Chapter 15: Debt Administration Outline: 1. Federal Debt 2. State and local government debt 3. Bond values 4. Ratings 5. Credit enhancements 6. Underwriting, Interest rates & Ownership

What is a bond? A certificate of debt (usually interest- bearing or discounted) that is issued by a government or corporation in order to raise money; the issuer is required to pay a fixed sum annually until maturity and then a fixed sum to repay the principal. May be financed by corporate or individual investors.

Bond issues are the #1 method governments uses to borrow private funds toward public projects. Federal govt. issues treasury bonds (borrowing against the federal treasury reserves); State govts. issue state bonds; and local govts. issue municiple, or special unit bonds (ex: school districts, utility districts, etc.)

Bonds Bonds are composed of a principle (amount borrowed), interest rate (amount paid to the investor who buys a bond), coupon rate ($ amount of the return), maturity date (time when the bond expires and needs to be paid back) The individual investor who purchases the bond risks that the bond will not be paid back. This risk is reflected in the interest paid to the investor. The higher the risk, the greater the payment an investor expects.

Government debt results from: 1. Covering deficits (whenever annual expenditures are greater than annual revenues) 2. Financing capital-project construction 3. Covering short periods within a fiscal year when expenditure exceed revenues

Federal Deficits Debt comes from: War financing Micro-economic stabilization attempts (ex: tax breaks, re-financing) Specific political agendas

Two methods to measure federal debt 1. Gross debt equaling all federal debt outstanding 2. All federal debt held by private investors, minus that held by federal accounts & the Federal Reserve Debt held by private investors is the major concern

General trend (since late 1990s) is a decrease in private investor debt as a share of total GPD However foreign debt has grown to 40% of all privately held debt, and is expected to continue to grow When owed externally, requires greater fiscal discipline Most federal debt is short-term (~6 yrs) and is used to finance annual deficits, rather than long term projects

State and Local Govt. Debt Includes all borrowing by states, counties, municipalities, townships, school districts and special districts Generally called “municipal debt” to distinguish it from corporate and federal debt. Most of this debt is long-term, reflecting the use of bonds to finance long term projects (such as education, utilities, etc.)

Two general types Full-faith-and-credit - has a legal claim on the revenue of the debt issuer (for govt. this means tax and other revenues). Lower risk and therefore offers a lower interest rate. Nonguaranteed, or limited liability - lacks assurance of having a full claim on all revenues and are sold on the basis of the likelihood of repayment from the source (minus the legal claim on revenues). Higher risk and therefore higher interest rate. However allows local govts. to avoid the legal restrictions on general obligation debt

Municipal bonds and tax reform act of 1986 Tradition of intergovernmental tax impunity prevented taxation on local government interests on borrowing Because no tax, municipalities could borrow at artificially low interest rates, which distorted capital-market relations. Tax exception made municipal bonds more attractive to high-income investors as a tax shelter

Most important change to municipal bond market came with 1986 Tax Reform Act Created two Municipal bond categories: 1. Private activity (taxable) If bond issue is greater of 5% or 5 mill used for loans to nongovernmental entities More than 10% of the bond used by used by, or secured with private entity 2. Public-purpose and tax-exempt bonds (does not fit the above criteria) Special districts remain tax-exempt (water, electric, gas utilities, hazardous waste disposal sites, etc.)

Appropriate debt policy General rule – do not issue debt that will be paid for beyond the life the project the debt has been issued to pay for Should not make people pay for a project that no longer provides a benefit Long-term debt is appropriate for long term capital projects

Some govts. have adopted pay-as-you-go financing, where governments only pay for projects out of annual appropriations Problems: Tends to burden current residents of an area, even if they leave and no longer receive benefits (as opposed to longer- term debt) High up-front construction cost will discourage useful projects Can produce tax-rate instability, with high rates during construction phase and artificially lower after construction

Bond values Bond issue represent a lender who exchanges funds today for the contractual promise of repayment in the future Bond contract specifies the interest the borrower will pay lender for using the money The return on the bond is the coupon rate Has both an annuity component (coupons) and a lump sum (face value paid at maturity) Market value of the bond is a calculation of present value of both components Calculate the present value of the original borrowed amount (face value) Then calculate the present value of the stream of annuities

Example: Bond has 10 yrs to maturity, annual coupon of $80, face value $1,000. So what is the coupon rate?

Present Value of a Bond Bond Value = PV of coupons + PV of par Bond Value = PV annuity + PV of lump sum Present value of a bond = PV annuity + PV of face value

The Bond-Pricing Equation PV annuity + PV face value

Bond value Example: What is the present value of a bond issued with par value $1,000, at 10 yrs to maturity, annual coupon of $80. PV of Par = 1000/ = 1000/ = Present value formula PV of Annuities = 80(1-1/ ) /.08 = Annuity formula Total Bond Value = = $1,000 Bond sells for face value, as should be expected at an interest rate of 8% paying coupons of $80.

Bond listings Financial media list quotes for tax-exempt tradable bonds Example price list: IssueCoupon Mat.Price Chg. Bid yield Okla Tpke ¼ … 7.35 Auth

Ratings Investors demand a higher interest rate on a bond as risk increases Commercial rating firms assess risk (Aaa, Bbb, B) Three common rating firms: Mergents (formerly Moody’s) Standard & Poor’s Fitch Investors Services Commercial US Federal Govt. is regarded as fully secure and the rate at which others bonds are compared

Bond ratings Typically based on: General economy – strength of potential revenues Debt – debt history and debt position of the issuing unit Professionalism within the governing unit – use of audits, documentation, staff training and political control over spending Financial analysis – balancing of spending and revenues, vulnerability to new debts, financial planning

Credit Enhancements Credit enhancements are used to reduce the interest rates that a borrower must pay by adding an additional guarantee of security This serves to reduce the risk of default

Include: 1. State-credit guarantees Explicit promise by the state to a local unit bondholder that if there are shortfalls in local revenues the state guarantees to use state funds 2. Bank letters of credit A private bank agrees to provide additional promise of support Municipal-bond insurance Insurance purchased to guarantee the re- payment of a bond issue

Underwriters Underwriters – firms that purchase large blocks of bonds (issues) to be resold to individual investors Make a profit based on difference between the price the underwriter pay the issuer and the price received from investors (the spread)

Lease-purchases Essentially an installment purchase Lessee (govt) buys a property on a payment program where they pay from annual appropriations After a set number of periods, lessee gets full ownership of the property Investors may purchase certificates of participation (COP) that give shares of base payment, excepting investors from federal taxation