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PA 546 Constantine Hadjilambrinos. Debt Administration. Lecture 13 November 29, 2005. PA 546 Constantine Hadjilambrinos. Federal Debt. Primarily used to finance government operations. Primarily short term.
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PA 546 Constantine Hadjilambrinos Debt Administration Lecture 13 November 29, 2005
PA 546 Constantine Hadjilambrinos Federal Debt • Primarily used to finance government operations. • Primarily short term. • Some debt is held by federal accounts and the Federal Reserve System (Social Security, Medicare/Medicaid). • Majority of debt held by private investors (60% in 2001). • Of this, a continually increasing amount (42.1% in 2001) is held by foreign investors. This has serious implications for resource allocation.
PA 546 Constantine Hadjilambrinos State and Local Government (Municipal) Debt • Primarily used to finance capital projects (infrastructure). • Primarily long term. • “Full faith and credit debt”—used for projects that do not generate revenue. Often limited statutorily. • Non-guaranteed debt—Revenue bonds. • “Private” debt: Industrial Development Bonds.
PA 546 Constantine Hadjilambrinos Appropriate Debt Policy Debt is usually the most appropriate financing option for capital projects. • If capital projects were to be financed from current budget, most would be impossible. • Debt financing fulfills equity criteria: users pay for projects. • Most appropriate length of financing is to coincide with useful life of project.
PA 546 Constantine Hadjilambrinos Mechanics of Bond Values Calculation based on equations for present and future values. FVn Future value in year n PV Present value r Rate of return/interest n Number of years
PA 546 Constantine Hadjilambrinos Mechanics of Bond Values Special terminology for bonds. P Price (present value) F Face value (future value) c Coupon rate (bond interest rate) r Market rate of return m Coupon period (annual or semi- annual) Annual Semi-annual
PA 546 Constantine Hadjilambrinos Debt Structure and Design • Pursue least-cost marketability. • Simplify debt management. • Provide appropriate cost signals to decision makers.
PA 546 Constantine Hadjilambrinos Credit Ratings • Three major credit rating firms: • Moody’s (Aaa, Aa, A, Baa) • Standard and Poor’s (AAA, AA, A, BBB) • Fitch (AAA, AA, A, BBB) • Ratings reflect level of risk. • Lower ratings mean higher interest rates must be paid by bond issuers. • Investment grade: Adequate safeguards against default. • Junk bonds: Lower than Baa or BBB rating (4%-6% above U.S Treasury).
PA 546 Constantine Hadjilambrinos Credit Enhancements • State-credit guarantees. Promise by the state to make up any shortfall in local resources. • Bank letters of credit. Promise by a bank to make principal and interest payments of specified amount and duration (there is a fee). • Municipal bond insurance. Purchased from an insurer, takes payments on in case of trouble (there is a fee).
PA 546 Constantine Hadjilambrinos Bond Issue Costs • Underwriting fees (Underwriter purchases bond issue and resells it). • Rate insurance (Provides security against rate increases). • Pricing (Depends on Rating and maturity)—can be complicated for composite bond issue (comprising of bonds of different maturities).
PA 546 Constantine Hadjilambrinos Creative Finance Lease-purchase financing. • Payments part of current operations expenditures. • Gets around various restrictions on government borrowing.
