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Chapter 15: Debt Administration
Outline:1. Federal Debt2. State and local government debt3. Bond values4. Ratings5. Credit enhancements6. 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
t
t
r)(1
F
rr)(1
1-1
C Value Bond
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 = 1000/1.0810 = 1000/2.1589 = 463.19- Present value formula
PV of Annuities = 80(1-1/1.0810) /.08 = 536.81- Annuity formula
Total Bond Value = 463.19 + 536.81 = $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:
Issue Coupon Mat. Price Chg. Bid yield
Okla Tpke 7.700 01-01-22 104 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