CHAPTER
FORTY-FOUR
THE CREDIT ANALYSIS OF MUNICIPAL GENERAL OBLIGATION AND REVENUE BONDS
Director
Investment Department
Guardian Life Insurance Company of America
ALEXANDER GRANT
Portfolio Manager, RS Tax-Exempt and
RS High Yield Municipal Bond Funds
DAVID RATNER, CFA
Industry Consultant
The degree of safety of investing in municipal bonds has been considered second only to that of U.S. Treasury bonds, but beginning in the fourth quarter of the last century, ongoing concerns developed among many investors and underwriters about the potential default risks of municipal bonds.
One concern resulted from the well-publicized billion-dollar general obligation note defaults in 1975 of New York City. Not only did specific investors face the loss of their principal, but the defaults sent a loud and clear warning to municipal bond investors in general. The warning was that regardless of the supposedly ironclad legal protections for the bondholder, when issuers have severe budget-balancing difficulties, the political hues, cries, and financial interests of public employee unions, vendors, and community groups may be dominant forces in the initial decision-making process.
This reality was further reinforced by the new federal bankruptcy law that took effect on October 1, 1979, which makes it easier for municipal bond issuers to seek protection from bondholders by filing for bankruptcy. One by-product of the increased investor concern is that since 1975, the official statement, which is the counterpart to a prospectus in an equity or corporate bond offering and is to contain a summary of the key legal and financial security features, has become more comprehensive. As an example, before 1975 it was common for a city of New York official statement for a general obligation bond sale to be only six pages long, whereas for a bond sale at the end of 2003 it was 165 pages long.
More recently, with the recession that began in December of 2007 and the well-publicized bond defaults of both Vallejo, California (in Chapter 9 under the U.S. Bankruptcy Code), and Harrisburg, Pennsylvania (considering a Chapter 9 filing) as well as the budgetary stresses of many large states and cities, the credit quality of municipal bonds has received increased attention.
The second reason for the increased interest in credit analysis was derived from the changing nature of the municipal bond market. It is now characterized by strong buying patterns by private investors and institutions. The patterns were caused in part by high federal, state, and local income tax rates. Tax-exempt bonds increasingly have become an important and convenient way to shelter income. One corollary of the strong buyers’ demand for tax exemption has been an erosion of the traditional security provisions and bondholder safeguards that had grown out of the default experiences of the 1930s. General obligation bond issuers with high tax and debt burdens, declining local economies, and chronic budget-balancing problems had little difficulty finding willing buyers. Also, revenue bonds increasingly were rushed to market with legally untested security provisions, modest rate covenants, reduced debt reserves, and weak additional-bond tests. Because of this widespread weakening of security provisions, it has become more important than ever before that the prudent investor carefully evaluate the creditworthiness of a municipal bond before making a purchase.
This concern has been increased when the rating agencies in 2009 recalibrated their ratings upward on many general obligation and essential service revenue bonds. They argued that municipal bond issues probably should have slightly better ratings relative to corporate bonds in the context of both historical default rates and recovery levels following default. This resulted in higher ratings on many municipal bonds.
In analyzing the creditworthiness of a general obligation, tax-backed, or pure revenue bond, the investor should cover five categories of inquiry: (1) legal documents and opinions, (2) politics/management, (3) underwriter/financial advisor, (4) general credit indicators and economics, and (5) red flags, or danger signals.
The purpose of this chapter is to set forth the general guidelines that the investor should rely upon in asking questions about specific bonds.
THE LEGAL OPINION
Popular opinion holds that much of the legal work done in a bond issue is boilerplate in nature, but from the bondholder’s point of view the legal opinions and document reviews should be the ultimate security provisions because, if all else fails, the bondholder may have to go to court to enforce his or her security rights. Therefore, the integrity and competency of the lawyers who review the documents and write the legal opinions that usually are summarized in the official statements are very important.
The relationship of the legal opinion to the analysis of municipal bonds for both general obligation and revenue bonds is threefold. First, the lawyer should check to determine whether the issuer is indeed legally able to issue the bonds. Second, the lawyer is to see that the issuer has properly prepared for the bond sale by enacting the various required ordinances, resolutions, and trust indentures and without violating any other laws and regulations. This preparation is particularly important in the highly technical areas of determining whether the bond issue is qualified for tax exemption under federal law and whether the issue has been structured in such a way as to not violate federal arbitrage regulations. Third, the lawyer is to certify that the security safeguards and remedies provided for the bondholders and pledged by either the bond issuer or third parties (such as banks with letter-of-credit agreements) are actually supported by federal, state, and local government laws and regulations.
General Obligation Bonds
General obligation bonds are debt instruments issued by states, counties, towns, cities, and school districts. They are secured by the issuers’ general taxing powers. The investor should review the legal documents and opinion as summarized in the official statement to determine what specific unlimited taxing powers, such as those on real estate and personal property, corporate and individual income taxes, and sales taxes, are legally available to the issuer, if necessary, to pay the bondholders. Usually for smaller governmental jurisdictions, such as school districts and towns, the only available unlimited taxing power is on property. If there are statutory or constitutional taxing power limitations, the legal documents and opinion should clearly describe how they affect the security of the bonds.
For larger general obligation bond issuers, such as states and big cities that have diverse revenue and tax sources, the legal opinion should indicate the claim of the general obligation bondholder on the issuer’s general fund. Does the bond-holder have a legal claim, if necessary, to the first revenues coming into the general fund? This is the case with bondholders of state of New York general obligation bonds. Does the bondholder stand second in line? This is the case with bondholders of state of California general obligation bonds. Or are the laws silent on the question altogether? This is the case for most other state and local governments.
Additionally, certain general obligation bonds, such as those for water and sewer purposes, are secured in the first instance by user charges and then by the general obligation pledge. (Such bonds are popularly known as being “double barreled.”) If so, the legal documents and opinion should state how the bonds are secured by revenues and funds outside the issuer’s general taxing powers and general fund.
Revenue Bonds
Revenue bonds are issued for project or enterprise financings that are secured by the revenues generated by the completed projects themselves, or for general public-purpose financings in which the issuers pledge to the bondholders tax and revenue resources that were previously part of the general fund. This latter type of revenue bond, sometimes known as a “dedicated tax bond,” is usually created to allow issuers to raise debt outside general obligation debt limits and without voter approvals. The trust indenture and legal opinion for both types of revenue bonds should provide the investor with legal comfort in six bond-security areas:
• The limits of the basic security
• The flow-of-funds structure
• The rate, user-charge, or dedicated revenue and tax covenants
• The priority of pledged revenue claims
• The additional-bonds test
• Other relevant covenants and issues
The Limits of the Basic Security
The legal documents should explain what the pledged revenues for the bonds are and how they may be limited by federal, state, and local laws. The importance of this is that although most revenue bonds are structured and appear to be supported by identifiable revenue streams, those revenues sometimes can be negatively affected directly by other levels of government. For example, the state of Wyoming in the early 1980s issued Mineral Royalties Revenue Bonds. On the surface, the bond issue had all the attributes of a revenue bond. The bonds had a first lien on the pledged revenues, and additional bonds could only be issued if a coverage test of 125% was met. Yet the revenues to pay bondholders were to be received by the state from the federal government as royalty payments for mineral production on federal lands. The U.S. Congress was under no legal obligation to continue this aid program. Therefore, the investor must read carefully the legal documents to learn if there are shortcomings of the bond security.
More recently, in 2011 the governor of California proposed eliminating local redevelopment agencies and transferring their tax increment revenues to other purposes. In a worst-case scenario if all the revenues were taken away, there would be no monies left to pay the redevelopment agency bondholders. The governor did not propose this, but the legal documents should indicate that this could happen.
The Flow-of-Funds Structure
The legal documents should explain what the bond issuer has promised to do concerning the pledged revenues received. What is the order of the revenue flows through the various accounting funds of the issuer to pay for the operating expenses of the facility, payments to the bondholders, maintenance and special capital improvements, and debt service reserves? This sometimes is referred to as the “waterfall.” Additionally, the legal documents should indicate what happens to excess revenues after they pass through the waterfall. Do they go to the issuer’s general fund or do they stay within the indenture to be used to call bonds or make capital repairs.
The flow of funds of many revenue bonds is structured as net revenues (i.e., debt service is paid to the bondholders immediately after revenues are paid to the basic operating and maintenance funds, but before paying all other expenses). A gross revenues flow-of-funds structure is one in which the bondholders are paid even before the operating expenses of the facility are paid. Examples of gross revenue bonds are those issued by the New York Metropolitan Transportation Authority. However, although it is true that these bonds legally have a claim to the fare-box revenues before all other claimants, it is doubtful that the system could function if the operational expenses, such as wages and electricity bills, were not paid first.
The Rate, User-Charge, or Dedicated Revenue and Tax Covenants
The legal documents should indicate what the issuer has legally committed itself to do to safeguard the bondholders. If user rates are involved do they only have to be sufficient to meet expenses, including debt service, known as one times debt service coverage. Is the one-time coverage test calculated for the average annual debt service requirement or for the higher maximum annual debt service one? Additionally, is the coverage requirement for higher amounts such as 1.1 times or 1.25 times so as to provide for reserves? The legal documents should indicate whether or not the issuer has the legal power to increase rates or charges of users without having to obtain prior approvals by other governmental units.
The Priority of Pledged Revenue Claims
The legal documents should state whether or not other levels of government or claimants can legally tap the revenues of the issuer even before they start passing through the issuer’s flow-of-funds structure. An example would be the highway revenue bonds issued by the Puerto Rico Highway Authority. These bonds are secured in part by the revenues from the Commonwealth of Puerto Rico gasoline tax. Yet, if in a worst case scenario no other funds are available to pay their debt service, under the Commonwealth’s constitution the moneys are first to be applied to the Commonwealth’s own general obligation bonds.
The Additional-Bonds Test
The legal documents should indicate under what circumstances the issuer can issue additional bonds that share equal claims to the issuer’s revenues. Usually, the legal requirement is that the maximum annual debt service on the new bonds as well as on the old bonds be covered by the projected net revenues by a specified minimum amount. This can be as low as one times coverage. Some revenue bonds have stronger additional-bonds tests to protect the bondholders. Also, how the historical revenues are calculated is important. Can the issuer select specific prior months to be used such as 12 out of the last 15 months? Who determines the projection numbers for the future revenues? Is it an independent consultant with expertise in the area? How conservative are the projections and how are they certified? Additionally, the definition of revenues is important. Does it include revenues generated by the enterprise, or could it also include special supplemental payments? These are all questions that have to be addressed by the analyst in reviewing the additional bonds test formula.
Other Relevant Covenants and Issues
Lastly, the legal documents should indicate whether there are other relevant covenants for the bondholder’s protection. These usually include pledges by the issuer of the bonds to insure the project (if it is a project-financing revenue bond), to have the accounting records of the issuer annually audited by an outside certified public accountant and provide timely reports to investors, and to employ independent engineers to annually review the capital plant and make mandatory recommendations to keep the facility operating for the life of the bonds.
In addition to the above aspects of the specific revenue structures of general obligation and revenue bonds, two other developments over the recent past make it more important than ever for the investor to carefully review the legal documents and opinions summarized in the official statements. The first development involves the mushrooming of new financing techniques that may rest on legally untested security structures. The second development is the increased use of legal opinions provided by local attorneys who may have little prior municipal bond experience. (Legal opinions traditionally have been written by experienced municipal bond attorneys.)
Legally Untested Security Structures and New Financing Techniques
In addition to the more traditional general obligation bonds and toll road, bridge, and tunnel revenue bonds, there are now more non-voter-approved, innovative, and legally untested security mechanisms. These innovative financing mechanisms include lease-rental bonds, moral obligation housing bonds, “dedicated tax-backed” and structured “asset-backed” bonds, take-and-pay power bonds with step-up provisions requiring the participants to increase payments to make up for those that may default, commercial bank-backed letter-of-credit “put” bonds, and tax-exempt commercial paper. What distinguishes these newer bonds from the more traditional general obligation and revenue bonds is that they have little history of court decisions and other case law to firmly protect the rights of the bondholders. For the newer financing mechanisms, the legal opinion should include an assessment of the probable outcome if the bond security were challenged in court. Note, however, that most official statements do not provide this to the investor.
The Need for Reliable Legal Opinions
For many years, concern over the reliability of the legal opinion was not as important as it is now. As a result of the numerous bond defaults and related shoddy legal opinions in the nineteenth century, the investment community demanded that legal documents and opinions be written by recognized municipal bond attorneys. As a consequence, over the years, a small group of primarily Wall Streetbased law firms and certain recognized firms in other financial centers dominated the industry and developed high standards of professionalism.
Now, however, more and more issuers have their legal work done by local law firms, a few of whom have little experience in municipal bond work. This development, along with the introduction of more innovative and legally untested financing mechanisms, has created a greater need for reliable legal opinions. An example of a specific concern involves the documents the issuers’ lawyers must complete so as to avoid arbitrage problems with the Internal Revenue Service.
By 2011, there were thousands of attorneys located throughout the country who were listed in the Bond Buyers’ Municipal Marketplace directory. They presented themselves as being experts in municipal finance law and provided various security structure and tax opinions. Sorting out quality distinctions in their work and who is well grounded in the law, and who is not, is challenging.
On negotiated bond issues, one remedy has been for the underwriters to have their own counsels review the documents and to provide separate legal opinions.
THE NEED TO KNOW WHO REALLY IS THE ISSUER
Still another general question to ask before purchasing a municipal bond is just what kind of people are the issuers? Are they conscientious public servants with clearly defined public goals? Do they have histories of successful management of public institutions? Have they demonstrated commitments to professional and fiscally stringent operations? Additionally, issuers in highly charged and partisan environments in which conflicts chronically occur between political parties or among political factions or personalities are clearly bond issuers to scrutinize closely and possibly to avoid. Such issuers should be scrutinized regardless of the strength of the surrounding economic environment.
For General Obligation and Tax-Backed Bonds
For general obligation bond issuers, focus on the political relationships that exist among chief executives such as mayors, county executives, and governors, and among their legislative counterparts. Issuers with unstable political elites are of particular concern. Of course, rivalry among politicians is not necessarily bad. What is undesirable is competition so bitter and personal that real cooperation among the warring public officials in addressing future budgetary problems may be precluded. An example of an issuer that was avoided because of such dissension was the city of Cleveland. The political problems of the city in 1978 and the bitter conflicts between Mayor Kucinich and the city council resulted in a general obligation note default in December of that year.
For Revenue Bonds
When investigating revenue bond issuers, it is important to determine not only the degree of political conflict, if any, that exists among the members of the bondissuing body but also the relationships and conflicts among those who make the appointments to the body. Additionally, the investor should determine whether the issuer of the revenue bond has to seek prior approval from another governmental jurisdiction before the user fees or other charges can be levied. If this is the case, then the stability of the political relationships between the two units of government must be determined.
An important example involves the creditworthiness of the water and electric revenue bonds and notes issued by Kansas City, Kansas. Although the revenue bonds and notes were issued by city hall, it was the six-member board of public utilities, a separately elected body, that had the power to set the water and electricity rates. In the spring of 1981, because of a political struggle between a faction on the board of public utilities and the city commissioners (including the city’s finance commissioner), the board refused to raise utility rates as required by the covenant. The situation came under control only when a new election changed the makeup of the board in favor of those supported by city hall.
In addition to the preceding institutional and political concerns, for revenue bond issuers in particular, the technical and managerial abilities of the staff should be assessed. The professional competency of the staff is a more critical factor in revenue bond analysis than it is in the analysis of general obligation bonds. The reason is that unlike general obligation bonds, which are secured in the final instance by the full faith and credit and unlimited taxing powers of the issuers, many revenue bonds are secured by the ability of the revenue projects to be operational and financially self-supporting.
The professional staffs of authorities that issue revenue bonds for the construction of nuclear and other public power-generating facilities, apartment complexes, hospitals, water and sewer systems, and other large public works projects, such as convention centers and sports arenas, should be reviewed carefully. Issuers who have histories of high management turnovers, project cost overruns, or little experience should be avoided by the conservative investor or at least considered higher risks than their assigned commercial credit ratings may indicate. Additionally, it is helpful for revenue bond issuers to have their accounting records annually audited by outside certified public accountants so as to provide the investor with a more accurate picture of the issuer’s financial health.
ON THE FINANCIAL ADVISOR AND UNDERWRITER
Shorthand indications of the quality of the investment are (1) who the issuer selected as its financial advisor, if any; (2) its principal underwriter if the bond sale was negotiated; and (3) its financial advisor if the bond issue came to market competitively. Additionally, many prudent underwriters will not participate if there are significant credit-quality concerns. Therefore, it is also useful to learn who was the underwriter for the bond sales as well.
Identifying the financial advisors and underwriters is important for two reasons.
The Need for Complete, Not Just Adequate, Investment Risk Disclosures
The first reason relates to the quality and thoroughness of information provided to the investor by the issuer. The official statement, or private-placement papers if the issue is placed privately, is usually prepared with the assistance of lawyers and a financial advisor or by the principal underwriter. There are industry-wide disclosure guidelines that generally are adhered to, but not all official statements provide the investor with complete discussions of the risk potentials that may result from either the specific economics of the project or the community settings and the operational details of the security provisions. It is usually the author of this document who decides what to emphasize or downplay in the official statement. The more professional and established the author is in providing unbiased and complete information about the issuer, the more comfortable the investor can be with information provided by the issuer and in arriving at a credit-quality conclusion.
The Importance of Firm Reputation for Thoroughness and Integrity
By itself, the reputation of the issuer’s financial advisor and/or underwriter should not be the determinant credit-quality factor, but it is a fact the investor should consider, particularly in the case of marginally feasible bond issues that have complex flow-of-funds and security structures. The securities industry is different from other industries, such as real estate, in that trading and investment commitments are usually made over the phone or electronically with a paper trail following days later. Many institutional investors, such as banks, bond funds, and property and casualty insurance companies, have learned to judge issuers by the company they keep. Institutions tend to be conservative, and they are more comfortable with financial information provided by established financial advisors and underwriters who have recognized reputations for honesty. Individual investors and analysts would do well to adopt this approach.
GENERAL CREDIT INDICATORS AND ECONOMIC FACTORS IN THE CREDIT ANALYSIS
The last analytical factor is the economic health or viability of the bond issuer or specific project financed by the bond proceeds. The economic factors cover a variety of concerns. When analyzing general obligation bond issuers, one should look at the specific budgetary and debt characteristics of the issuer, as well as the general economic environment. For project-financing, or enterprise, revenue bonds, the economics are limited primarily to the ability of the project to generate sufficient charges from the users to pay the bondholders. These are known as pure revenue bonds.
For revenue bonds that rely not on user charges and fees but instead on general purpose taxes and revenues, the analysis should take basically the same approach as for the general obligation bonds. For these bonds, the taxes and revenues diverted to the bondholders would otherwise go to the state’s or city’s general fund.
As an example, the bonds of the New York State Municipal Assistance Corporation for the City of New York Bonds (MAC), secured by general New York City sales taxes and annual state-aid appropriations, were structured to appear as pure revenue bonds, but in essence they were not. They incorporated a bond structure created to bail out New York City from severe budget deficits. The creditworthiness of the bond was tied to that of the underlying jurisdiction, which has had portions of its taxing powers and general fund revenues diverted to secure this new revenue-type bailout bond. Besides looking at the revenue features, the investor therefore must look at the underlying jurisdiction. These MACs were first issued in 1975 and refunded through the years. It should be noted that in 2004, the MACs were refunded, now with “Sales Tax Asset Receivable Corporation” bonds and stretched out to 2033 for paying off operating deficits of the 1960s.
For General Obligation Bonds
For general obligation bonds, the economic concerns include questions in four specific areas: debt burden, budget soundness, tax burden, and the overall economy.
Debt Burden
In relation to the debt burden of the general obligation bond issuer, some of the more important concerns include the determination of the total amount of debt outstanding and to be issued that is supported by the general taxing powers of the issuer as well as by earmarked revenues.
For example, general obligation bonds issued by school districts in New York State are general obligations of the issuer and are also secured by state-aid payments due the issuer. If the issuer defaults, the bondholder can go to the state comptroller and be paid from the next state-aid payment due the local issuer. An example of another earmarked-revenue general obligation bond is the State of Illinois General Obligation Transportation, Series A Bond. For these state general obligations, debt service is secured by gasoline taxes in the state’s transportation fund.
Key debt ratios that reveal the burden on local taxpayers include determining the per capita amount of general obligation debt as well as the per capita debt of the overlapping or underlying general obligation bond issuers. Other key measures of debt burden include determining the amounts and percentages of the outstanding general obligation bonds as well as the outstanding general obligation bonds of the overlapping or underlying jurisdictions to real estate valuations. These numbers and percentages can be compared with most recent year medians, as well as with the past history of the issuer, to determine whether the debt burden is increasing, declining, or remaining relatively stable.
In addition to the general obligation bonds outstanding, the debt of the general obligation bond issuer could include leases, certificates of participation (COPs), appropriation, and “moral obligation” bonds.
Additionally, the amount of the unfunded pension liabilities should be determined. What is the difference between the expected assets of the public employee system at current annual contribution rates, the future benefits to be paid out, and if the issuer has a reasonable plan to eliminate the unfunded liability? Can pension benefits unilaterally be reduced by the local governments? Such steps are allowed in some jurisdictions, but not in others. An example of the latter is New York State, where the state constitution prevents the reduction of pension benefits once they are granted. Therefore, the unfunded pension liabilities of local governments in New York must be taken much more seriously than in states where such guarantees do not exist.
Still another special debt figure that came into the forefront in the first decade of the twenty-first century involves the actuarially determined costs of providing health care for retirees. These are postemployment benefits. In many jurisdictions they are not legally mandatory and are paid on a pay-as-you-go basis. There are usually strong political groups such as unions and the retirees themselves that support these benefits. In some jurisdictions the potential size of this liability is greater than the outstanding general obligation bonds.
For purposes of determining the special debt figure—which represents the potential liability in a worst-case environment—the COPs, appropriation and lease obligations, the moral obligations, the unfunded pension liabilities, and the retiree health care costs should be shown and broken out.
Budgetary Soundness
Concerning the budgetary operations and budgetary soundness of the general obligation bond issuer, some of the more important questions include how well the issuer over at least the previous five years has been able to maintain balanced budgets and fund reserves. How dependent is the issuer on short-term debt to finance annual budgetary operations? How have increased demands by residents for costly social services been handled? That is, how frugal is the issuer? How well have the public-employee unions been handled? They usually lobby for higher salaries, liberal pensions, and other costly fringe benefits. Clearly, it is undesirable for the pattern of dealing with the constituent demands and public-employee unions results in raising taxes and drawing down nonrecurring budget reserves. Last, another general concern in the budgetary area is the reliability of the budget and accounting records of the issuer. Are interfund borrowings reported? Who audits the books?
It should be noted that by 2011, e-commerce and Internet usage were steadily growing among American consumers. Many states, counties, and city governments over the past 50 years have derived substantial revenues from sales taxes that are not always applied to Internet sales. In some jurisdictions, over 20% of an issuer’s revenues may come from local sales taxes. How the growth of the Internet affects this revenue source is uncertain at this time, but at some future date could be a significant negative for the budgets of at least some issuers as well as for their bonds secured by these taxes.
Tax Burden
Concerning the tax burden, it is important to learn two things initially. First, what are the primary sources of revenue in the issuer’s general fund? Second, how dependent is the issuer on any one revenue source? If the general obligation bond issuer relies increasingly on a property tax, wage and income taxes, or sales tax to provide the major share of financing for annually increasing budget appropriations, taxes could quickly become so high as to drive businesses and people away. Many larger northern states and cities with their relatively high income, sales, and property taxes appear to be experiencing this phenomenon. Still another concern is the degree of dependency of the issuer on intergovernmental revenues, such as federal or state revenue sharing and grants-in-aid, to finance its annual budget appropriations. Political coalitions on the state and federal levels that support these financial transfer programs are not permanent and could undergo dramatic change very quickly. Therefore, a general obligation bond issuer that currently has a relatively low tax burden but receives substantial amounts of intergovernmental monies should be reviewed carefully by the investor. If it should occur that the aid monies are reduced, as has been occurring under many federal and state programs, certain issuers primarily may increase their taxes instead of reducing their expenditures to conform to the reduced federal grants-in-aid.
Overall Economy
The fourth and last area of general obligation bond analysis concerns the issuer’s overall economy. For local governments, such as counties, cities, towns, and school districts, key items include learning the annual rate of growth of the full value of all taxable real estate for the previous 10 years and identifying the 10 largest taxable properties. What kinds of business or activity occur on the respective properties? What percentage of the total property tax base do the 10 largest properties represent? What has been the building permit trend for at least the previous five years? What percentage of all real estate is tax-exempt, and what is the distribution of the taxable ones by purpose (such as residential, commercial, industrial, railroad, and public utility)? Last, who are the five largest employers? Concerning the final item, communities that have one large employer are more susceptible to rapid adverse economic change than communities with more diversified employment and real estate bases. For additional information that reveals economic health or decline, one must determine whether the population of the community over the previous 10 years has been increasing or declining by age and income and how the monthly and yearly unemployment rates compare with the national averages, as well as with the previous history of the community.
For state governments that issue general obligation bonds, the economic analysis should include many of the same questions applied to local governments. In addition, the investor should determine on the state level the annual rates of growth for the previous five years of personal income and retail sales and how much the state has had to borrow from the Federal Unemployment Trust Fund to pay unemployment benefits. This last item is particularly significant for the longterm economic attractiveness of the state because employers in states with large federal loans in arrears may be required to pay increased unemployment taxes to the federal government.
For Revenue Bonds
Airport Revenue Bonds
For airport revenue bonds, the economic questions vary according to the type of bond security involved. There are two basic security structures.
The first type of airport revenue bond is one based on traffic-generated revenues that result from the competitiveness and passenger demand of the airport. The financial data on the operations of the airport should come from audited financial statements going back at least three years. If a new facility is planned, a feasibility study prepared by a recognized consultant should be reviewed. The feasibility study should have two components: (1) a market and demand analysis to define the service area and examine demographic and airport use trends and (2) a financial analysis to examine project operating costs and revenues.
Revenues at an airport may come from landing fees paid by the airlines for their flights, passenger facility charges (PFCs), concession fees paid by restaurants, shops, newsstands, and parking facilities, and from airline apron and fueling fees.
Also, in determining the long-term economic viability of an airport, the investor should determine whether or not the wealth trends of the service area are upward, whether the airport is dependent on tourism or serves as a vital transfer point, whether passenger enplanements and air cargo handled over the previous five years have been growing, whether increased costs of jet fuel and airport safety would make other transportation such as trains and automobiles more attractive in that particular region, and whether the airport is a major domestic hub for an airline, which could make the airport particularly vulnerable to route changes caused by schedule revisions and changes in airline corporate management.
The second type of airport revenue bond is secured by a lease with one or more airlines for the use of a specific facility such as a terminal or hangar. The lease usually obligates them to make annual payments sufficient to pay the expenses and debt service for the facility. For many of these bonds, the analysis of the airline lease is based on the credit quality of the lessee airline. Whether or not the lease should extend as long as the bonds are outstanding depends on the specific airport and facility involved. For major hub airports, it may be better not to have long-term leases because without leases, fees and revenues can be increased as the traffic grows, regardless of which airline uses the specific facility. Of course, for regional or startup airports, long-term leases with trunk (i.e., major airline) carriers are preferred.
After 9/11, air travel suffered a unique temporary downturn. While air travel remains an essential service, after the terrorist attacks, the analysis of the credit quality of airports and airlines with related bankruptcy issues has undergone increased scrutiny.
Charter School Bonds
Charter school bonds are for publicly funded private schools that offer more institutional and academic flexibility than local public schools. State-aid funding usually follows the student who goes from a traditional public school to a charter school. Bond proceeds go for capital improvements.
Some important credit questions to ask include: (1) How long is the charter granted by the state or local school district, and is it renewable? (2) What is the charter school enrollment history—is it growing? (3) Does the school serve a specialty academic niche, or is it just relieving overcrowding at local public schools? (4) What is its reputation in the community? (5) Is there competition? (6) Is there a waiting list? (7) Is the school prudently run with cash reserves, i.e., how many days of cash are on hand? and (8) How reasonable are the operating and maintenance expenses in relationship to the revenues and debt service requirements?
Continuing Care Retirement Community Bonds
A continuing care retirement community (CCRC) provides housing accommodations and health-related services to elderly persons, typically for the duration of their lifetimes. These nonprofit organizations finance a portion of development and operating costs by issuing bonds secured by the entrance fees and monthly fees paid by their residents. The potential demand for a CCRC is largely affected by the number of elderly persons in the nearby area with qualifying assets and income, the presence and proximity of competitor facilities, and the strength of the local real estate market. Other important considerations include whether advance fee deposits are partially or fully refundable, the experience of the general contractor and management, the background of the sponsor, and the amount of cash reserves on hand. A careful analysis of the data and assumptions of any feasibility study formed is essential.
Dedicated Tax-Backed and Structured/Asset-Backed Bonds
More recently, states and local governments have issued increasing amounts of bonds where the debt service is to be paid from so-called dedicated revenues such as sales taxes, tobacco settlement payments, fees, and penalty payments. Many are structured to mimic the asset-backed bonds that are common in the taxable market. The “assets” providing the security for the municipal bonds are the “dedicated” revenues instead of credit card receivables, home equity loans, and auto loan repayments that are commonly used to secure the taxable asset-backed bonds.
Additionally, the municipal bonds are usually subject to some form of annual legislative appropriation and result from statutes specially created to pledge the identified taxes and revenues and allow for the bond sales. In good economic times many investors as well as the rating agencies tend to blur the credit distinctions between these bonds and the issuer’s own general obligation bonds. In fact, many such bonds carry higher credit ratings than the underlying general obligation bonds because the “coverage” on the former appears to be so high. In most instances, the general obligation bonds are legally backed by specific state constitutional provisions, whereas, the dedicated tax and structured/asset-backed bonds are recent legislative creations and have not been tested yet in stressful budgetary, economic, and political environments.
Higher Education Bonds
Debt is often issued by institutions of higher education to finance the costs of building/renovating facilities or purchasing land for expansion. These bonds are secured by revenues of the given project, student charges, and/or a general obligation of the college or university. An investor in higher education bonds should carefully consider the following: (1) Is student demand for the issuing institution strong and growing? (2) Does the school have flexibility to increase tuition or enrollment if needed? (3) How experienced are senior management and the board of trustees? (4) What are the school’s various sources of funding? (5) What is the endowment level and how is it trending? (6) How well does the school manage expenses and repay its debts? (7) What is the physical condition of school facilities? and (8) Are there any construction or project-specific risks?
Highway Revenue Bonds
There are generally two types of highway revenue bonds. The bond proceeds of the first type are used to build specific revenue-producing facilities such as toll roads, bridges, and tunnels. For these pure enterprise revenue bonds, the bondholders have claims to the revenues collected through the tolls. The financial soundness of the bonds depends on the ability of the specific projects to be self-supporting. Proceeds from the second type of highway revenue bond generally are used for public highway improvements, and the bondholders are paid by earmarked revenues such as gasoline taxes, automobile registration payments, and driver’s license fees.
Concerning the economic viability of a toll revenue bond, the investor should ask a number of questions.
1. What is the traffic history, and how inelastic is the demand? Toll roads, bridges, and tunnels that provide vital transportation links are clearly preferred to those that face competition from interstate highways, toll-free bridges, or mass transit.
2. How well is the facility maintained? Has the issuer established a maintenance reserve fund at a reasonable level to use for such repair work as road resurfacing and bridge painting?
3. Does the issuer have the ability to raise tolls to meet covenant and debt reserve requirements without seeking approvals from other governmental actors such as state legislatures and governors? In those few cases where such approvals are necessary, the question of how sympathetic these other power centers have been in the past in approving toll-increase requests should be asked.
4. What is the debt-to-equity ratio? Some toll authorities have received substantial nonreimbursable federal grants to help subsidize their costs of construction. This, of course, reduces the amount of debt that has to be issued.
5. What is the history of labor-management relations, and can public-employee strikes substantially reduce toll collections?
6. When was the facility constructed? Generally, toll roads financed and constructed in the 1960s tend to be in better financial condition because the cost of financing was much less.
7. If the facility is a bridge that could be damaged by a ship and made inoperable, does the issuer have adequate use-and-occupancy insurance?
Those few toll revenue bonds that have defaulted have done so because of either unexpected competition from toll-free highways and bridges, poor traffic projections, or substantially higher than projected construction costs. An example of one of the few defaulted bonds is the West Virginia Turnpike Commission’s Turnpike Revenue Bonds, issued in 1952 and 1954 to finance the construction of an 88-mile expressway from Charleston to Princeton, West Virginia. The initial traffic-engineering estimates were overly optimistic, and the construction costs came in approximately $37 million higher than the original budgeted amount of $96 million. Because of insufficient traffic and toll collections, between 1956 and 1979 the bonds were in default. By the late 1970s with the completion of various connecting cross-country highways, the turnpike became a major link for interstate traffic. The bonds became self-supporting in terms of making interest coupon payments. It was not until 1989 that all the still-outstanding bonds were finally redeemed.
More recently, a new group of start-up toll roads has been financed with municipal bonds. The revenue projections for several roads turned out to be overly optimistic. Some have had to draw on the debt reserves. Others have had to be restructured and even defaulted. Examples include the Santa Rosa Bay Bridge Authority in Florida, the Southern Connector Toll Road in South Carolina, and the San Joaquin Toll Road in California.
Concerning the economics of highway revenue bonds that are not pure enterprise type but instead are secured by earmarked revenues, such as gasoline taxes, automobile registration payments, and driver’s license fees, the investor should ask the following questions:
• Are the earmarked tax revenues based on state constitutional mandates, such as the state of Ohio’s Highway Improvement Bonds, or are they derived from laws enacted by state legislatures, such as the state of Washington’s Chapters 56, 121, and 167 Motor Vehicle Fuel Tax Bonds? A constitutional pledge is usually more permanent and reliable.
• What has been the coverage trend of the available revenues to debt service over the previous 10 years? Has the coverage been increasing, stable, or declining?
• If the earmarked revenue is a gasoline tax, is it based on a specific amount per gallon of gasoline sold or as a percentage of the price of each gallon sold? With greater conservation and more efficient cars, the latter tax structure is preferred because it is not as susceptible to declining sales of gasoline and because it benefits directly from any increased gasoline prices at the pumps.
• What has been the history of statewide gasoline consumption through recessions and oil shocks?
Hospital Revenue Bonds
Two unique features of hospitals make the analysis of their debt particularly complex and uncertain. The first concerns their sources of revenue, and the second concerns the basic structure of the institutions themselves.
During the past 40 years, the major sources of revenue for most hospitals have been (1) payments from the federal (Medicare) and combined federal-state (Medicaid) hospital reimbursement programs, and (2) appropriations made by local governments through their taxing powers. It is not uncommon for hospitals to receive at least half of their annual revenues from these sources. How well the hospital management markets its service to attract more private-pay patients and commercial insurers, and how conservatively it budgets for the governmental reimbursement payments are key elements for distinguishing weak from strong hospital bonds.
Particularly for community-based hospitals (as opposed to teaching hospitals affiliated with medical schools), a unique feature of their financial structure is that their major financial beneficiaries, physicians, have no legal or financial liabilities if the institutions do not remain financially viable over the long term. An example of the problems that can be caused by this lack of liability is found in the story of the Sarpy County, Nebraska, Midlands Community Hospital Revenue Bonds. These bonds were issued to finance the construction of a hospital three miles south of Omaha, Nebraska, that was to replace an older one located in the downtown area. Physician questionnaires prepared for the feasibility study prior to the construction of the hospital indicated strong support for the replacement facility. Many doctors had used the older hospital in downtown Omaha as a backup facility for a larger nearby hospital. Unfortunately, once the new Sarpy hospital opened in 1976, many physicians found that the new hospital could not serve as a backup because it was 12 miles further away from the major hospital than the old hospital had been. Because these physicians were not referring their patients to the new Sarpy hospital, it was soon unable to make bond principal payments and was put under the jurisdiction of a court receiver.
The preceding factors raise long-term uncertainties about many community-based hospitals, but certain key areas of analysis and trends reveal the relative economic health of hospitals that already have revenue bonds outstanding. The first area is the liquidity of the hospital as measured by the ratio of dollars held in current assets to current liabilities. In general, a five-year trend of high values for the ratio is desirable because it implies an ability by the hospital to pay short-term obligations and thereby avoid budgetary problems. Days cash on hand is an important measure as well. The second indicator is the ratio of long-term debt to equity, as measured in the unrestricted end-of-year fund balance. In general, the lower the long-term debt to equity ratio, the stronger the finances of the hospital are. The third indicator is the actual debt service coverage of the previous five years, as well as the projected coverage. The fourth indicator is the annual bed-occupancy rates for the previous five years. The fifth is the percentage of physicians at the hospital who are professionally approved (board certified), their respective ages, and how many of them use the hospital as their primary institution.
For new or expanded hospitals, much of the preceding data are provided to the investor in the feasibility study. One item in particular that should be determined for a new hospital is whether the physicians who plan to use the hospital actually live in the area to be served by the hospital. Because of its importance in providing answers to these questions, the feasibility study must be prepared by reputable, experienced researchers.
Housing Revenue Bonds
For housing revenue bonds, the economic and financial questions vary according to the type of bond security involved. There are two basic types of housing revenue bonds, each with a different type of security structure. One is the housing revenue bond secured by single-family mortgages, and the other is the housing revenue bond secured by mortgages on multifamily housing projects.
Concerning single-family housing revenue bonds, the strongly secured bonds usually have five characteristics:
• The single-family home loan bonds are collateralized by GNMA, FNMA, or FHLMC; or the loans are insured by the Federal Housing Administration (FHA), Department of Veteran Affairs (VA), or an acceptable private mortgage insurer or its equivalent. If the individual home loans are not insured, then they should have a loan-to-value ratio of 80% or less. Prior to 2007, many bonds had acceptable private mortgage insurance.
• If the conventional home loans have less than 100% primary mortgage insurance coverage, or are not backed by federal collateral, an additional 5% to 10% mortgage-pool insurance policy or its equivalent may be required.
• In addition, there is a mortgage reserve fund equal at least to 1% of the mortgage portfolio outstanding.
• The issuer of the single-family housing revenue bonds is in a region of the country that has stable or strong economic growth as indicated by increased real estate valuations, personal income, and retail sales, as well as low unemployment rates.
• State housing finance agency support.
In the 1970s, state agency issuers of single-family housing revenue bonds assumed certain prepayment levels in structuring the bond maturities. In recent years, most issuers have abandoned this practice but investors should review the retirement schedule for the single-family mortgage revenue bonds to determine whether or not the issuer has assumed large, lump-sum mortgage prepayments in the early year cash-flow projections. If so, how conservative are the prepayment assumptions, and how dependent is the issuer on the prepayments to meet the annual debt service requirements? Of course, while the focus of this chapter is on credit analysis, the investor should be aware that extraordinary redemptions of these bonds can occur from prepayments on the mortgages.
It should be noted that since the mid-1990s, issuers have adopted structures similar to those in the taxable mortgage-backed securities market that incorporate prepayment assumptions. In tax-exempt single-family housing bonds, these are usually the planned amortization class (PAC) structures.
State issuing agencies usually have professional in-house staffs that closely monitor the home mortgage portfolios, whereas the local issuers do not. Finally, many state issuing agencies have accumulated substantial surplus funds over the years that can be viewed as an additional source of bondholder protection.
For multifamily housing revenue bonds, there are four specific, although overlapping, security structures. The first type of multifamily housing revenue bond is one in which the bonds are secured by federally insured mortgages. Usually, the federal insurance covers all but the difference between the outstanding bond principal and collectible mortgage amount (usually 1%), and all but the nonasset bonds (i.e., bonds issued to cover issuance costs and capitalized interest). The attractiveness of the federal insurance is that it protects the investor against bond default within the limitations outlined. The insurance protects the bondholders regardless of whether the projects are fully occupied and generating rental payments.
The second type of multifamily housing revenue bond is one in which the federal government subsidizes, under the HUD Section 8 program, all annual costs (including debt service) of the project not covered by tenant rental payments. Under Section 8, the eligible low-income and elderly tenants pay only 15% to 30% of their incomes for rent. Because the ultimate security comes from the Section 8 subsidies, which normally escalate annually with the increased cost of living in that particular geographic region, the bondholder’s primary risks concern the developer’s ability to complete the project, find tenants eligible under the federal guidelines to live in the project, and then maintain high occupancy rates for the life of the bonds. The investor should carefully review the location and construction standards used in building the project, as well as the competency of the project manager in selecting tenants who will take care of the building and pay their rents. In this regard, state agencies that issue Section 8 bonds usually have stronger in-house management experience and resources for dealing with problems than do the local development corporations that have issued Section 8 bonds. It should be noted that the federal government has eliminated appropriations for new Section 8 projects. Since 1995, the federal government has restricted automatic rent increases under the Section 8 program. This has introduced financial pressure.
The third type of multifamily housing revenue bond is one in which the ultimate security for the bondholder is the ability of the project to generate sufficient monthly rental payments from the tenants to meet the operating and debt service expenses. Some of these projects may receive governmental subsidies (such as interest-cost reductions under the federal Section 236 program and property tax abatements from local governments), but the ultimate security is the economic viability of the project. Key information includes the location of the project, its occupancy rate, whether large families or the elderly will primarily live in the project, whether or not the rents necessary to keep the project financially sound are competitive with others in the surrounding community, and whether or not the project manager has a proven record of maintaining good service and of establishing careful tenant selection standards.
A fourth type of multifamily housing revenue bond is one that includes some type of private credit enhancement to the underlying real estate. These credit enhancements can include guarantees or sureties of an insurance company, securitization by Fannie Mae (Federal National Mortgage Association or FNMA), or a bank letter-of-credit.
Other financial features desirable in all multifamily housing bonds include a debt service reserve fund, which should contain an amount of money equal to the maximum annual debt service on the bonds, a mortgage reserve fund, and a capital repair and maintenance fund.
Another feature of many multifamily housing revenue bond programs, particularly those issued by state housing agencies, is the state moral obligation pledge. Several state agencies have issued housing revenue bonds that carry a potential state liability for making up deficiencies in their one-year debt service reserve funds, should any occur. In most cases, if a drawdown of the debt reserve occurs, the state agency must report the amount used to its governor and state budget director. The state legislature, in turn, may appropriate the requested amount, although there is no legally enforceable obligation to do so. Bonds with this makeup provision are called moral obligation bonds.
The moral obligation provides a state legislature with permissive authority—not mandatory authority— to make an appropriation to the troubled state housing agency. Therefore, the analysis should determine (1) whether the state has the budgetary surpluses for subsidizing the housing agency’s revenue bonds, and (2) whether there is a consensus within the executive and legislative branches of that particular state’s government to use state general fund revenues for subsidizing multifamily housing projects.
Industrial Revenue Bonds
Generally, industrial revenue bonds are issued by state and local governments on behalf of individual corporations and businesses. The security for the bonds usually depends on the economic soundness of the particular corporation or business involved. If the bond issue is for a subsidiary of a larger corporation, one question to ask is whether or not the parent guarantees the bonds. Is it obligated only through a lease, or does it not have any obligation whatsoever for paying the bondholders? If the parent corporation has no responsibility for the bonds, then the investor must look very closely at the operations of the subsidiary in addition to those of the parent corporation.
For companies that have issued publicly traded common stock, operating data are readily available in the quarterly (10-Q) and annual (10-K) financial reports that must be filed with the Securities and Exchange Commission. For privately held companies, financial data are more difficult to obtain.
In assessing the economic risk of investing in an industrial revenue bond, another question to ask is whether the bondholder or the trustee holds the mortgage on the property. Although holding the mortgage is not an important economic factor in assessing either hospital or low-income multifamily housing bonds in which the properties have very limited commercial value, it can be an important strength for the holder of industrial development revenue bonds. If the bond is secured by a mortgage on a property of a major retailer, or an industrial facility such as a warehouse, the property location and resale value of the real estate may provide some protection to the bondholder, regardless of what happens to the company that issued the bonds. Of course, the investor always should avoid possible bankruptcy situations regardless of the economic attractiveness of the particular piece of real estate involved. The reason is that the bankruptcy process usually involves years of litigation and numerous court hearings, about which no investor should want to be concerned.
Land-Secured “Dirt” Bonds
Public infrastructure costs associated with new development projects on raw land are often financed by land-secured bonds, also known as “dirt” bonds. Revenue from the additional tax or assessment placed on the properties benefitting from these improvements is the primary security for the bondholders. Additional security is provided by the ability of the sponsoring governmental entity to commence foreclosure or tax sales if property owners are delinquent on their taxes or assessments. Important credit factors to consider include: (1) Is the development’s location, demographics, and competitive position favorable? (2) Does the developer possess sufficient experience and financial resources? (3) Is there a debt service reserve and other funds, and how are they funded? (4) Is the lien created by the tax/assessment fixed or variable, and what is the resulting debt service coverage provided? (5) Is the value of the land relative to the outstanding liens sufficient to discourage property owners from walking away?
Lease-Rental Bonds
Lease-rental bonds usually are structured as revenue bonds, and annual payments, paid by a state or local government, cover all costs including operations, maintenance, and debt service. It should be noted that many Certificate of Participation Bonds, or COPs, are similar in security structure in that they too are dependent on the annual legislative appropriation process. The public purposes financed by these bond issues include public office buildings, fire houses, police stations, university buildings, mental health facilities, and highways, as well as office equipment and computers. In some instances, the payments may come from student tuition, patient fees, and earmarked tax revenues, and the state or local government is not legally obligated to make lease-rental payments beyond the amount of available earmarked revenues. However, for many lease-rental bonds, the underlying lessee state, county, or city is to make payment from its general fund subject to annual legislative appropriation. For example, the Albany County, New York, Lease Rental South Mall Bonds were issued to finance the construction of state office buildings. Although the bonds were technically general obligations of Albany County, the real security came from the annual lease payments made by the State of New York. These payments were appropriated annually. For such bonds, the basic economic and financial analysis should follow the same guidelines as for general obligation bonds.
Public Power Revenue Bonds
Public power revenue bonds are issued to finance the construction of electrical generating plants. An issuer of the bonds may construct and operate one power plant, buy electric power from a wholesaler and sell it retail, construct and operate several power plants, or join with other public and private utilities in jointly financing the construction of one or more power plants. This last arrangement is known as a joint-power financing structure. Although there are revenue bonds that can claim the revenues of a federal agency (e.g., the Washington Public Power Supply System’s Nuclear Project No. 2 Revenue Bonds, which if necessary could claim the revenues of the Bonneville Power Administration), and others may require the participating underlying municipal electric systems to pay the bondholders whether or not the plants are completed and operating, the focus here is how the investor determines which power projects will be financially self-supporting without these backup security features.
There are at least five major questions to ask when evaluating the investment soundness of a public power revenue bond:
• Does the bond issuer have the authority to raise its electric rates in a timely fashion without going to any regulatory agencies? This is particularly important if substantial rate increases are necessary to pay for new construction or plant improvements.
• How diversified is the customer base among residential, commercial, and industrial users?
• Is the service area growing in terms of population, personal income, and commercial/industrial activity so as to warrant the electrical power generated by the existing or new facilities?
• Are rates competitive with neighboring IOUs?
• What are the projected and actual costs of power generated by the system, and how competitive are they with other regions of the country? Power rates are particularly important for determining the long-term economic attractiveness of the region for industries that are large energy users.
• How diversified is the fuel mix? Is the issuer dependent on one energy source such as hydro dams, oil, natural gas, coal, or nuclear fuel?
Concerning electrical generating plants fueled by nuclear power, the aftermath of the Three Mile Island nuclear accident in 1979 has resulted in greater construction and maintenance reviews and costly safety requirements prompted by the Federal Nuclear Regulatory Commission (NRC). The NRC oversees this industry. In the past, although nuclear power plants were expected to cost far more to build than other types of power plants, it also was believed that once the generating plants became operational, the relatively low fuel and maintenance costs would more than offset the initial capital outlays. However, with the increased concern about public safety brought about by the Three Mile Island accident, repairs and design modifications are now expected to be made even after plants begin to operate. Of course, this increases the ongoing costs of generating electricity and reduces the attractiveness of nuclear power as an alternative to the oil, gas, and coal fuels.
Public-Private Partnerships
Privatization is a form of municipal financing where a private company pays a large payment to operate, and often build or improve, a governmental asset (e.g., usually toll roads). The purchaser issues debt to help finance this large upfront cost, and the operating revenues are pledged to repay bondholders. The bonds issued are referred to as private-placement partnership bonds (PPP). Important questions to ask about these bonds are: (1) What is the length of the concession agreement? (2) How are prices or tolls set? (3) Does the governmental entity share in any revenue? (4) Are there any noncompete provisions? (5) What levels of maintenance, capital expenditures, and service are required? (6) What are the conditions and repercussions for nonperformance? and (7) What are the assumptions and conclusions of any feasibility study performed?
Tobacco Revenue Bonds
Some tobacco bonds are solely secured by revenues in the Master Settlement Agreement (MSA) annually paid to states by cigarette companies. Important credit issues include: (1) The credit quality of the cigarette companies making the annual payments; (2) the consumption assumptions used in sizing the original bond issue, i.e., the degree of leveraging used; (3) current consumption trends and their impacts on cash-flows and debt coverage; and (4) the status of the various court cases.
Tribal Casino Bonds
Native American governments in general finance the construction of their casino gaming facilities by issuing debt. Tribal casino bonds derive their revenues from the gaming operations of these facilities. Given the limited diversity of the revenue streams and the lack of hard collateral assets, evaluating the future viability and profitability of the new gaming facility is essential, including analysis of the relevant demographics, competitive factors, and quality of casino management. Buyers should also assess the financial strength, governance structure, and development project expertise of the issuing tribal entity. Other issues to consider include whether the cash trapping and debt service reserve fund features of the issued debt are sufficient, any gaming compact and revenue sharing arrangements with state governments, and potential regulatory changes. It should be noted that a U.S. Federal District court in Wisconsin recently ruled in favor of a tribal bond issuer seeking to abandon its payment obligation, claiming the related indenture breached federal tribal gaming regulations. This case was under appeal.
Water and Sewer Revenue Bonds
Water and sewer revenue bonds are issued to provide for a local community’s basic needs and as such are not usually subject to general economic changes. Because of the vital utility services performed, their respective financial structures are usually designed to have the lowest possible user charges and still remain financially viable. Generally, rate covenants requiring that user charges cover operations, maintenance, and approximately 1.2 times annual debt service and reserve requirements are most desirable. On the one hand, a lower rate covenant provides a smaller margin for unanticipated slow collections or increased operating and plant maintenance costs caused by inflation. On the other hand, rates that generate revenues more than 1.2 times the annual debt service and reserve requirements could cause unnecessary financial burdens on the users of the water and sewer systems.
A useful indication of the soundness of an issuer’s operations is to compare the water or sewer utility’s average quarterly customer billings to those of other water or sewer systems. Assuming that good customer service is given, the water or sewer system that has a relatively low customer billing charge generally indicates an efficient operation and therefore strong bond-payment prospects.
Key questions for the investor to ask include the following:
• Has the bond issuer, through local ordinances, required mandatory water or sewer connections? Also, local board of health directives against well water contamination and septic tank usage can often accomplish the same objective as the mandatory hookups.
• Does the issuer have to comply with an EPA consent decree and thereby issue significant amounts of bonds?
• What is the physical condition of the facilities in terms of plant, lines, and meters, and what capital improvements are necessary for maintaining the utilities as well as for providing for anticipated community growth?
• For water systems in particular, it is important to determine if the system has water supplies in excess of current peak and projected demands. An operating system at less than full utilization is able to serve future customers and bring in revenues without having to issue additional bonds to enlarge its facilities.
• What is the operating record of the water or sewer utility for the previous five years?
• If the bond issuer does not have its own distribution system but instead uses other participating local governments that do, are the charges or fees based on the actual water flow drawn (for water revenue bonds) and sewage treated (for sewer revenue bonds) or on gallonage entitlements?
• For water revenue bonds issued for agricultural regions, what crop is grown? An acre of oranges or cherries in California will provide the grower with more income than will an acre of corn or wheat in Iowa.
• For expanding water and sewer systems, does the issuer have a record over the previous two years of achieving net income equal to or exceeding the rate covenants, and will the facilities to be constructed add to the issuer’s net revenues?
• Has the issuer established and funded debt and maintenance reserves to deal with unexpected cash-flow problems or system repairs?
• Does the bond issuer have the power to place tax liens against the real estate of those who have not paid their water or sewer bills? Although the investor would not want to own a bond for which court actions of this nature would be necessary, the legal existence of this power usually provides an economic incentive for water and sewer bills to be paid promptly by the users.
Additional bonds should be issued only if the need, cost, and construction schedule of the facility have been certified by an independent consulting engineer and if the past and projected revenues are sufficient to pay operating expenses and debt service. Of course, for a new system that does not have an operating history, the quality of the consulting engineer’s report is of the upper-most importance.
RED FLAGS FOR THE INVESTOR
In addition to the areas of analysis just described, certain red flags, or negative trends, suggest increased credit risks.
For General Obligation Bonds
For general obligation bonds, the signals that indicate a decline in the ability of a state, county, town, city, or school district to function within fiscally sound parameters include the following:
• Declining property values and increasing delinquent taxpayers
• An annually increasing tax burden relative to other regions
• An increasing property tax rate in conjunction with a declining population
• Declines in the number and value of issued permits for new building construction
• Actual general fund revenues consistently falling below budgeted amounts
• Increasing end-of-year general fund deficits
• Budget expenditures increasing annually in excess of the inflation rate
• The unfunded pension liabilities are increasing
• General obligation debt increasing while property values are stagnant
• Declining economy as measured by increased unemployment and declining personal income
For Revenue Bonds
For revenue bonds, the general signals that indicate a decline in credit quality include the following:
• Annually decreasing coverage of debt service by net revenues
• Use of debt reserve and other reserves by the issuer
• Growing financial dependence of the issuer on unpredictable federal and state-aid appropriations for meeting operating budget expenses
• Chronic lateness in supplying investors with annual audited financials
• Unanticipated cost overruns and schedule delays on capital construction projects
• Frequent or significant rate increases
• Deferring capital plant maintenance and improvements
• Excessive management turnovers
• Shrinking customer base
• New and unanticipated competition
INFORMATION SOURCES FOR THE ANALYST
The Official Statement
An official statement describing the issue and the issuer is prepared for new offerings. A preliminary official statement is issued prior to the final official statement. These statements are known as the OS and POS. These statements provide potential investors with a wealth of information. The statements contain basic information about the amount of bonds to be issued, maturity dates, coupons, the use of the bond proceeds, the credit ratings, a general statement about the issuer, and the name of the underwriter and members of the selling group. Much of this information can be found on the cover page or in the first few pages of the official statement. It also contains detailed information about the security and sources of payments for the bonds, sources and uses of funds, debt service requirements, relevant risk factors, issuer’s financial statements, a summary of the bond indenture, relevant agreements, notice of any known existing or pending litigation, the bond insurance policy specimen (if insured), and the form of opinion of bond counsel. The official statement contains most of the information an investor will need to make an informed and educated investment decision.
Continuing Disclosure Under Rule 15c2-12
Rule 15c2-12, which took effect in 1995, required dealers to determine that issuers before issuing new municipal bonds made arrangements to disclose in the future financial information at least annually as well as notices of the occurrence of any of 11 “material event notices” as specified in the rule. By 2011, the amended rule contained 14 material event notices. Also by 2011, the annual report and notices of material events are to be filed with the Municipal Securities Rulemaking Board (MSRB), in an electronic format as prescribed by the MSRB. The MSRB designated its Electronic Municipal Market Access system (EMMA), found at http://emma.msrb.org as the sole repository for such disclosure filings.
It should be noted that many issuers, such as hospitals, toll roads, and CCRCs provide unaudited interim information to bondholders on a quarterly and even a monthly basis.
The National Federation of Municipal Analysts
The National Federation of Municipal Analysts (NFMA) was established in 1983 and by 2011 had a membership of 1,000 municipal professionals, drawing in part from the institutional investors in municipal bonds who advocated increased and timely information for investors. By 2011, its committees have developed detailed disclosure guidelines and risk factors in municipal securities ranging from specific credit sectors to swap structures. They are recommended for municipal bond issuers to use in providing ongoing financial and operating information to investors and analysts. The web site is www.nfma.org.
The Governmental Standards Accounting Board
The Governmental Standards Accounting Board (GSAB) is a nonprofit organization that sets generally accepted accounting standards (GAAP) for state and local governments. Established in 1984 it provides detailed guidelines. For many years it has improved financial reporting standards in reports of state and local governments that are used by analysts, auditors, and other users. By improving the transparency of state and local government accounting, it helps prevent issuers from obfuscating budget deficits and long-term liabilities that in the past had resulted in budgetary disasters and bond defaults. The web site is http://gasb.org.
KEY POINTS
• The five categories of inquiry when analyzing the creditworthiness of a general obligation, tax-backed, or pure revenue bond are (1) legal documents and opinions, (2) politics/management, (3) underwriter/financial advisor, (4) general credit indicators and economics, and (5) red flags, or danger signals.
• From the perspective of the bondholder, the legal opinions and document reviews should be the ultimate security provisions. The reason is that if all else fails, the bondholder may have to go to court to enforce his or her security rights. The relationship of the legal opinion to the analysis of municipal bonds for both general obligation and revenue bonds is the following: (1) the attorney should check to determine whether the issuer is indeed legally able to issue the bonds; (2) the attorney is to see that the issuer has properly prepared for the bond sale by enacting the various required ordinances, resolutions, and trust indentures and without violating any other laws and regulations; and (3) the attorney is to certify that the security safeguards and remedies provided for the bondholders and pledged by either the bond issuer or third parties are actually supported by federal, state, and local government laws and regulations.
• Before purchasing a municipal bond the investor should investigate whether the issuer’s officials (1) are conscientious public servants with clearly defined public goals; (2) have a history of successful management of public institutions; and (3) have demonstrated commitments to professional and fiscally stringent operations. In addition, it is important to scrutinize closely (and possibly avoid) issuers in highly charged and partisan environments in which conflicts chronically occur between political parties or among political factions or personalities.
• Indicators of the quality of the investment are (1) who the issuer selected as its financial advisor, if any; (2) its principal underwriter if the bond sale was negotiated; and (3) its financial advisor if the bond issue came to market competitively. It is also useful to find out who was the underwriter for the issue.
• An analytical factor to consider in assessing the creditworthiness of an issue is the economic health or viability of the bond issuer or specific project financed by the bond proceeds. The economic factors cover a variety of concerns. When analyzing general obligation bond issuers, the specific budgetary and debt characteristics of the issuer, as well as the general economic environment should be investigated. For project-financing, or enterprise, revenue bonds, the economics are limited primarily to the ability of the project to generate sufficient charges from the users to pay the bondholders. In the case of revenue bonds that rely not on user charges and fees, but instead on general purpose taxes and revenues, the analysis should take basically the same approach as for the general obligation bonds. For these bonds, the taxes and revenues diverted to the bondholders would otherwise go to the state’s or city’s general fund.