Municipal lease-purchase obligations: a different kind of tax-free investment.

The capital markets are constantly introducing a wide array of new investment vehicles. It's important for practitioners to keep up with these changes so they can advise their clients appropriately. This month, Lance L. Dominique, director of municipal general lease placements, Bankers Leasing Association, Inc., Northbrook, Illinois, and Peter D. Fleming, CFP, a senior editor with the Journal, write about municipal lease-purchase obligations.

Municipal lease--purchase obligations are a form of short-term, tax-exempt financing often used by municipalities or other government entities to purchase essential equipment. They represent a municipality's promise to pay under installment purchase contracts. These obligations are typically incurred by municipalities when they need to purchase equipment and don't want to issue bonds, buy the equipment for cash or rent it.

The types of equipment purchased with municipal lease--purchase obligations range from fire and garbage trucks to computers and telephones.

SPECIAL USES

Municipalities use lease financing for several reasons; they are often issued to avoid state-imposed constitutional

Amortization schedule
Principal: $35,000
Interest rate: 8%
Term: Three years
Payment schedule: $1,096.77 monthly
                                       Approximate
                                        principal
                                       balance at
Year   Principal   Interest     Total   yearend
  1     $10,750     $2,411     $13,161  $24,250
  2      11,642      1,519      13,161   12,608
  3      12,608       553       13,161    (*)
  * A final payment, usually $1 or less, is sometimes necessary
to fully repay principal.

and statutory limitations on the issuance of debt.

At other times, the cost of the equipment beign financed is not large enough to justify the expense of a bond issue. Or the useful life of the equipment itself is not long enough to match the life of the bond. The term of municipal lease--purchase obligations takes into consideration the particular useful life of the underlying equipment.

Municipal lease financing can be completed in a fraction of the time it takes for a full bond issue. This allows municipalities to acquire equipment when they need it.

TAX-EXEMPT INVESTMENT

As with most state and local government financing arrangements, a municipality's leasing equipment results in creation of a tax-exempt investment, in this case a municipal lease-purchase obligation. A more accurate term is actually "municipal installment purchase agreement," since the transaction is not a true lease but is in fact an installment loan. By making installment payments over a two- to five-year period, the municipality is able to purchase the equipment it needs on more favorable terms.

Because of the municipal lease structure, these obligations carry a relatively high tax-exempt yield and have a shorter maturity when compared to more conventional municipal bonds. Currently, municipal lease-purchase obligations are yielding 7.5% to 8.25% and have two- to five-year maturities. Yields on other municipal securities of comparable maturity are only in the range of approximately 5% to 6%. The exhibit above shows the amortization of a typical municipal lease--purchase obligation.

Investors in conventional municipal bonds, with maturities of 10,20 or 30 years, receive semiannual interest payments and no principal payments until the bonds mature. Municipal lease-purchase obligations are different. Over the term of the obligation, the investor receives regular payments including both principal and interest. Most leases make montly payments; quarterly, semi-annual or annual payments also exist, at the option of the municipality. After a final payment of $1, the municipality owns the property subject to the lease.

Municipal leases typically are originated in amounts ranging from $5,000 to as much as several hundred thousand dollars, depending on the equipment acquired. Many are offered through private placements in which one investor acquires the entire lease. Other leases are offered to more than one investor through securities firms.

SAFETY RATING

Unlike most municipal bonds, municipal lease-purchase obligations are hardly ever rated by Moody's, Standard & Poors or other bond-rating agencies. Due to their small size, it's not cost-effective for the instruments to be rated. The obligations usually don't have Municipal Bond Insurance Agency insurance for the same reason. To date, the safety record of municipal lease-purchase obligations has been very good, with a default rate similar to the municipal bond industry as a whole and many leases accorded investment-grade status.

RISKS

But there are risks involved. Generally, municipally lease-purchase obligations are issued without a pledge of the taxing power of the particular municipality, although the municipality does promise to make all appropriations necessary for the full term of the loan. The obligations typically contain clauses that provide the municipality has no obligation to make lease payments beyond the current fiscal year unless funds are appropriated for that purpose.

If the state legislature fails to make such an appropriation, the lease terminates without recourse to the municipality. Although it doesn't happen frequently, this could result in a loss to the investor. However, if the equipment is essentially, the municipality is likely to find the funds to continue making the lease payments. In addition, the municipality's debt rating might be affected adversely by the municipality's failure to make necessary appropriations.

To be safe, investors should find an issue that contains a nonsubstitution clause, which prevents the municipality from replacing the underlying equipment until the lease is paid. Also, investors should avoid municipalities with a history of suspending services or those with known financial difficulties.

While municipal lease-purchase obligations usually are secured by the equipment subject to the lease, disposition of the equipment in the event of foreclosure may be difficult. To counter this risk, some obligations are issued with third-party credit enhancements sucsuch as insurance or letters of credit. These usually accompany very large financings.

INCOME TAX

CONSEQUENCES

As with other municipal bonds, interest received on municipal lease-purchase obligations is tax-exempt. And principal payments are treated as a tax-free return of capital. The interest rarely is subject to the alternative minimum tax for individual investors because the majority of municipal leases have no private sector involvement--they are used almost exclusively for public purposes, with the funds to pay for the lease coming from a general operating fund.

INVESTOR SUITABILITY

Municipal lease--purchase obligations are acquired by both individual and institutional investors. Generally, the individual investors are in high tax brackets and can benefit from tax-exempt income.

Because municipal lease-purchase obligations are relatively illiquid, it is usually recommended investors have investment portfolios of at least $100,000 before purchasing them. Although municipal lease financing has been around in some form or another for more than 100 years, they have been commonly offered to the public only in the last two decades. As a result, no active secondary market exists for municipal leases as it does for conventional municipal bonds.

Municipal leases generally are appropriate for those who are able to buy and hold the leases until maturity. The illiquidity of municipal lease-purchase obligations--not the increased risk due to the possibility of nonappropriation--is the reason why these instruments offer investors a higher yield.

GROWING POPULARITY

The volume in the municipal lease industry has grown substantially in terms of both investors and municipalities. Annual volume is approximately $7 billion, as compared to $1 billion in 1980. With consistent demand by taxpayers for increased municipal services from governments faced with static budgets, municipal lease-purchase financing is likely to remain popular in years to come.

Mr. Fleming is an employee of the American Institute of CPAs and his views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.