Planning and Finance Series: Fun with Bond Financing

Bond financing can be a complex topic. A better understanding of the dynamics of bond financing is needed to avoid harmful misunderstandings by the media that mislead the public.

by Patrick L. Dugan, Everett, Washington

Local governmental finance can be complex and is frequently misunderstood by the media. Unfortunately, these misunderstandings can also mislead the public. An example of such misunderstandings recently occurred in Seattle. A Seattle Times article (along with other media reports) alleged that the city spent about $7.5 million paying interest on transportation bonds sold before the projects were ready for construction, implying that since the projects were not ready for construction this money was needlessly spent on interest rather than other purposes.1 Public comments on the article expressed outrage at the city’s “mismanagement” and “waste” of these funds. Since this article unfortunately illustrates a fundamental misunderstanding of bond financing, it offers a good opportunity to refresh understandings about how bond financing works and provide a little historical background.

What the article overlooks is that, when bonds are sold, the proceeds from the bonds are invested and earn money. Also, the same amount of interest will be paid to the bond holders irrespective of when the money is actually spent, so it makes no difference that the projects were not built immediately after the bonds were sold.

Arbitrage in the old days

In the old days, cities could make money by borrowing money (selling bonds) and then investing the proceeds. This was possible because cities may borrow money at low interest rates, since the interest earnings on municipal bonds are not taxed while, at the same time, invest in regular market investments that generally have higher interest rates. For example, in 1980, tax free high grade municipal bonds earned 8.51 percent interest while taxable ten year treasury bonds earned 11.43 percent and corporate bonds earned 11.94 percent. Consequently, if a city sold bonds it could turn around and invest those bonds in taxable investments and earn a difference of almost 3 percent on the amount.2 In finance, the practice of borrowing low and investing high is called “arbitrage.”

Unfortunately for local governments, Congress thought that cities earning revenues by arbitraging their tax free bond proceeds was an abuse of the tax free privilege. As a result, in the 1986 Tax Reform Act, Congress included severe restrictions on the interest income earned on the investment of bond proceeds. While the arbitrage restrictions are among the most complex aspects of tax law, in simple terms, income earned in excess of a tax-exempt cost-of-funds must be returned to the federal government. These requirements are implemented by complex rules and requirements that are hard to understand and very difficult to manage. For many finance directors, the arbitrage restrictions took the “fun” out of being a local governmental finance director.

Since 1986

Much has changed since 1986. The interest spread between taxable treasury investments and tax exempt has gradually declined. In 2007, just before the great recession, the spread had declined to where treasuries were only 0.21 percent higher than municipals. After 2007, the great recession has turned much in the finance world “upside down” and the interest yields on ten year treasury bonds have been less than tax free municipals; in 2011, taxable ten year treasuries were 1.51 percent lower than tax free municipals!3 The interest earnings on day to day investments for local governments have been even lower. The City of Seattle budget documents estimate that it currently earns between 0.94 percent and 1.25 percent.4

Bond interest earnings in Seattle

While arbitrage isn’t what it used to be, the City of Seattle still earns revenue off money it has in “the bank.” As reported in the article, $7.5 million of interest was paid on bonds that were “idle” over five years. Meanwhile, from data reported in the article, the city would have earned between $2 million and $4 million at 1 percent interest over the five years, depending on the actual date of the sale of the bonds and the date of dispersing the bond proceeds to construction projects.

This $2 million to $4 million is money the city would not have earned if it had spent the bond proceeds immediately. On the other hand, the interest payments on the bonds would be the same whether the bond proceeds are spent promptly or not. Therefore, because the city did not spend the bond proceeds promptly, the city has up to $4 million more to spend on transportation — not less money, as implied by the media discussion of the situation.

The only practical negative effect of spending the $7.5 million on interest now is that it takes money out of the current budget that could be spent on other things now. But, since the $7.5 million spent on interest now avoids having to spend it out of future budgets, this frees up $7.5 million in future budgets to spend on those other things — so those expenses are only postponed. The cost of spending it now, rather than later, is the $2 million to $4 million earnings, which seems like a high price to pay to do something today, rather than tomorrow.


Although construction delays cause the city to not spend the bond proceeds as soon as planned, the city, nonetheless, comes out ahead financially. Bond financing can be complex and it has changed dramatically in recent years. As such, it lends itself to misunderstandings. Too often, such misunderstanding is on the part of the media, which, in turn, misleads the public. A better understanding of the dynamics of bond financing is needed to avoid such misunderstandings.

Patrick L. Dugan has been a city planning director and a city finance director. During the last 30 years, he has held various financial and planning positions in cities, counties, and regional agencies in three states. Now a private consultant in Washington, he can be reached at


  1. Mike Lindblom, “Seattle paid millions in interest on transportation bonds before projects were ready,” Seattle Times, March 20, 2013,
  2. Steven Mcquire, Tax Exempt Bonds: A Description of State and Local Government Debt, Congressional Research Service, June 19, 2012, page 3.
  3. Ibid.
  4. City of Seattle – 2013 Adopted and 2014 Endorsed Budget, page 69.

Published in the October/November 2013 Issue

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