Financial Management SeriesFinancial Management SeriesNumber 12Number 12
BONDS &BONDS & BOND BOND RATINGSRATINGS
Alan ProbstLocal Government SpecialistUW-Extension Local Government Center(608) 262-5103
Long-Term DebtLong-Term Debt
BondsBonds are the primary source are the primary source of long-term debt for local of long-term debt for local governmentsgovernments
BondsBonds
A A bondbond is a is a debt instrumentdebt instrument issued for a issued for a period of period of more than one yearmore than one year with the with the purpose of raising capital by purpose of raising capital by borrowing. The Federal government, borrowing. The Federal government, states, cities, corporations, and many states, cities, corporations, and many other types of institutions sell bonds. other types of institutions sell bonds. Generally, a bond is a promise to repay Generally, a bond is a promise to repay the principal along with interest the principal along with interest ((couponscoupons) on a specified date ) on a specified date ((maturitymaturity). ).
Types of BondsTypes of Bonds
There are commonly two types There are commonly two types of bonds:of bonds:
General Obligation (GO) BondsGeneral Obligation (GO) Bonds
Revenue BondsRevenue Bonds
General Obligation (GO)General Obligation (GO)
Unlimited-tax GO bonds are secured by Unlimited-tax GO bonds are secured by the full faith, credit, and taxing powers the full faith, credit, and taxing powers of the issuing governmentof the issuing government
Legally obligate the local government Legally obligate the local government to levy taxes on all assessable property to levy taxes on all assessable property within its jurisdiction to a level within its jurisdiction to a level necessary to meet the bond payment necessary to meet the bond payment obligationobligation
General Obligation (GO)General Obligation (GO)
GO bonds are an appropriate financing GO bonds are an appropriate financing vehicle for capital projects that benefit vehicle for capital projects that benefit the community as a whole.the community as a whole.
May be limited by constitutional and May be limited by constitutional and statutory restrictions.statutory restrictions.
Normally require voter approval Normally require voter approval
Revenue BondsRevenue Bonds
Revenue bonds are secured by the Revenue bonds are secured by the revenues from the project being revenues from the project being financedfinanced
Their credit strength depends upon the Their credit strength depends upon the financial strength of the capital projectfinancial strength of the capital project
Revenue BondsRevenue BondsCommon types of revenue bonds Common types of revenue bonds
include:include: Airport revenue bondsAirport revenue bonds Hospital and nursing home revenue Hospital and nursing home revenue
bondsbonds Public power revenue bondPublic power revenue bond Water and sewer revenue bondsWater and sewer revenue bonds Sports complex and convention center Sports complex and convention center
revenue bondsrevenue bonds
What is a Bond Rating?What is a Bond Rating?
Bond Rating is an independent assessment Bond Rating is an independent assessment
It is associated with purchase and holding a It is associated with purchase and holding a particular bond particular bond
It assesses relative credit riskIt assesses relative credit risk
Ratings indicate likelihood that the obligation Ratings indicate likelihood that the obligation will be repaidwill be repaid
What is a Bond Rating?What is a Bond Rating?
In essence, a local government’s bond In essence, a local government’s bond rating is the government equivalent of rating is the government equivalent of your personal credit score or credit your personal credit score or credit rating.rating.
Both indicate the likelihood of the Both indicate the likelihood of the borrowed money being paid back.borrowed money being paid back.
Who determines Bond Rating?Who determines Bond Rating?
Ratings are given by independent rating agenciesRatings are given by independent rating agencies
Ratings are independent source of information and Ratings are independent source of information and analysis for capital marketsanalysis for capital markets
Primary agencies rating municipal debt – Fitch IBCA Primary agencies rating municipal debt – Fitch IBCA Inc., Moody’s Investors Service and Standard & Inc., Moody’s Investors Service and Standard & Poor’s Rating ServicesPoor’s Rating Services
What factors determine Bond Rating?What factors determine Bond Rating? Debt management using key financial ratios such as Debt management using key financial ratios such as
debt per capita debt per capita
Administrative issues relating to direct authority of Administrative issues relating to direct authority of government’s responsibility government’s responsibility
Financial performance analyzing revenues and Financial performance analyzing revenues and expenditure trendsexpenditure trends
Economic outlook based on tax base, income, Economic outlook based on tax base, income, population, employment and otherspopulation, employment and others
Service Base also included for Revenue BondsService Base also included for Revenue Bonds
What do different ratings mean?What do different ratings mean?
Ratings compare relative risks of Ratings compare relative risks of different debt issuesdifferent debt issues
Ratings scale is a consistent Ratings scale is a consistent framework for comparisonsframework for comparisons
Each agency has it own rating Each agency has it own rating scalescale
ExampleExample: Rating Scale of Fitch IBCA: Rating Scale of Fitch IBCA
AAAAAA
AA (+ or - )AA (+ or - )
A(+ or -)A(+ or -)
BBB (+ or -)BBB (+ or -)
BB (+ or -)BB (+ or -)
B (+ or -)B (+ or -)
CCC, CC, C (+ or -)CCC, CC, C (+ or -)
DD
- - Highest credit qualityHighest credit quality
- Very high credit quality- Very high credit quality
- High credit quality- High credit quality
- Good credit quality- Good credit quality
- Speculative- Speculative
- Highly speculative- Highly speculative
- High default risk- High default risk
- In default- In default
How does rating affect How does rating affect cost of borrowing?cost of borrowing?
A high bond rating (e.g. AAA) indicates low credit A high bond rating (e.g. AAA) indicates low credit risk to investorrisk to investor
Borrowing will be less costly for an issuer with Borrowing will be less costly for an issuer with higher rating than with lower ratinghigher rating than with lower rating
For each drop in ratings, bond issuers pay additional For each drop in ratings, bond issuers pay additional basis points basis points (a basis point is 1/100 of a percentage point)(a basis point is 1/100 of a percentage point)
When in millions, a few basis points can translate When in millions, a few basis points can translate into thousands of dollarsinto thousands of dollars
Bond PricingBond Pricing
Bonds can be priced at a Bonds can be priced at a premiumpremium, , discountdiscount, or at , or at parpar. If the bond’s price . If the bond’s price is higher than its par value, it will sell at is higher than its par value, it will sell at a premium because its interest rate is a premium because its interest rate is higher than the current prevailing rates. higher than the current prevailing rates. If the bond’s price is lower than its par If the bond’s price is lower than its par value, the bond will sell at a discount value, the bond will sell at a discount because its interest rate is lower than because its interest rate is lower than current prevailing rates.current prevailing rates.
ExampleExample
The quoted price is usually based on the bond The quoted price is usually based on the bond maturity at a price of maturity at a price of parpar, or 100.00. In the , or 100.00. In the case of a bond 6% of June 1, 2008, if the case of a bond 6% of June 1, 2008, if the price is $105.13, this means the bond is at a price is $105.13, this means the bond is at a 5.13% 5.13% premium premium to its maturity price (par or to its maturity price (par or 100.00). An investor who pays $105.13 for the 100.00). An investor who pays $105.13 for the bond will receive only $100.00 back on bond will receive only $100.00 back on maturity. Conversely,maturity. Conversely, bond selling at a price bond selling at a price that is less than its par value is selling at a that is less than its par value is selling at a discountdiscount..
ExampleExample: : City A issues 30-year bond City A issues 30-year bond with a 10 million face value with a 10 million face value
With AAA Bond ratingWith AAA Bond rating
Pays 2% annual interestPays 2% annual interest
Issues bonds at premium at Issues bonds at premium at $15,000,000 $15,000,000
Total Interest cost over 30 Total Interest cost over 30 yearsyears
15,000,000 x 0.02 x 3015,000,000 x 0.02 x 30
== $9,000,000 $9,000,000
With BBB Bond RatingWith BBB Bond Rating
Pays 7% annual interestPays 7% annual interest
Issues bonds at discount at Issues bonds at discount at $7,000,000$7,000,000
Total Interest cost over 30 Total Interest cost over 30 yearsyears
7,000,000 x 0.07 x 307,000,000 x 0.07 x 30
== $14,700,000$14,700,000
Why does Local Government Why does Local Government need Bond Rating?need Bond Rating?
Investors use bond ratings as they are easy Investors use bond ratings as they are easy to access and understandto access and understand
Investors consider ratings as indication of Investors consider ratings as indication of government’s overall fiscal healthgovernment’s overall fiscal health
Local Government will find it more difficult to Local Government will find it more difficult to sell an unrated bondsell an unrated bond
Why does Local Government Why does Local Government need Bond Rating?need Bond Rating?
Even if the local govt. sells the bond, Even if the local govt. sells the bond, investors will pay less to compensate for investors will pay less to compensate for uncertaintyuncertainty
Bond ratings necessary only if issue is larger Bond ratings necessary only if issue is larger than $1millionthan $1million
Bond Ratings give access to national debt Bond Ratings give access to national debt marketmarket
How long does a rating last?How long does a rating last? Until the Bond expiresUntil the Bond expires
Changes if there is an upgrade or Changes if there is an upgrade or downgrade in the ratings over timedowngrade in the ratings over time
Rating agency withdraws ratings due to Rating agency withdraws ratings due to insufficient informationinsufficient information
How do rating agencies evaluate How do rating agencies evaluate Local Governments?Local Governments?
Rating agencies use debt indicatorsRating agencies use debt indicators
They study both debt outstanding and debt service They study both debt outstanding and debt service as indicators of debt burdenas indicators of debt burden
Current year and long term financial projectionsCurrent year and long term financial projections
News and other publicly available informationNews and other publicly available information
What indicators of debt outstanding What indicators of debt outstanding are used in Bond Rating?are used in Bond Rating?
Debt outstanding measures total dollar amount of principal to be Debt outstanding measures total dollar amount of principal to be repaidrepaid
Indicator 1:Indicator 1:Debt as a % of fair market value (FMV) of taxable propertyDebt as a % of fair market value (FMV) of taxable property
Example:Example:County A has General Obligation Debt of $40,000,000 on a Fair County A has General Obligation Debt of $40,000,000 on a Fair
Market Value of 1,000,000,000 of taxable property.Market Value of 1,000,000,000 of taxable property.
Debt as a % of FMV = 40,000,000 /1,000,000,000 Debt as a % of FMV = 40,000,000 /1,000,000,000 = = 0.0400.040 or or 4%4%
Uses:Uses: Important measure of local government’s wealth available to Important measure of local government’s wealth available to
support present and future tax taxing capacity to meet debt support present and future tax taxing capacity to meet debt obligationsobligations
What indicators of debt outstanding What indicators of debt outstanding should be used in Bond Rating?should be used in Bond Rating?
Indicator 2:Indicator 2:Debt as a % of per capita incomeDebt as a % of per capita income
Example:Example:The per capita income of the citizens of County A is $35,000 per The per capita income of the citizens of County A is $35,000 per
year. The total amount of debt is $4,000,000. The population is year. The total amount of debt is $4,000,000. The population is 20,000. 20,000.
Debt as a % of per capita income = $4,000,000/$35,000Debt as a % of per capita income = $4,000,000/$35,000 = = .875%.875%
Uses:Uses: Realistic estimate based on the assumption that all taxes and Realistic estimate based on the assumption that all taxes and
therefore the total principal debt are paid by the citizenstherefore the total principal debt are paid by the citizens
What indicators of debt outstanding What indicators of debt outstanding should be used in Bond Rating?should be used in Bond Rating?
Indicator 3:Indicator 3:Debt per capita as a % of personal income per capitaDebt per capita as a % of personal income per capita **********
Example:Example:The per capita income of the citizens of County A is $35,000 per The per capita income of the citizens of County A is $35,000 per
year with personal income being $70,000,000. The total amount year with personal income being $70,000,000. The total amount of debt is $40,000,000. The population is 20,000. of debt is $40,000,000. The population is 20,000.
Debt per capita:$40,000,000/20,000= $2,000Debt per capita:$40,000,000/20,000= $2,000Personal income per capita:$70,000,000/20,000=3,500Personal income per capita:$70,000,000/20,000=3,500
Debt per capita/Personal income per capita:Debt per capita/Personal income per capita: ==2,000/3,5002,000/3,500 = = Uses:Uses: More practical than debt per capita method as it incorporates More practical than debt per capita method as it incorporates
citizens’ ability to paycitizens’ ability to pay
What typical indicators of debt What typical indicators of debt service are used in Bond Rating?service are used in Bond Rating?
Debt service (ie principal & interest payments) is an allocation of current Debt service (ie principal & interest payments) is an allocation of current resources that are otherwise unavailable for other expendituresresources that are otherwise unavailable for other expenditures
Indicator 1Indicator 1Debt service as a % of property tax revenueDebt service as a % of property tax revenue
Example:Example:County A has Property Tax Revenue of $10,000,000 and debt service County A has Property Tax Revenue of $10,000,000 and debt service
amount of $4,000,000.amount of $4,000,000.
Debt as a % of Property Tax Revenue:Debt as a % of Property Tax Revenue: = 4,000,000/10,000,000 = 0.40 or = 4,000,000/10,000,000 = 0.40 or 40%40%
Uses:Uses: Particularly useful for evaluating cities that rely heavily on property Particularly useful for evaluating cities that rely heavily on property
taxestaxes
What typical indicators of debt What typical indicators of debt service are used in Bond Rating?service are used in Bond Rating?
Indicator 2:Indicator 2:Debt service as a % of per capita income Debt service as a % of per capita income
Example:Example:The per capita income of the citizens of County A is $35,000 per The per capita income of the citizens of County A is $35,000 per
year. The total amount of debt service is $40,000,000. The year. The total amount of debt service is $40,000,000. The population is 20,000. population is 20,000.
Debt as a % of per capita income = $40,000,000/$35,000/20,000Debt as a % of per capita income = $40,000,000/$35,000/20,000 = = 5.7%5.7%
Uses:Uses: Annual per capita burden on the citizens based on the Annual per capita burden on the citizens based on the
assumption that all taxes and therefore the principal and assumption that all taxes and therefore the principal and interest payments are paid by the citizensinterest payments are paid by the citizens
What typical indicators of debt What typical indicators of debt service are used in Bond Rating?service are used in Bond Rating?
Indicator 3:Indicator 3:Debt service per capita as a % of income per capita Debt service per capita as a % of income per capita
Example:Example:The per capita income of the citizens of County A is $35,000 per The per capita income of the citizens of County A is $35,000 per
year with personal income being $700,000,000. The total year with personal income being $700,000,000. The total amount of debt service is $40,000,000. The population is amount of debt service is $40,000,000. The population is 20,000. 20,000.
Debt service per capita = $40,000,000/20,000=$2,000Debt service per capita = $40,000,000/20,000=$2,000Income per capita:$700,000,000/20,000,000=$35,000Income per capita:$700,000,000/20,000,000=$35,000Debt per capita/Personal income per capita: Debt per capita/Personal income per capita: = $2,000/35,000 = = $2,000/35,000 = 5.7%5.7%Uses:Uses: More practical than debt per capita method as it incorporates More practical than debt per capita method as it incorporates
citizens’ ability to paycitizens’ ability to pay
What typical indicators of debt What typical indicators of debt service are used in Bond Rating?service are used in Bond Rating?
Indicator 4:Indicator 4:
Debt service as a % of General Funds (GF) RevenueDebt service as a % of General Funds (GF) Revenue
Example:Example:County A has General Funds (GF) Revenue of $200,000,000 and debt service County A has General Funds (GF) Revenue of $200,000,000 and debt service
amount of $40,000,000.amount of $40,000,000.
Debt as a % of Property Tax Revenue: Debt as a % of Property Tax Revenue: = 40,000,000/200,000,000 = = 40,000,000/200,000,000 = 0.200.20 or or 20%20%
Uses:Uses: Reflects relatively narrow measure of resources that are available for the local Reflects relatively narrow measure of resources that are available for the local
government operations . Appropriate when debt service is essentially paid for government operations . Appropriate when debt service is essentially paid for with GF revenueswith GF revenues
What typical indicators of debt What typical indicators of debt service are used in Bond Rating?service are used in Bond Rating?
Indicator 5:Indicator 5:
Debt service as a % of General Funds (GF) Budgeted ExpendituresDebt service as a % of General Funds (GF) Budgeted Expenditures
Example:Example:County A has General Funds (GF) Budgeted Expenditures of $275,000,000 County A has General Funds (GF) Budgeted Expenditures of $275,000,000
and debt service amount of $40,000,000.and debt service amount of $40,000,000.
Debt as a % of General Funds Budgeted ExpendituresDebt as a % of General Funds Budgeted Expenditures = 40,000,000/275,000,000 = = 40,000,000/275,000,000 = 0.10 or 10%0.10 or 10%
Uses:Uses: Reflects that total resources appropriated by local government can Reflects that total resources appropriated by local government can
exceed revenues due to transfer from another fund, balance due to exceed revenues due to transfer from another fund, balance due to other borrowings. Also identifies relative spending priorities such as other borrowings. Also identifies relative spending priorities such as how much is spent on debt service vs current services like public how much is spent on debt service vs current services like public safetysafety
What typical indicators of debt What typical indicators of debt service are used in Bond Rating?service are used in Bond Rating?
Indicator 6:Indicator 6:
Debt service as a % of Operating ExpendituresDebt service as a % of Operating Expenditures
Example:Example:County A has Operating Expenditures of $40,000,000 and debt service County A has Operating Expenditures of $40,000,000 and debt service
amount of $400,000.amount of $400,000.
Debt as a % of Operating Expenditures: Debt as a % of Operating Expenditures: = 400,000/40,000,000 = = 400,000/40,000,000 = 0.01 or 1%0.01 or 1%
Uses:Uses: Eliminates budgetary and accounting glitches by encompassing Eliminates budgetary and accounting glitches by encompassing
expenditures from GF, special revenue funds and debt service fundsexpenditures from GF, special revenue funds and debt service funds
What fiscal indicators should be What fiscal indicators should be included in Bond Rating?included in Bond Rating?
General Fund BalanceGeneral Fund Balance Cash FlowsCash Flows Net Operating PositionNet Operating Position Revenue StructureRevenue Structure Revenue & Spending Revenue & Spending
Growth RatesGrowth Rates Revenue ForecastsRevenue Forecasts Property Tax Collection Property Tax Collection
RatesRates Local Tax BurdenLocal Tax Burden Tax Cap & LimitationsTax Cap & Limitations
Expenditures by Expenditures by functionfunction
Labor Settlements & Labor Settlements & LitigationsLitigations
Unfunded Pension Unfunded Pension ObligationsObligations
Capital Improvement Capital Improvement Plan TrendsPlan Trends
Debt RatiosDebt Ratios Debt CapacityDebt Capacity Number of EmployeesNumber of Employees
What economic indicators should be What economic indicators should be included in Bond Rating?included in Bond Rating?
PopulationPopulation Per Capita IncomePer Capita Income UnemploymentUnemployment Education LevelsEducation Levels Median AgeMedian Age Vacancy Rates for Vacancy Rates for
Downtown BuildingsDowntown Buildings
New Housing RatesNew Housing Rates Building PermitsBuilding Permits Construction ValueConstruction Value Major Construction Major Construction
ProjectsProjects Largest EmployersLargest Employers Fair Market Value of Fair Market Value of
PropertyProperty
Oriented on the FutureOriented on the Future
Rating agencies do Rating agencies do NOTNOT want to hear want to hear about what has happened in your about what has happened in your
government in the past but want to government in the past but want to focus on focus on FUTURE actions!!! actions!!!
How to Improve Your Bond How to Improve Your Bond RatingRating
1.1. Establish “rainy day” and budget Establish “rainy day” and budget stabilization reservesstabilization reserves
2.2. Review economic and revenue trends to Review economic and revenue trends to identify potential budget problemsidentify potential budget problems
3.3. Prioritize spending and establish Prioritize spending and establish contingency plans for budget shortfallscontingency plans for budget shortfalls
4.4. Develop a formal capital improvement Develop a formal capital improvement program and a debt affordability modelprogram and a debt affordability model
How to Improve Your Bond How to Improve Your Bond RatingRating
1.1. Incorporate pay-as-go financing in Incorporate pay-as-go financing in capital plans and operating budgetscapital plans and operating budgets
2.2. Anticipate the impact of capital and Anticipate the impact of capital and operating budgets in a multiyear operating budgets in a multiyear financial forecast.financial forecast.
3.3. Establish benchmarks and prioritiesEstablish benchmarks and priorities4.4. Establish and maintain effective Establish and maintain effective
management systemsmanagement systems
How to Improve Your Bond How to Improve Your Bond RatingRating
2.2. Consider the affordability of actions Consider the affordability of actions and plans before they become a part and plans before they become a part of the budgetof the budget
3.3. Have a well-defined and coordinated Have a well-defined and coordinated economic development strategyeconomic development strategy
ReferencesReferences
1.1. ““Capital Budgeting and Finance: A Guide for Local Capital Budgeting and Finance: A Guide for Local Governments” A. John Vogt, International Governments” A. John Vogt, International City/County Management Association, 2004City/County Management Association, 2004
3.3. ““Management Policies in Local Government Management Policies in Local Government Finance” Fifth Edition, International City/County Finance” Fifth Edition, International City/County Management Association, 2004Management Association, 2004
5.5. http://www.investorwords.comhttp://www.investorwords.com
7.7. ““Investopedia”http://www.investopedia.com/univerInvestopedia”http://www.investopedia.com/university/advancedbond/advancedbond2.aspsity/advancedbond/advancedbond2.asp
http://lgc.uwex.edu/
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