
1.2
1.9
1.7

$0.7
0.7
0.6
1.0
0.9
1.0
1.9
2.0
1.8

$2.3
2.3
2.3
2.2
2.1
2.3
3.1
4.2
4.4

$1.0
0.7
1.3
0.9
0.7
0.8
1.8
1.8
1.7

$2.0
1.5
1.4
2.8
3.4
3.8
1.7
2.2
2.2

* Offered for cash in the United States,
t Excludes investment companies.
Source: Securities and Exchange Commission

institutions

more than doubled.

The dollar

at relatively high levels fo r the next two years,

volume of bonds issued by financial and real estate

reflecting the boom in capital spending.

companies expanded from 1963 until 1966, when

SUPPLY OF FUNDS
During the 1960-1968 period, the composition

high interest rates and a decline in stock prices
dampened their straight and convertible bond

offerings.11

considerably. The identity of purchasers of new

Three other groups of issuers—the communica

ownership

corporate

bonds

changed

bond issues is not known, and so an analysis of

tions, commercial, and transportation industries—

ownership

accounted fo r about equal shares of the remainder

issues.

must

confined

outstanding

Some of the recent ownership changes

of the bond offerings. The dollar volume of bonds

reflect the interest rate developments mentioned

offered by the communications and transportation

earlier. Perhaps more important is the fact that

industries advanced sharply in 1966 and remained

some investors chose to invest a larger share of
assets in corporate stocks. For example, during the
period under review, corporate stock holdings of

1^The

dollar volume of consumer instalment credit

outstanding at financial institutions amounted to $77.5
billion in December 1968, compared with $37.2 billion in
December 1960.

11 The volume of convertible bonds offered by financial

private pension funds rose from about one-third to
1?
over one-half of total financial assets.
State and
12

Data are from the Flow of Funds accounts of the

Federal

Reserve

System,

although

these

data

have

limitations for this analysis, particularly in the valuation
of outstanding financial assets.

and real estate companies amounted to $355 million in
1965, $34 million in 1966, $100 million in 1967, and

$598 million in 1968.

Federal Reserve Bank of Cleveland, November 1968.

Digitized for12
FRASER

"A Note on Private Pension Funds,” Econom ic Review,

SEPTEMBER 1969
local

governments,

insurance

companies,

and

mutual savings banks also increased their corporate

outstandings held by state and local governments
increased appreciably (from

11 percent to 21

toward

percent). The strong demand fo r corporate bonds

equities rather than fixed interest investments is

on the part of state and local governments stems

the concern about inflation: Investors want to

from the rapid growth of state retirement systems.

hedge against inflation by holding securities that

Most states require their retirement systems to

may

holding

invest a substantial part of their assets in bonds. In

investments such as bonds, with a market value

1967, 51 percent of the assets of major state

stock

holdings.

appreciate

Underlying the trend

in value, instead of

that generally declines when the price level rises.
Share of Outstandings. The bulk of corporate

retirement systems was invested

in corporate

bonds, compared w ith 38 percent in 1961.

bonds are held by institutional investors that have

In 1968, life insurance companies, state and

legal restrictions on equity holdings or prefer

local

long-term securities with fixed coupon yields. It is

together accounted fo r nearly 80 percent of the

not

dollar

surprising,

therefore,

that,

during

the

governments, and
volume

private

outstanding

pension

plans

corporate

and

1960-1968 period, life insurance companies held

foreign

the largest dollar volume of corporate and foreign

largest fraction

bonds (see Table V I). Although life insurance

volume until 1968, when other investors more

companies increased the dollar volume of their

than doubled their bond holdings.

bonds.

Households accounted for the
of the

remaining outstanding

holdings of bonds over the period, the data in

Annual Net Purchases. The data in Table VII

Table VI show that they reduced their share of

reveal some additional information about the

total outstanding corporate and foreign bonds

suppliers o f funds through

appreciably (from 54 percent to 43 percent).

corporate bonds. State and local governments and

Private pension funds held the second largest

life insurance companies made the largest annual

net

purchases of

dollar volume of corporate and foreign bonds

net purchases of corporate and foreign bonds in

before 1964 and the third

the period under review. Both types of institutions

largest volume in

subsequent years. Nevertheless, their relative share

increased their holdings of bonds by nearly equal

of total outstandings showed little net change.

amounts from 1960 through 1962. Thereafter, the

Thus, in

pension funds

dollar volume of annual net purchases by state and

acquired bonds at a faster rate than life insurance

local governments substantially exceeded those by

recent years, private

companies, but at a slower rate than state and

life insurance companies. In comparison, the dollar

local governments. These differences reflect the

volume of annual net purchases by private pension

relative rates of growth of the investing institu

funds varied somewhat during 1960-1966 and then

tions

dropped

investment

well

outlets

legal

restrictions

and alternative

regarding
investment

o ff

purchases of equity issues.

opportunities.

Equally

During the period under review, the dollar

sharply as the funds shifted to

households,

important,
and

mutual

commercial

savings
banks

banks,

generally

amount of corporate and foreign bonds held by
state and local governments increased more than

threefold.

Investment Bankers Association of America, 1968), p. 7.

Moreover,

the

proportion

of total

State and Local Pension Funds 1968 (Washington, D. C.:

ECONOMIC REVIEW
TABLE VI
Distribution of Ownership of Outstanding Corporate
and Foreign Bonds
Yearend Levels 1960—1968
Amount (Bil. of $)
1960

1961

1962

1963

1964

1965

1966

1967

1968

State and local governments
Commercial banks
Mutual savings banks
Life insurance companies
Other insurance companies
Private pension funds
Households
Others

$ 10.2
1.0
3.8
48.2
1.7
15.7
6.7
2.8

$ 12.6
0.9
3.6
50.7
1.7
16.9
6.5
2.2

$ 15.3
0.8
3.5
53.2
1.8
18.1
5.8
2.3

$ 18.4
0.8
3.2
56.0
2.0
19.6
4.8
2.5

$ 21.7
0.9
3.1
58.3
2.4
21.2
4.4
3.0

$ 24.8
0.8
2.9
61.1
3.4
22.7
4.6
3.5

$ 29.2
0.9
3.2
63.3
3.6
24.6
5.7
4.9

$ 36.0
1.6
5.2
67.1
3.9
25.6
6.8
5.8

$ 35.4
1.8
6.6
71.2
4.1
26.5
9.2
11.8

Total

$ 90.1

$ 95.8

$101.6

$108.1

$115.7

$124.7

$136.1

$152.0

$166.6

Owners

Percent Distribution
State and local governments
Commercial banks
Mutual savings banks
Life insurance companies
Other insurance companies
Private pension funds
Households
Others
Total

11.3%
1.1
4.2
53.5
1.9
17.4
7.4
2.0

13.2%
0.9
3.8
52.9
1.8
17.6
6.8
2.3

15.1%
0.8
3.4
52.4
1.8
17.8
5.7
2.3

17.0%
0.7
3.0
51.8
1.9
18.1
4.4
2.3

18.8%
0.8
2.7
50.4
2.1
18.3
3.8
1.6

19.9%
0.6
2.3
49.0
2.7
18.2
3.7
2.8

21.5%
0.6
2.4
46.5
2.6
18.1
4.2
2.6

23.7%
1.1
3.4
44.1
2.6
16.8
4.5
3.8

21.2%
1.1
4.0
42.7
2.5
15.9
5.5
7.1

100.0%

NOTE: Details may not add to totals because of rounding.
Source: Board of Governors of the Federal Reserve System, Flow of Funds
Accounts

liquidated

corporate and foreign bonds when

market yields were relatively

fla t during the

1960-1965 period (see Chart 1). However, these

the

buyers'

portfolios;

a decline

means the

opposite.
Three important trends stand out from the data

investors were attracted by rising coupon yields in

in Table V III: (1) A t life insurance companies, the

recent years and showed net purchases of bonds.

financial

assets

accounted

fo r

Share of Assets. One measure of the relative

corporate and foreign bonds declined only slightly

importance of bonds is the share of the buyers'

year over year. In 1968, bonds accounted for 39.1

financial assets accounted for by corporate and

percent

foreign bonds. In essence, the dollar volume of

percentage points less than in 1960. (2) Among

corporate and foreign bonds is compared w ith the

state and local governments, however, corporate

dollar volume of all financial assets for each type

and foreign bonds assumed a substantially more

total

financial

assets,

only

2.5

of buyer. An increase in the ratio indicates that

important role. For example, in 1968, corporate

bonds assumed a larger or more important role in

and foreign bonds accounted fo r nearly one-third

SEPTEMBER 1969
TABLE V II
Annual Net Changes in Ownership of Corporate
and Foreign Bonds
1960-1968
(Bil. of $)
Type of Buyer
State and local governments
Commercial banks
Mutual savings banks
Life insurance companies
Other insurance companies
Private pension funds
Households
Others
Total t

1960

1961

1962

$2.4
- 0.2
- 0.1
2.5
*

0.2

1.2
0.4
0.3

$5.6

$1.9
0.2
0.2
1.8
0.1
1.6
*

1963

$2.7
*
0.1
2.5
0.1
1.2
0.7
0.1
$5.9

$3.2
*
-

1964

0.3
2.8
0.1
1.5
1.0
0.4

$3.2
0.1
- 0.2
2.3
0.3
1.6
- 0.8
0.4

$6.6

$7.1

1965

1966

1967

1968

$3.2
0.1
0.1
2.8
1.1
1.5
- 0.3
0.5

$ 4.4
0.1
0.3
2.2
0.1
1.9
1.2
1.6

$ 6.5
0.8
2.1
4.3
0.8
1.0
1.6
0.3

$ 4.7
0.2
1.4
3.6
0.1
1.0
2.9
0.5

$8.6

$11.8

$17.2

$14.6

NOTE: Details may not add to totals because of rounding.
* Less than ± 50 million.
t Totals in this table are not strictly comparable with totals in Table II.
Source: Board of Governors of the Federal Reserve System, Flow of Funds
Accounts

TABLE V III
Corporate and Foreign Bonds as a Percent of the
Buyers' Financial Assets
Yearend Levels 1960—1968
Type of Buyer

1960

1961

1962

1963

1964

1965

1966

1967

1968

State and local governments
Commercial banks
Mutual savings banks
Life insurance companies
Other insurance companies
Private pension funds
Households
Others

20.6%
0.4
9.4
41.6
6.0
42.7
0.7
8.1

23.3%
0.4
8.4
41.3
5.4
37.7
0.6
7.9

25.5%
0.3
7.5
41.2
5.6
39.6
0.6
7.5

27.3%
0.3
6.4
40.9
5.7
36.5
0.4
8.1

29.0%
0.3
5.7
40.2
6.3
34.1
0.3
8.3

30.0%
0.2
5.0
39.6
8.5
32.3
0.3
8.5

32.0%
0.3
5.2
39.1
9.0
34.4
0.4
10.9

35.7%
0.4
7.8
38.8
8.7
29.5
0.4
9.7

32.1%
0.4
9.3
39.1
8.6
28.1
0.6
18.9

Source: Board of Governors of the Federal Reserve System, Flow of Funds
Accounts

ECONOMIC REVIEW
of financial assets of state and local governments,

interest rates. The influence of the inflationary

compared w ith one-fifth of such assets in 1960.

period on the corporate bond market is reflected

(3) Finally, corporate and foreign bonds became

in (1) the reduced a ttritio n ratio, (2) the increased

considerably less important in the portfolios of

dollar volume of publicly offered corporate bonds

private pension funds. In 1968, corporate and

in contrast to the smaller dollar volume of directly

foreign bonds amounted to 28 percent of the

placed issues, and (3) the rise in the dollar volume

financial

of convertible bond offerings.

assets

private pension funds,

contrast to nearly 43 percent in 1960. This decline

During

the

period

studied,

manufacturing

in the relative importance of corporate and foreign

corporations and public utilities issued the largest

bonds reflects the fact that private pension funds

dollar volume of corporate bonds, w ith most of

have become more "e q u ity " oriented than in the

the funds spent on plant and equipment.
Finally, the composition of the ownership of

past.

corporate bonds, or alternatively the suppliers of
funds,

SUMMARY

also

changed

considerably

during the

dollar

period. The changed composition of ownership

volume of corporate bond financing increased

and relative importance of corporate bonds to the

markedly, particularly in the last four years which

holders reflect interest rate developments, legal

were marked

restrictions, and the trend toward equities.

During

the

1960-1968

inflation

16FRASER
Digitized for

period,

the

and sharply rising

SEPTEMBER 1969

THE MUNICIPAL BOND MARKET, 1 9 6 0 - 1 9 6 8
In recent years, state and local governments

and credit of the issuing body is not pledged to

have accounted for about one-fourth of gross new

support revenue bonds. Instead, revenue to pay

issues of capital market securities in the United

interest and principal is derived from the sale of

States. Although the demand for funds by state

public services, such as water, or based on a lease

and local governments has grown steadily in the

w ith a public agency, such as a school district.

postwar period, the supply of funds has been

A fter World War II, the relative importance of

subject to sharp and frequent swings that reflect a

revenue bonds rose markedly, from 17 percent of

complex structure

investment policies and

new issues of state and local debt in 1946 to 30

decisions. This article examines the market for

percent in I9 6 0 .1 Since 1960, about one-third of

state and local government securities (commonly

new state and local government debt issues has

referred to as "m unicipals") during the 1960-1968

been in the form of revenue bonds (see Table I).

period, with emphasis on the demand for and

The postwar rise in revenue issues largely reflects a

supply of funds and the impact of credit condi

broadened concept of public purpose to include

tions on the municipal bond market.

to ll roads, port authorities, transit facilities, and so
on.

TYPES OF INSTRUMENTS
Most state and local government obligations are

DEVELOPMENT OF THE M AR KET

"fu ll faith and credit," or general credit, obliga

Before World War II, practically all state and

tions of the issuing body. Payment of interest and

local long-term borrowing was financed through

principal on such obligations is based upon the

general obligation bonds, w ith the dollar volume

taxing authority of the issuer, rather than on any

of new issues increasing each year. The first serious

assets pledged as security. As shown in Table I,

reduction in state and local government borrowing

genera! obligation bonds accounted for about 60
percent of all new state and local government
1See

issues during the 1960-1968 period.
Revenue bonds comprise the other major group
of state and local government obligations.

contrast to general obligation bonds, the full faith

Frank

Curley,

"Patterns of

Revenue Bond

Financing," in U. S. Congress, Joint Economic Com
mittee,

State

and

Local

Public

F a cility

Needs and

Financing, Vol. II, 89th Cong. 2nd Sess., (Washington:
U. S. Government Printing Office, 1966), pp. 156-161.

ECONOMIC REVIEW

TABLE I

ipal bonds have had this unique privilege since
1941, when the Federal Government elected to

New Issues of State and Local
Government Securities
By Type of Issue
1960-1968

tax interest on its own obligations.4 Consequently,
investors who are subject to high income tax rates

Amount

Percent

(mil. of $)
$ 60,584
33,830
3,739
1,945

60.5%
33.8
3.7
1.9

T O TA L

$100,184

100.0%

Source: Board of
System

not

add

totals

municipal

bonds an extremely attractive

investment.5 Because of the tax exempt feature,
interest rates on municipal bonds are generally

General Obligation
Revenue
Public Housing Authority
U. S. Government Loans

NOTE: Details may
rounding.

find

because of

lower than rates on other securities of comparable
m aturity and security (see Chart 1).
New issues o f state and local government
obligations are generally sold first to investment
bankers6 who purchase the bonds and then distrib
ute them to a large number of investors, including

Governors

of the

Federal

Reserve
For a discussion of the tax exemption of municipal

occurred during the depression of the 1930's,
when about $2 billion, or approximately 9 percent

bonds see, Roland I. Robinson, Postwar M arket fo r State
and Local G overnm ent Securities (Princeton, New Jersey:
National Bureau of Economic Research, 1960); David J.

of all outstanding municipal bonds, went into

Ott and Allan H. Meltzer, Federal Tax Treatm ent o f State

default.2 Although the Public Works Administra

and Local Securities (Washington: The Brookings Institu

tion loaned funds to local governments after 1933,
during the 1930's the dollar volume of outstanding
issues never surpassed the level attained in 1929.

tion, 1963); and "Comparison of the Interest Cost Saving
and Revenue Loss on Tax-Exempt Securities," in State
and Local Public F a c ility Needs and Financing, op. cit.,
pp. 327-333.

A fter World War II, state and local government
borrowing mushroomed with outstanding debt,
rising from $13 billion in 1946 to $125 billion in
1968—a tenfold increase. In contrast, the Federal

For example, the taxable equivalent yields of a tax-free
municipal

bond

yielding 5 percent for selected tax

brackets are:

debt rose only 30 percent during this period (from

20 percent tax bracket

$270 billion in 1946 to about $360 billion in

30 percent tax bracket

7.15 percent

45 percent tax bracket

9.12 percent

1968).
Nature of the

Market. The exemption of

6.28 percent

65 percent tax bracket

14.08 percent

75 percent tax bracket

20.20 percent

interest from Federal income taxation has distin
guished state and local government obligations
from all other capital market instruments.3 Munic-

Investment banker is a term applied to a security dealer
or a dealer bank that underwrites securities. Commercial

John

Dawson,

"Patterns

General

Obligation

banks that are members of the Federal Reserve System

Bonds," in State and Local Public F a c ility Needs and

may underwrite general obligation municipal issues but

Financing, op. cit., p. 148.

are not permitted to underwrite revenue bonds. For a
discussion of the function of the investment banker, see

The present tax exempt status of municipal bonds may

John E. Walker, "Municipal Bond Underwriting," in State

be substantially altered, or even removed, by the tax

and Local Public F a c ility Needs and Financing, op. c it.,

reform bill that is currently being considered in Congress.

pp. 173-202.

SEPTEMBER 1969

C h a r t 1.

CAPITAL MARKET YIELDS
Percent

Last entry:

D e c e m b e r 19 6 8

S o u r ce o f d a t a :

B o a r d of G o v e r n o r s o f th e F e d e r a l Reserve Sys tem

individuals, commercial banks, and insurance com

and is almost w holly contained in the organiza

panies. The bonds may be sold either by negotia

tional structure of the new issues market. The

tion or by advertisement leading to open bids by

investment bankers that underwrite new issues are

prospective purchasers. Generally, the proportion

usually the same firms that maintain continuing

of negotiated sales is higher for revenue bonds

secondary markets in the securities.

than general obligation bonds.7
Secondary marketing of municipal securities
consists of the sale of such securities by one

DEMAND FOR FUNDS BY
STATE AND LOCAL G OVERNM ENTS

investor to another, usually through a security

State and local governments borrow in the

dealer. Secondary markets exist because borrowers

capital markets principally to finance large capital

generally need undisturbed use of funds fo r a

expenditures.

longer period

investors, on average, are

usually constrained by tradition or law to balance

willing or able to grant. The secondary market for

their current budgets, borrowing for capital pur

municipal bonds is an "over-the-counter" market

poses is widely sanctioned.

than

Although

these governments are

Purposes of Borrowing. Approxim ately 60 per
cent of all state and local borrowing is used to
^Investment Bankers Association of America, "Public

finance capital expenditures for education, roads,

Sale Versus Negotiation in the Marketing of Municipal
Bonds," IB A Statistical B ulletin, Occasional Paper No. 2

8 For a detailed discussion of the secondary market for

(September 1962).

municipal bonds, see Robinson, op. cit.. Chapter 5.

ECONOMIC REVIEW
TABLE II
Use of Proceeds of New Issues of State and Local Government Securities
1946-1955 and 1960-1968
1946-1955
Amount

1960-1968
Percent

(mil. of $)

Amount

Percent

(mil. of $)

Education
Roads and bridges
Utilities
Housing
Other purposes

$ 7,863
8,428
6,494
2,868
12,437

19.9%
21.4
16.5
7.3
31.5

$ 31,260
9,944
18,547
5,248
31,530

31.2%
9.9
18.5
5.2
31.5

Total new capital
Refunding

$38,090
1,341

96.6%
3.4

$ 96,529
3,635

96.5%
3.6

T O TA L

$39,430

100.0%

$100,184

100.0%

NOTE: Details may not add to totals because of rounding.
Sources: Roland I. Robinson, Postwar M arket fo r State and Local Government
Securities (Princeton: Princeton University Press, 1960) and Board of
Governors of the Federal Reserve System

and utilities. Significant shifts in financing these

the significant rise in

three governmental functions occurred between

proportion of borrowed funds fo r education.

both

the volume and

1960-1968

Between the tw o periods, borrowing for u tili

period. As shown in Table II, during the first

ties increased slightly as a share of total borrowing,

the early

postwar period and the

postwar decade, spending for roads and bridges

while borrowing fo r housing decreased slightly.

accounted fo r slightly more than one-fifth of the

There was no change in the proportion of total

proceeds of state and local government borrowing,

borrowing fo r all other governmental functions

compared

(slightly more than 30 percent fo r both periods).

w ith

only

one-tenth

during

the

1960-1968 period. The decline in the proportion

Borrowing by Level of Government. State and

of borrowed funds devoted to highways reflects

local governmental units that borrow in the capital

the adoption of the Interstate Highway Act in

market vary widely in both size and nature. In

1956 that provided fo r a nationwide highway

fact, no other capital market covers such a wide

system financed by gasoline taxes and paid for

range of borrowers. V irtually every state and local

through Federal grants-in-aid to the states.

governmental unit is a potential borrower in the

Borrowing fo r educational purposes jumped

capital market, and there are about 90,000 state

from about 20 percent of the total during the

and local governments in the United States. It is

1946-1955 decade to more than 30 percent during

estimated that roughly 25,000 state and local units

the 1960's. The increase in the school-age popula

have tapped the capital market for funds.

tion between the two periods and the demand for
increased and better educational facilities caused

2Ib id ., p. 54.

SEPTEMBER 1969
TABLE III
State and Local Government Debt
By Level of Government
Am ount Outstanding June 30, 1960 and New Issues 1960—1968
Amount Outstanding
June 30, 1960
Amount

New Issues
1960-1968

Percent

(bil. of $)
State governments
Local governments
Counties
Municipalities and
Townships
School districts
Special districts

$18.5
51.4
5.1

TO TA L

$70.0

Amount

Percent

(bil. of $)
26.5%
73.4
7.3
34.7
17.3
14.1

24.3
12.1
9.9

100.0%

$ 18.3
81.8
7.3
26.3
15.7
32.8
$100.2

18.3%
81.8
7.3
26.3
15.7
32.8
100.0%

NOTE: Details may not add to totals because of rounding.
Sources: U. S. Department of Commerce, Bureau of the Census and Board of
Governors of the Federal Reserve System

Local government borrowing exceeded state
government borrowing

in terms of the

ranked second in the volume of new issues, with

volume of debt outstanding as of June 30, 1960,

about one-fourth of the total. Special districts and

and

the

volume

both

during the period. Municipalities and townships

the

municipalities and townships combined accounted

1960-1968 period (see Table III). Municipalities

new

issues

during

for almost 60 percent of the total volume of new

had the largest proportion of

issues. Although state governments raised over $18

outstanding debt in 1960, accounting for over

billion in new issues during the 1960-1968 period,

one-third of the total. State governments ranked

an amount equivalent to their outstanding debt in

and townships

second in the am ount,of outstanding debt—over

mid-1960, they accounted fo r less than one-fifth

one-fourth of the total. School districts and special

of the total volume of new issues.

districts each accounted fo r about one-seventh of

SUPPLY OF FUNDS
BY INVESTORS

the outstanding debt in 1960.
During the 1960-1968 period, however, bor

As mentioned earlier, one principal feature that

rowing activity in the new issues market did not

sets state and local government securities apart

conform to the distribution of outstanding debt as

from other capital

of mid-1960. Special districts (such as water,

interest earned on such securities is exempt from

sewer,

accounted for

Federal income taxation. Another distinguishing

almost one-third of the total funds raised by all

feature of the market fo r municipal securities is

levels of state and local government during the

the pronounced and frequent changes in owner

1960's and thus dominated the new issues market

ship. As shown in Table IV, no group of investors

and irrigation

districts)

market instruments is that

ECONOMIC REVIEW
TABLE IV
Distribution of New Issues of State and Local Government Securities
Purchased by Private Investors
1960-1968

Households
Commercial banks
Insurance companies
Life insurance
companies
Other insurance
companies
Corporate nonfinancial
business
Mutual savings banks
Security brokers
and dealers
TOTAL

51.4%
17.1
34.3

25.5%
54.9
25.5

14.0%
77.2
15.8

11.4

5.9

1.8

22.9

19.6

14.0

5.7
*

3.9
*

7.0
3.5

2.9

3.9

3.5

100.0%

1964

1963

1962

1961

1960

34.9%
57.1
4.8

9.5%
70.2
9.5
-

2.7

1965

1.6

3.9

10.8

6.3

12.2
1.4

3.2
*

9.1
1.3

3.2

2.6

100.0%

5.2

100.0%

34.9%
38.1
15.9

27.3%
66.2
1.3
-

1967

1966

34.9%
7.5

1968
12.2%
70.4
16.5

1.9

22.2

9.4

16.5

12.7
1.6

6.6
*

1.0
*

0.9

1.0

100.0%

6.3

100.0%

NOTE: Details may not add to totals because of rounding.
* Less than 0.05 percent.
Source: Board of Governors of the Federal Reserve System, F lo w o f Funds
Accounts

has had a stable p a rtic ip a tio n record. F o r e xam p le,

In addition to the decline in the share of

commercial banks' purchases of new issues ranged

municipal securities held in recent years, house

from

17 percent (in 1960) to 77 percent (in

holds have been irregular purchasers of new issues

1962), while households ranged from zero (in

of state and local securities (see Table IV). Such

1967) to 51 percent (in 1960).

buyers,

who

are

mostly wealthy

individuals,

Households. In 1946, households held 60 per10

absorbed about one-half of all new issues of

cent of all privately held municipal securities.

municipal bonds in 1960, but virtually withdrew

Since then, however, the proportion of municipal

from the market in 1967. The irregularity of the

issues held by households has dropped sharply.

acquisition of state and local securities by house

Although households still held the largest single

holds or individuals suggests that municipal secu

proportion of outstanding state and local securities

rities are not primarily bought out of current

in 1960, their share had dropped to about 47

savings, but are acquired in portfolio rearrange

percent of the total (see Table V). Moreover, by

ment. Thus, the market potential, at least over the

the end of 1968, their share had fallen to about

short run, is more a matter of relative yields than

one-third of the total, while commercial banks had

current savings. These factors led one observer to

become the largest holders, accounting fo r slightly

view the level of equity prices as a market factor

less than one-half the total.

of considerable significance: "When individuals are
bullish

'° lb id . , p. 70.

Digitized for22
FRASER

equities, their tax-exempt security

buying suffers, but when the equity outlook grows

SEPTEMBER 1969
TABLE V
Ownership of State and Local Government Securities
By Private Investors
1960 and 1968
1968

1960
Amount

Percent

Amount

(bil. of $)

(bil. of $)
Households*
Commercial banks
Insurance companies
Life insurance companies
Other insurance companiest
Corporate nonfinancial business^
Mutual savings banks
Security brokers and dealers

$28.7
17.6
11.7
3.6

T O TA L

$61.5

Percent

33.7%
46.6
14.8
2.3
12.5
4.2

0.7

$ 42.0
58.1
18.5
2.9
15.6
5.3
0.3
0.7

100 .0 %

$124.8

100 .0 %

46.7%
28.6
19.0
5.9
13.1
3.9

8.1
2.4
0.7
0.4

1.1

0.2
0.6

NOTE: Details may not add to totals because of rounding.
* Includes nonprofit organizations serving individuals.
t Includes fire and casualty insurance companies and insurance activities of
fraternal orders.
J Includes holding companies and closed end investment companies.
Source: Board of Governors of the Federal Reserve System, F lo w o f Funds
Accounts

dim, tax-exempt buying by individuals becomes
,,1 1
more important.
The tax-exempt status of state and local govern

and

percent

the

income

bracket fo r

$100,000 and over.
Furthermore, the study found that the impor

ment securities is clearly one of the most impor

tance of state and local government securities, as a

tant influences on individual participation in the

component of the total financial p ortfolio of an

market. For example, a recent study found that

individual, rose as income increased. The propor

investment in state and local securities was gener

tion

ally not attractive to families with an annual

$50,000 to $100,000 income group. For the group

reached a peak of 12.8 percent fo r the

income of less than $25,000.12 In contrast, 7

with income over $100,000, however, the share of

percent of the families in the $25,000 to $50,000

state and local obligations declined to 8 percent of

income bracket held municipal securities; 24 per

the total

cent in the $50,000 to $100,000 income bracket,

invested a much larger share of their total port

portfolio. The highest income class

folio in common stocks than any other income
111bid., pp. 79-80.

group and showed decidely less preference fo r all

types of fixed income securities. On balance, it is

Helmut Wendel, "Individuals as a Source of Funds for

State and Local Governments," in State and Local Public

apparent that individual participation in the mar

F acility Needs and Financing, op. c it., pp. 444-453.

ket fo r state and local government securities is

ECONOMIC REVIEW
Despite year-to-year variation in the acquisition
C h a r t 2.

of new issues of state and local securities by

DISTRIBUTION of TOTAL INVESTMENTS

commercial banks, municipals became an increas

A ll Comm ercial Banks

ingly important investment outlet for banks during

Percent of Total Investments

the 1960-1968 period. In contrast, U. S. Govern
ment securities declined sharply as a percent of
total bank investments (see Chart 2). This shift
reflects the expansion of economic activity during
the 1960's w ith subsequent heavy demands fo r
funds from businesses, households, and govern
ments. In addition, the shift reflects an attempt to
increase bank earnings by switching from relatively
low-yielding U. S. Government securities to higher
yielding loans and tax-exempt municipal secu
rities.13 Moreover, the banking comm unity has
developed more sophisticated portfolio manage
ment techniques in recent years that have reduced

Last e nt r y :

1968

S ou rc e o f d a t a :

the reliance on U. S. Government securities to
Bo a r d of G o v e r n o r s o f the F e d e r a l
Reserve Sys te m

offset

short-run

fluctuations

reserves.

For

example, the development of the Federal funds
market in the 1950's and the Eurodollar market
during the 1960's has provided important alter
native sources of short-term funds to adjust bank
largely limited to households w ith high incomes

reserve positions. The marked improvement in the

that stand to benefit from the tax-exempt feature

secondary market fo r municipal obligations in

of municipal bonds.
Commercial Banks.

recent years has also increased the liqu id ity of
1960-1968

bank holdings of tax-exempt issues. Consequently,

period, commercial banks became the holders of

the importance of U. S. Government securities in

During

the

the largest proportion of municipal bonds, increas

providing a margin of liqu id ity in bank portfolios

ing their share of total private holdings from about

has been significantly reduced.

one-fourth in 1960 to almost one-half in 1968 (see
Table

V).

Commercial

banks also have been

irregular buyers, dominating the market in periods
of reduced loan demand and relaxed credit condi

For a discussion of the changing composition of

commercial

banks' investment portfolios, see Jack C.

Rothwell, "The Move to Municipals," Business Review,
Federal Reserve Bank of Philadelphia (September 1966);

tions and withdrawing from the market in periods

William F. Staats, "Commercial Banks and the Municipal

of credit restraint (see Table IV). For example,

Bond M arket," Business Review, Federal Reserve Bank of

commercial banks acquired less than 40 percent of

Philadelphia (February 1967); and Peter S. Rose, "U . S.
Government and Municipal Securities at Member Banks,"

the new municipal issues in 1966, compared w ith

Business Review, Federal Reserve Bank of Dallas (March

about 70 percent in 1968.

1969).

SEPTEMBER 1969
The appeal of municipal bonds to commercial
banks is based on a combination of factors,

CREDIT C O NDITIO NS AND THE
M UNICIPAL BOND M AR KET

including the tax-exempt privilege, the availability

It is generally conceded that state and local

of short maturities, and the fact that banks may

governments are sensitive to financial conditions

underwrite general obligations (based on the full

and monetary policy.

faith and credit of the issuer). In addition, many

recent studies have demonstrated that: (1) chang

However, a number of

banks are committed to the welfare of their

ing credit conditions have a greater impact on the

communities by civic sentiment and the pressure

tim ing and the nature (short-term—long-term) of

of their customers. That is, banks are usually

municipal financing than on the volume; and (2)

under pressure to support the financing of local

the

governmental units. In fact, in order to obtain the

largely a function of the size of the governmental

deposit balances of nearby local governments,

unit involved.

response to changing credit conditions is

A study o f the pattern of municipal bond sales

banks must often be w illing to bid on and hold the

during the 1952-1959 period, found that state and

securities of such governments.
companies

local bond sales were moderately sensitive to

make up the third major group of holders of state

monetary policy.15 The sale o f state and local

Insurance

Companies.

Insurance

and local government securities. In 1968, insur

securities reached the highest levels during the

ance companies accounted fo r about 15 percent of

troughs of the tw o recessions during the period

all

(see Table V). Fire and

studied as state and local governments shifted

casualty insurance companies are more important

about 10 percent o f their bond offerings from the

private holdings

than life insurance companies in the volume of

final stages of the expansion periods to recession

securities held, due largely to their greater expos

and recovery periods. However, the sale of bonds

ure to Federal tax liabilities. In fact, a survey of

for projects that are d iffic u lt to postpone, such as

mutual

schools and water and sewer projects, was rela

fire and casualty insurance companies

found that the most important factor in the

tively insensitive to changing credit conditions.

variation of holdings of municipal securities was

Another analysis found that interest rates had a

the individual company's tax situation.14 Both

significant impact on state and local borrowing

types of insurance companies showed swings in the

during the 1952-1965 period, although the effect

volume of new issues of municipal obligations

was greater on tim ing than on volume.16 The

purchased during the 1960-1968 period (see Table

borrowing decisions of state and local governments

IV), but it is significant that life insurance com

were found

be influenced

by the spread

panies have virtually withdrawn from the new
issues market since 1962.

Frank E. Morris, "Impact of Monetary Policy on State

and

Local

Governments:

Empirical

Study,"

The

Journal o f Finance, X V (May 1960), pp. 232-249.
1fi

"Fire and Casualty Insurance Companies," in State and

Paul F. McGouldrick, "The Effect of Credit Conditions

on State and Local Bond Sales and Capital Outlays Since

Local Public F a c ility Needs and Financing, op. cit., pp.

World War II," in State and Local Public F a c ility Needs

382-397.

and Financing, op. cit., pp. 299-321.

ECONOMIC REVIEW

between actual and expected interest rates. In

time surrounded by special circumstances, the

contrast, lenders were found to be more concerned

findings suggest that changing credit conditions

w ith the existing spread between yields on munic

have a greater impact on large governmental units

ipals and other securities. Furthermore, the fin d

than on small units.

ings suggested that the positive effects of rising

The survey revealed that large governmental

municipal bond rates on the willingness of lenders

units postponed or reduced planned long-term

to purchase municipal bonds more than offset the

borrowing in 1966 by about $1.4 billion, or 20

negative effects of such increases on the w illing

percent of planned levels, largely because of high

ness of state and local governments to offer new

interest rates. Actual spending, however, was only

debt issues. The interaction of these forces may

reduced by about $250 m illion in 1966 and 1967

explain, in part, the observed limited impact of

(roughly 1.0 to 1.5 percent of actual spending),

monetary policy on the municipal bond market.

because most units substituted short-term borrow

The impact, however, was found to differ at

ing or used liquid assets. Because large govern

various levels of government because most of the

mental units usually borrow well in advance of

interest rate sensitivity displayed by aggregate

cash needs, capital spending in those years was

state and local bond sales was found to be due to

insulated from the impact of restrictive credit

the high interest elasticity of new debt issues of

conditions. In short, the survey revealed that large

states.17

state

Local debt issues showed very little

and

local

governments

adjusted

their

interest elasticity. The differences were found to

financing requirements rather quickly to changing

lie in the follow ing factors that differentiate the

credit conditions, w ith virtually no effect on

two levels of government: (1) the larger scale of

contract awards or capital spending.

operations at the state level; (2) the greater
frequency

w ith

which

In contrast, the concurrent survey of small

state governments use

governments revealed that these units were rela

capital markets; (3) the higher ratio of liquid assets

tively insensitive to changing credit conditions.19

to capital expenditures at the state level; and (4)

The sample of small governments indicated that

the larger proportion of interest sensitive revenue

planned borrowing was reduced by about $2.6

bonds among all state issues.

billion during 1966. Most of this reduction (about

The Federal Reserve System's surveys of state

40 percent of the dollar volume of actual spend

and local government borrowing in the 1966 credit

ing) resulted from defeats of bond referendums.

markets largely support the above study.

A l

High borrowing costs, the major cause of borrow

though the surveys covered a discrete period of

ing reductions fo r large units, accounted fo r only
about one-third ($900 m illion) o f the reduction in

Michael D. Tanzer, "State and Local Government Debt

in the

Postwar

Period,"

Review o f Economics and

borrowing by small units. Although small govern
mental units had relatively less borrowing d iffi

Statistics (August 1964), pp. 237-244.

culty due to restrictive credit conditions than large

18Paul F. McGouldrick and John E. Peterson, "Monetary

19John E. Peterson and Paul F. McGouldrick, "Monetary

Restraint and Borrowing and Capital Spending by Large

Restraint,

State and Local Governments in 1966," Federal Reserve

Local Governments and State Colleges in 1966," Federal

B u lle tin (July 1968), pp. 552-571.

Reserve B u lle tin (December 1968), pp. 953-973.

Borrowing, and Capital Spending by Small

SEPTEMBER 1969

units, such difficulties as did develop led to the

tively

high

liqu id ity

positions of many large

cancellation of a higher volume of planned con

governmental units enabled them to postpone

tract awards ($400 m illion compared w ith $250

long-term borrowing plans with little effect on

m illion). This difference between large and small

their spending plans. In fact, withdrawal of large

units was due largely to the fact that the small

governmental

units did not have sufficient liquid assets to

during a period of high interest rates was an

units from

the

capital

markets

finance the projects and because the lead time

indication of their financial strength.

between borrowing and cash needs was shorter.
Those small units that proceeded w ith planned

SUMMARY

projects in spite of borrowing difficulties did so by

Both demands and supplies in the municipal

resorting to short-term borrowing, reducing cur

bond market changed markedly during the 1960's.

rent expenditures, or postponing cash disburse

Local governments in general, and special districts

ments. On balance, the findings indicated that

and municipalities in particular, were the heaviest

once small governmental units received permission

borrowers in the capital

to borrow, they were less apt to change their

through 1968. Commercial banks replaced house

financing plans than large units; where borrowing

holds as the largest holders of state and local
securities.

markets from

addition,

1960

plans were changed, they were more likely to

government

abandon the projects than to obtain financing

volume of funds supplied changed frequently,

the total

from alternative sources.

reflecting a growing complexity of investment

In general, the Federal Reserve survey indicated

policies due largely to the tax exempt feature of

that high interest rates and severe credit restraint

municipal bonds. In fact, many of the sharp swings

during 1966 did have some impact on state and

in the municipal bond market thus far in 1969

local government borrowing plans, but only a

have been due to changing credit conditions and

marginal impact on actual capital spending. Large

the tax reform bill under discussion in Congress.

governmental units were often able to postpone

Finally, a number of recent studies have found

borrowing by reducing the lead time between

that state and local governments are sensitive to

financing and cash needs and utilizing liquid assets.

financial conditions and monetary policy. The

In contrast, small governmental units were less

bulk of the evidence fo r the 1960-1968 period

inclined to speculate on interest rate fluctuations

seems to suggest that changing credit conditions

and were more inclined to see borrowing plans

had a greater impact on the tim ing and nature of

through. Finally, the results of the survey suggest

municipal financing than on the dollar volume,

that causation runs not only from changes in

and that the response to changing credit condi

borrowing plans to changes in liquid asset hold

tions was largely a function of the size of the

ings, but in the reverse direction also. The rela

governmental unit involved.

Fourth Federal Reserve District