Guidelines on Local Government Borrowing and Recent Developments in South East Europe
3. Which debt instrument is suitable?

There are two major types of debt instruments available to finance municipal capital expenditures: (i) loans and (ii) bonds. Loans are granted by a financial institution (e.g. commercial bank) directly to the local government. Applying for a loan is less complex than the procedures required for bond issuance. From this point of view, loans are more advantageous to small and medium size municipalities seeking external financing. Many international financial institutions have dedicated programs aimed at supporting and financing local governments' infrastructure projects, especially in the emerging markets. The financing occurs either directly or indirectly, via intermediated loans to local banks in target countries. The terms and conditions of such loans are more favorable to the local governments than in case of typical commercial banking loans. Bonds are the preferred form of financing for large capital investment projects which require long term financing. Bonds are issued by local governments either directly or via financial intermediaries (e.g. funds, banks) to institutional or individual investors. The cost of borrowing using bonds is usually lower than in case of a loan. There are two types of municipal bonds. A. General obligation bonds are secured by the local governments' revenues stream. Such bonds are used to finance investments in public goods (public safety, streets and bridges, public parks and open space, public buildings etc.). B. Revenue bonds are backed by the stream of revenues generated by the project, financed from the bond sale. Revenue bonds are not backed by the taxing power of the local government. Typical projects financed by revenue bonds include: municipally-owned airports, water and sewer systems, electric utilities, athletic and sport facilities and limited access highways

Debt instruments can be broadly classified in two categories: (i) loans and (ii) bonds.

In case of loans, debtors deal directly with lenders (e.g. banks, pension funds or insurance companies) – i.e. borrower negotiates terms of the loan directly with the lender. The due diligence process (risk assessment and monitoring) of the borrower is performed by the creditor.

Bonds represent a different kind of financial intermediation. They are sold directly or via financial intermediaries (e.g. funds, banks) to institutional or individual investors. In 37 case of bonds, due diligence is the responsibility of credit rating agencies (or financial intermediaries). Based on their analysis, investors decide under what conditions (i.e. required yield) they are willing to buy the bonds.

Loans have been more popular as a debt financing instrument of local governments across Western Europe, where they financed municipal investment throughout the 20th century. Bonds are characteristic for the U.S. market, laying the foundation of municipal credit market development in North America.

In its early stages, local government credit markets may start with either of the two models but usually end up with both models serving different segments of the market. The same legal framework should be applied to all types of debt instruments without discrimination. Competition between banks, a bond market and other available financing instruments can help keep the costs of capital as low as possible for municipal borrowers and increase the flow of information about credit quality in between market stakeholders.