Financial Management Series Number 12 BONDS & BOND RATINGS Alan Probst Local Government Specialist UW-Extension Local Government Center (608) 262-5103

Financial Management SeriesFinancial Management SeriesNumber 12Number 12

BONDS &BONDS & BOND BOND RATINGSRATINGS

Financial Management SeriesFinancial Management SeriesNumber 12Number 12

BONDS &BONDS & BOND BOND RATINGSRATINGS

Alan ProbstLocal Government SpecialistUW-Extension Local Government Center(608) 262-5103

Alan ProbstLocal Government SpecialistUW-Extension Local Government Center(608) 262-5103

Long-Term DebtLong-Term DebtLong-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

BondsBondsBondsBonds

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 BondsTypes 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)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 of the full faith, credit, and taxing powers of the issuing governmentthe issuing government

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

General Obligation (GO)General Obligation (GO)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 BondsRevenue 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 BondsRevenue 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?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?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?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?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?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 IBCAExampleExample: 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?

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

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

Borrowing will be less costly for an issuer with higher Borrowing will be less costly for an issuer with higher rating than with lower ratingrating 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 into When in millions, a few basis points can translate into thousands of dollarsthousands of dollars

Bond PricingBond PricingBond 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.

ExampleExampleExampleExample

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

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



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?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?

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?

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



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 year with 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 personal income being $70,000,000. The total amount of debt is $40,000,000. The population is 20,000. $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 citizens’ More practical than debt per capita method as it incorporates citizens’

ability to payability to pay

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


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



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 year 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 with personal income being $700,000,000. The total amount of debt service is $40,000,000. The population is 20,000. service is $40,000,000. The population is 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


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



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



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?

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?

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 FutureOriented 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



5.5. Incorporate pay-as-go financing in Incorporate pay-as-go financing in capital plans and operating budgetscapital plans and operating budgets

6.6. 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.

7.7. Establish benchmarks and prioritiesEstablish benchmarks and priorities8.8. Establish and maintain effective Establish and maintain effective

management systemsmanagement systems



9.9. 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

10.10. Have a well-defined and coordinated Have a well-defined and coordinated economic development strategyeconomic development strategy

ReferencesReferencesReferencesReferences

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

2.2. ““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

2.2. http://www.investorwords.comhttp://www.investorwords.com

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

http://lgc.uwex.edu/http://lgc.uwex.edu/

Documents

Financial Management Series Number 12 BONDS & BOND RATINGS Alan Probst Local Government Specialist UW-Extension Local Government Center (608) 262-5103