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ip ®w te w SEPTEMBER 1 96 9 IN TH IS ISSUE Corporate Bonds 1960-1968 ....................3 The Municipal Bond Market, 1960-1968 ....................17 FEDERAL RESERVE BANK OF 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 In 1900, corporate bonds outstanding amounted to $5.9 billion (par amount).1 By made to the preinflationary period and the yearend 1968, the volume of outstandings had 1965-1968 inflationary period, because the behav increased ior to nearly $167 billion. Currently, of 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 a background of of corporate bonds vary widely. Denominations, for example, range from $100 to $10,000 or more, 1 W. Braddock Hickman, The Volume o f Corporate Bond Financing Since 1900 (Princeton, N. 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 3 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. 2 3 Detailed definitions of the various types of corporate bonds may be found corporation finance. 4 FRASER Digitized for in a standard textbook on 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 5 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 of 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 of 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 of 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 of 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 of 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. as 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, if interest rates were high interest in 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 $) (bil. of $) (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 at 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 9 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 share competitive corporate bonds because they are more readily arranged by (debt and equity) bidding or negotiation, purchases securities from a borrowing company and, in turn, of 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 to 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 g 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. In a direct placement, a borrower borrower). For and a lender detailed together and examination assist of in 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 Q 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 of instalment credit at 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. 10 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 of offerings.11 considerably. The identity of purchasers of new Three other groups of issuers—the communica ownership of 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. 19 must be confined to 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 13 $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 of 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 as investment well as 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 14 threefold. Investment Bankers Association of America, 1968), p. 7. Moreover, the proportion of total State and Local Pension Funds 1968 (Washington, D. C.: 13 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% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 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. share of financial assets accounted fo r by 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 of 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 $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 15 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 of private pension funds, in 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 by 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 of 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. In contrast to general obligation bonds, the full faith Frank E. 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. 17 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 to 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 B. Dawson, "Patterns of 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. 18 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. O 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. 19 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 20 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 of 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 21 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% 100.0% 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% 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% 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 on 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 67 percent in 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 12 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 23 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 in 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 13 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). 24 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 to be influenced by the spread panies have virtually withdrawn from the new issues market since 1962. 15 Frank E. Morris, "Impact of Monetary Policy on State and Local Governments: An Empirical Study," The Journal o f Finance, X V (May 1960), pp. 232-249. 1fi 14 "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. 25 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 17 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. 26 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. In 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. 27 Fourth Federal Reserve District