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Municipal Bonds: Understanding
the Fundamentals
Market Commentary September 2014
RECENT FOCUS ON MUNICIPAL BONDS AND THEIR CREDIT QUALITY emphasizes the
importance of understanding the nuances of the municipal market. Investors
with this knowledge will be better equipped to identify risks within this asset
class. One important factor in determining which municipal bonds may be
appropriate for an investor are the differences in pledged repayment sources.
This paper will outline key differences between two common repayment
pledges: tax-supported bonds and revenue bonds.
The sources of pledged revenue for bond repayment are diverse and often times com-
plicated. Broadly speaking, pledged revenues fall into two basic categories: taxes, which
support securities such as general obligation (GO), income tax and sales tax bonds, or
project related revenues that support revenues bonds. The former tend to be issued by
states and local governments and the latter by utilities, transportation agencies, and
health care providers. In the examples below, we focus on general obligation bonds
issued by local governments and revenue bonds issued by essential service utilities.
Beth Dougherty
Municipal Bond Issuance: Revenue vs GO Vice President,
(based on par amount at issuance) Senior Research Analyst
Nuveen Asset Management, LLC
Revenue Bonds GO Bonds
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
*2014 data is January through August only.
Source: The Bond Buyer/ Thomson Financial Yearbook, 2008 and The Bond Buyer, 2014.
NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE
Municipal Bonds: Understanding the Fundamentals September 2014
Quick Facts 2013 2014*
Total Municipal Bond Issuance: $333.8 billion $203.4 billion
Total Revenue Bond Par Amount: $206.0 billion $116.7 billion
Total General Obligation Par Amount: $127.8 billion $86.7 billion
*2014 data is January through August only.
Source: The Bond Buyer, 2014.
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.
The credit analysis of an issuer's general obligation bonds focuses on four key factors:
local economy and socio-demographics, health of financial operations, debt profile,
and the strength of management of the issuer. As GO bonds are typically backed by
property taxes, 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.
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Municipal Bonds: Understanding the Fundamentals September 2014
Though certainly not exhaustive, some common questions bondholders are ultimately dependent on the system to generate
examined as part of the GO analysis are: additional revenue for future debt service, it is reasonable that
Where is the municipality located? What is the size and operations and maintenance be paid prior to debt service so that
composition of the tax base? What is the socio-demographic the system remains functional over the long term.
profile of its residents? When issuing revenue bonds, the utility makes legal
How healthy is the employment base? Is there concentration commitments - known as covenants - such as the structuring of
in any given industry or employer? rates, the order in which revenues will be applied across various
What is the trend of financial operations? Is this supported by expenditures (including debt service), and requirements for
internal policies? Does the municipality retain any financial issuing additional bonds. The strength of these covenants, the
flexibility or reserves? revenue pledged, and the credit characteristics of the issuer are
How leveraged is the tax base and could it support all important factors in determining a bond's creditworthiness.
additional borrowing? Analyzing these characteristics of an essential service revenue
While general obligation bonds represent a very strong pledge, bond is somewhat similar to analyzing a general obligation
they are not completely free from any challenges. Spending bond. In the analysis of a revenue bond, we examine the qualities
and policy agendas are authorized by elected officials, be they of the customer base and physical infrastructure, health of
governors, mayors, city councils, or school board officials. As financial operations, debt portfolio, and quality of management.
a result, political pressures can influence budgetary decisions While the general factors are similar to that of GO bonds, the
to raise taxes and/or cut costs. Though ad valorem general supporting traits are quite different. Instead of looking at the
obligation bonds often benefit from a legally designated debt size and composition of the tax base, the diversity and size of
service levy, there are occasions when this levy is abated and the customer base is examined because it directly affects the
other available revenues are applied to debt service. In this strength of billing collections. Notably, the largest customers of
instance, when there are downswings in the economy and the enterprise system, consuming the greatest volume of services,
those other revenues are no longer sufficient to cover debt may not be the ones that pay the most. Also, the service area of
service, management will face the decision to raise its overall an essential utility can extend far beyond the boundaries of a
property tax levy or make other operating cuts to accommodate municipality and may provide wholesale service to other nearby
debt service. As recent debate has shown, both options can be municipalities.
politically challenging. When examining the ability of a utility to cover its expected
debt service, an analyst will consider:
Essential Service Revenue Bonds Who are the major users and largest billing accounts? Is there
Essential service utilities provide critical services such as water, a concentration of industry or any single user? What is the
sewer, and electricity. They are considered essential services due size and growth trend of customer accounts?
to their importance in maintaining public health and safety, How competitive are rates, and does management have the
and providing infrastructure that promotes economic growth. willingness and ability to raise them? How strong are reserves
The revenues generated by these utilities are primarily user fees, compared to operation and maintenance expense?
wholesale contracts, connection fees, and investment income. What is the ratio of net revenues to annual debt service and
The fees and contracts are set by the utility, though in some maximum annual debt service?
states there may be an oversight entity that must approve rate How much debt has the utility taken on, and are there
increases, which could limit the ability to raise revenues. additional capital needs?
A revenue bond is secured by either a gross revenue pledge or a Most often, these utilities are legally tied to a local government,
net revenue pledge, with the latter being more common. A gross like a city water department, making them subject to the same
revenue pledge promises to pay bondholders prior to any other management that oversees the general municipal operations.
expenditure. Under a net revenue pledge, the utility's operation In such cases, it is rare that the essential service revenue bond
and maintenance expenditures are paid prior to debt service. As
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