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Financial Management Series Number 12 BONDS & BOND RATINGS. Alan Probst Local Government Specialist UW-Extension Local Government Center (608) 262-5103. Long-Term Debt. Bonds are the primary source of long-term debt for local governments. Bonds.

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Financial management series number 12 bonds bond ratings

Financial Management SeriesNumber 12BONDS &BOND RATINGS

Alan Probst

Local Government Specialist

UW-Extension Local Government Center

(608) 262-5103


Long term debt
Long-Term Debt

Bonds are the primary source of long-term debt for local governments


Bonds
Bonds

A bond is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. The Federal government, states, cities, corporations, and many other types of institutions sell bonds. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity).


Types of bonds
Types of Bonds

There are commonly two types of bonds:

  • General Obligation (GO) Bonds

  • Revenue Bonds


General obligation go
General Obligation (GO)

  • Unlimited-tax GO bonds are secured by the full faith, credit, and taxing powers of the issuing government

  • Legally obligate the local government to levy taxes on all assessable property within its jurisdiction to a level necessary to meet the bond payment obligation


General obligation go1
General Obligation (GO)

  • GO bonds are an appropriate financing vehicle for capital projects that benefit the community as a whole.

  • May be limited by constitutional and statutory restrictions.

  • Normally require voter approval


Revenue bonds
Revenue Bonds

  • Revenue bonds are secured by the revenues from the project being financed

  • Their credit strength depends upon the financial strength of the capital project


Revenue bonds1
Revenue Bonds

Common types of revenue bonds include:

  • Airport revenue bonds

  • Hospital and nursing home revenue bonds

  • Public power revenue bond

  • Water and sewer revenue bonds

  • Sports complex and convention center revenue bonds


What is a bond rating
What is a Bond Rating?

  • Bond Rating is an independent assessment

  • It is associated with purchase and holding a particular bond

  • It assesses relative credit risk

  • Ratings indicate likelihood that the obligation will be repaid


What is a bond rating1
What is a Bond Rating?

In essence, a local government’s bond rating is the government equivalent of your personal credit score or credit rating.

Both indicate the likelihood of the borrowed money being paid back.


Who determines bond rating
Who determines Bond Rating?

  • Ratings are given by independent rating agencies

  • Ratings are independent source of information and analysis for capital markets

  • Primary agencies rating municipal debt – Fitch IBCA Inc., Moody’s Investors Service and Standard & Poor’s Rating Services


What factors determine bond rating
What factors determine Bond Rating?

  • Debt management using key financial ratios such as debt per capita

  • Administrative issues relating to direct authority of government’s responsibility

  • Financial performance analyzing revenues and expenditure trends

  • Economic outlook based on tax base, income, population, employment and others

  • Service Base also included for Revenue Bonds


What do different ratings mean
What do different ratings mean?

  • Ratings compare relative risks of different debt issues

  • Ratings scale is a consistent framework for comparisons

  • Each agency has it own rating scale


Example rating scale of fitch ibca

AAA

AA (+ or - )

A(+ or -)

BBB (+ or -)

BB (+ or -)

B (+ or -)

CCC, CC, C (+ or -)

D

- Highest credit quality

- Very high credit quality

- High credit quality

- Good credit quality

- Speculative

- Highly speculative

- High default risk

- In default

Example: Rating Scale of Fitch IBCA


How does rating affect cost of borrowing
How does rating affect cost of borrowing?

  • A high bond rating (e.g. AAA) indicates low credit risk to investor

  • Borrowing will be less costly for an issuer with higher rating than with lower rating

  • For each drop in ratings, bond issuers pay additional basis points (a basis point is 1/100 of a percentage point)

  • When in millions, a few basis points can translate into thousands of dollars


Bond pricing
Bond Pricing

Bonds can be priced at a premium, discount, or at par. If the bond’s price is higher than its par value, it will sell at a premium because its interest rate is higher than the current prevailing rates. If the bond’s price is lower than its par value, the bond will sell at a discount because its interest rate is lower than current prevailing rates.


Example
Example

The quoted price is usually based on the bond maturity at a price of par, or 100.00. In the case of a bond 6% of June 1, 2008, if the price is $105.13, this means the bond is at a 5.13% premium to its maturity price (par or 100.00). An investor who pays $105.13 for the bond will receive only $100.00 back on maturity. Conversely, bond selling at a price that is less than its par value is selling at a discount.


Example city a issues 30 year bond with a 10 million face value

With AAA Bond rating

Pays 2% annual interest

Issues bonds at premium at $15,000,000

Total Interest cost over 30 years

15,000,000 x 0.02 x 30

= $9,000,000

With BBB Bond Rating

Pays 7% annual interest

Issues bonds at discount at $7,000,000

Total Interest cost over 30 years

7,000,000 x 0.07 x 30

=$14,700,000

Example: City A issues 30-year bond with a 10 million face value


Why does local government need bond rating
Why does Local Government need Bond Rating?

  • Investors use bond ratings as they are easy to access and understand

  • Investors consider ratings as indication of government’s overall fiscal health

  • Local Government will find it more difficult to sell an unrated bond


Why does local government need bond rating1
Why does Local Government need Bond Rating?

  • Even if the local govt. sells the bond, investors will pay less to compensate for uncertainty

  • Bond ratings necessary only if issue is larger than $1million

  • Bond Ratings give access to national debt market


How long does a rating last
How long does a rating last?

  • Until the Bond expires

  • Changes if there is an upgrade or downgrade in the ratings over time

  • Rating agency withdraws ratings due to insufficient information


How do rating agencies evaluate local governments
How do rating agencies evaluate Local Governments?

  • Rating agencies use debt indicators

  • They study both debt outstanding and debt service as indicators of debt burden

  • Current year and long term financial projections

  • News and other publicly available information


What indicators of debt outstanding are used in bond rating
What indicators of debt outstanding are used in Bond Rating?

Debt outstanding measures total dollar amount of principal to be repaid

Indicator 1:

Debt as a % of fair market value (FMV) of taxable property

Example:

County A has General Obligation Debt of $40,000,000 on a Fair Market Value of 1,000,000,000 of taxable property.

Debt as a % of FMV = 40,000,000 /1,000,000,000

= 0.040 or 4%

Uses:

  • Important measure of local government’s wealth available to support present and future tax taxing capacity to meet debt obligations


What indicators of debt outstanding should be used in bond rating
What indicators of debt outstanding should be used in Bond Rating?

Indicator 2:

Debt as a % of per capita income

Example:

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 20,000.

Debt as a % of per capita income = $4,000,000/$35,000

= .875%

Uses:

  • Realistic estimate based on the assumption that all taxes and therefore the total principal debt are paid by the citizens


What indicators of debt outstanding should be used in bond rating1
What indicators of debt outstanding should be used in Bond Rating?

Indicator 3:

Debt per capita as a % of personal income per capita*****

Example:

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 of debt is $40,000,000. The population is 20,000.

Debt per capita:$40,000,000/20,000= $2,000

Personal income per capita:$70,000,000/20,000=3,500

Debt per capita/Personal income per capita:

=2,000/3,500 =

Uses:

  • More practical than debt per capita method as it incorporates citizens’ ability to pay


What typical indicators of debt service are used in bond rating
What typical indicators of debt service are used in Bond Rating?

Debt service (ie principal & interest payments) is an allocation of current resources that are otherwise unavailable for other expenditures

Indicator 1

Debt service as a % of property tax revenue

Example:

County A has Property Tax Revenue of $10,000,000 and debt service amount of $4,000,000.

Debt as a % of Property Tax Revenue:

= 4,000,000/10,000,000 = 0.40 or 40%

Uses:

  • Particularly useful for evaluating cities that rely heavily on property taxes


What typical indicators of debt service are used in bond rating1
What typical indicators of debt service are used in Bond Rating?

Indicator 2:

Debt service as a % of per capita income

Example:

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 population is 20,000.

Debt as a % of per capita income = $40,000,000/$35,000/20,000

= 5.7%

Uses:

  • Annual per capita burden on the citizens based on the assumption that all taxes and therefore the principal and interest payments are paid by the citizens


What typical indicators of debt service are used in bond rating2
What typical indicators of debt service are used in Bond Rating?

Indicator 3:

Debt service per capita as a % of income per capita

Example:

The per capita income of the citizens of County A is $35,000 per year with personal income being $700,000,000. The total amount of debt service is $40,000,000. The population is 20,000.

Debt service per capita = $40,000,000/20,000=$2,000

Income per capita:$700,000,000/20,000,000=$35,000

Debt per capita/Personal income per capita:

= $2,000/35,000 = 5.7%

Uses:

  • More practical than debt per capita method as it incorporates citizens’ ability to pay


What typical indicators of debt service are used in bond rating3
What typical indicators of debt service are used in Bond Rating?

Indicator 4:

Debt service as a % of General Funds (GF) Revenue

Example:

County A has General Funds (GF) Revenue of $200,000,000 and debt service amount of $40,000,000.

Debt as a % of Property Tax Revenue:

= 40,000,000/200,000,000 = 0.20 or 20%

Uses:

  • Reflects relatively narrow measure of resources that are available for the local government operations . Appropriate when debt service is essentially paid for with GF revenues


What typical indicators of debt service are used in bond rating4
What typical indicators of debt service are used in Bond Rating?

Indicator 5:

Debt service as a % of General Funds (GF) Budgeted Expenditures

Example:

County A has General Funds (GF) Budgeted Expenditures of $275,000,000 and debt service amount of $40,000,000.

Debt as a % of General Funds Budgeted Expenditures

= 40,000,000/275,000,000 = 0.10 or 10%

Uses:

  • Reflects that total resources appropriated by local government can exceed revenues due to transfer from another fund, balance due to other borrowings. Also identifies relative spending priorities such as how much is spent on debt service vs current services like public safety


What typical indicators of debt service are used in bond rating5
What typical indicators of debt service are used in Bond Rating?

Indicator 6:

Debt service as a % of Operating Expenditures

Example:

County A has Operating Expenditures of $40,000,000 and debt service amount of $400,000.

Debt as a % of Operating Expenditures:

= 400,000/40,000,000 = 0.01 or 1%

Uses:

  • Eliminates budgetary and accounting glitches by encompassing expenditures from GF, special revenue funds and debt service funds


What fiscal indicators should be included in bond rating

General Fund Balance Rating?

Cash Flows

Net Operating Position

Revenue Structure

Revenue & Spending Growth Rates

Revenue Forecasts

Property Tax Collection Rates

Local Tax Burden

Tax Cap & Limitations

Expenditures by function

Labor Settlements & Litigations

Unfunded Pension Obligations

Capital Improvement Plan Trends

Debt Ratios

Debt Capacity

Number of Employees

What fiscal indicators should be included in Bond Rating?


What economic indicators should be included in bond rating

Population Rating?

Per Capita Income

Unemployment

Education Levels

Median Age

Vacancy Rates for Downtown Buildings

New Housing Rates

Building Permits

Construction Value

Major Construction Projects

Largest Employers

Fair Market Value of Property

What economic indicators should be included in Bond Rating?


Oriented on the future
Oriented on the Future Rating?

Rating agencies do NOT want to hear about what has happened in your government in the past but want to focus on FUTURE actions!!!


How to improve your bond rating
How to Improve Your Bond Rating Rating?

  • Establish “rainy day” and budget stabilization reserves

  • Review economic and revenue trends to identify potential budget problems

  • Prioritize spending and establish contingency plans for budget shortfalls

  • Develop a formal capital improvement program and a debt affordability model


How to improve your bond rating1
How to Improve Your Bond Rating Rating?

  • Incorporate pay-as-go financing in capital plans and operating budgets

  • Anticipate the impact of capital and operating budgets in a multiyear financial forecast.

  • Establish benchmarks and priorities

  • Establish and maintain effective management systems


How to improve your bond rating2
How to Improve Your Bond Rating Rating?

  • Consider the affordability of actions and plans before they become a part of the budget

  • Have a well-defined and coordinated economic development strategy


References
References Rating?

  • “Capital Budgeting and Finance: A Guide for Local Governments” A. John Vogt, International City/County Management Association, 2004

  • “Management Policies in Local Government Finance” Fifth Edition, International City/County Management Association, 2004

  • http://www.investorwords.com

  • “Investopedia”http://www.investopedia.com/university/advancedbond/advancedbond2.asp