Municipal Bonds: Understanding the Fundamentals
Recent events in the municipal market underscore the importance of understanding the nuances of municipal bonds. Investors who can discern the fundamental characteristics of municipal bonds will be better equipped to identify risks within this asset class. One characteristic in determining which municipal bonds may be appropriate are the differences between two common repayment pledges: tax-supported bonds and revenue bonds.
General Obligation Bonds General obligation (GO) bonds are loans backed by a state or local government’s full faith and credit, generally including its authority to levy taxes, most often property taxes. Frequent issuers of GO bonds are states, counties, cities and school districts. For states, this constitutes a pledge of its primary operating fund, or General Fund, receipts. For the local governments, the GO pledge is most commonly a covenant to levy property taxes to repay principal and interest, and therefore, the debt service due on a general obligation bond is supported by property tax collections. Failure to pay a property tax bill can lead to the loss of title to the property, providing a strong incentive for payment of property taxes and thereby making the payment stream for debt service fairly secure.
When a local government issues bonds backed by its pledge of property taxes, the security is often referred to as an ad valorem tax pledge. The ad valorem tax pledge can be limited or unlimited as to the rate applied or the amount collected. If the pledge is unlimited, there are no constraints on the municipality’s ability to raise taxes to pay debt service. However, the ability to issue unlimited tax debt often requires voter approval and therefore can be more difficult to issue than limited tax debt. Also, the tax levied for these bonds can only be used to pay debt service. The revenues cannot be used legally for any other purpose. If the tax pledge is limited, the municipality may only increase the property tax up to a certain rate and/ or dollar amount. The issuance of limited tax bonds does not usually require voter approval and, depending on the legal structure, the tax collections may or may not be redirected to other expenditures.
Credit analysis of an issuer’s general obligation bonds typically focuses on four key factors: local economy and sociodemographics, health of financial operations, debt profile, and the strength of management of the issuer. GO bonds are typically backed by property taxes, so the health of the local tax base and economy is an important indicator of its ability to support debt repayment. The issuer’s financial position provides a picture of what services the local tax base is (or is not) able to support as well as management’s effectiveness of working within certain economic and/or political constraints. A municipality’s debt profile will reflect how much, or little, debt it is already carrying and its capacity to meet additional borrowing needs. The analysis of management often goes hand in hand with the previous three factors as internal policies and historical practices regarding economic development, financial operations, and debt issuance reflect strength of management.
Though certainly not exhaustive, some common questions examined as part of the GO analysis are:
▪ Where is the municipality located? What is the size and composition of the tax base? What is the socio-demographic profile of its residents?
▪ How healthy is the employment base? Is there concentration in any given industry or employer?
▪ What is the trend of financial operations? Is this supported by internal policies? Does the municipality retain any financial flexibility or reserves?
▪ How leveraged is the tax base and could it support additional borrowing?
While general obligation bonds represent a very strong pledge, they are not completely free from challenges. Spending and policy agendas are authorized by elected officials such as governors, mayors, city councils, or school board officials. As a result, political pressures can influence budgetary decisions to raise taxes and/or cut costs. Though ad valorem general obligation bonds often benefit from a legally designated debt service levy, there are occasions when this levy is abated and other available revenues are applied to debt service. In this instance, when there are downswings in the economy and those other revenues are no longer sufficient to cover debt service, management will face the decision to raise its overall property tax levy or make other operating cuts to accommodate debt service. As recent debate has shown, both options can be politically challenging
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