Natural disaster devastation, pension and other post-employment benefit actuarial uncertainty, changing political landscapes, shrinking regional economies and complicated legal descriptions of security and default remedies all contribute to anxiety in owning municipal bonds.
While reading a bond issue’s official statement won’t eliminate those concerns, it is essential to understanding the risk factors in making a long-term fixed rate investment in state and local government debt, as well as qualified tax-exempt private activity bonds.
Official Statements (OS) can sometimes be as thick as War and Peace, with as many characters, but precious little of the plot development. Opening them up online is daunting, and downloading them can remind you of dial-up service.
But, to break down the document into something you can digest, consider the following checklist of questions:
1) What is being financed? Or what is the project?
2) What is the legal promise to repay you?
3) What cash flow secures your repayment?
4) How are the local and regional economies doing?
5) How capable is management? Electeds? Professional staff?
You can typically answer these questions in short order working from the OS’s table of contents.
1) What is being financed?
If you can’t determine the purpose of the financing after a quick look at the cover or in the body of the OS, you may want to look at other bonds. Once you understand the purpose of the financing, you should ask yourself if it makes sense. Is the project essential infrastructure? Does it meet an obvious public need in the community where it is being developed? You should be able to answer these quickly.
2) What is the legal promise to repay?
Every OS should have a section describing the legal authority of the issuer to offer the debt. This can look like boilerplate, but your investment is relying on the issuer’s legal authority to issue debt based on state and local legal authority and legislative action. Double check it and ask yourself if the authority is clear and makes sense. You can even search online to see if the local authority received unanimous legislative support or whether there was opposition.
There should also be a clear description of the legal promise to repay. Is it a resolution of the legislative body? Does it include a majority or super majority vote of the community? Additionally, there should be a clear description of what happens in the event of default. If repayment is secured by a lease, confirm that the payment is secured by an annual promise of the issuer to budget and appropriate, so long as the issuer has use and occupancy of the leased asset. Understand what happens if the issuer doesn’t have use and occupancy. Search in the document for “abatement.” Ask yourself how essential to the issuer is the leased asset? Would the issuer budget and appropriate lease payments if times became tight? Finally, is there any additional security, such as casualty insurance, rental interruption insurance or a reserve fund? If so, what are the legally promised obligations to purchase or transfer risk?
Toward the front of the OS should be information how the issuer can redeem your investment before maturity. Double check to make sure the description in the OS matches what is on the cover.
Utility financings can be simplified if you concentrate on what is the revenue pledge (gross or net of what?) and the rate covenant (at what point does the utility need to increase rates and charges to give you, the investor, comfort that payments will be made on time?).
3) What cash flow secures your repayment?
This should be obvious, but it isn’t always. Voted property taxes can be simple to understand. Sales tax pledges for transportation projects are much less so, as contracting economic activity might impair repayment. User fees for utility services like water and sewer can also be easy to break down. Net revenue pledges with cascading obligations in health care and housing bonds can be more complicated and require some reflection on best case, worst case and likely outcomes. Limited tax pledges from tax increment finance, or TIF transactions, also require some reflection because if there is a contraction in property value, the issuer will be “limited” in assisting investors with a resolution. Leases can be secured by an issuer’s general fund that might have police and fire services as a top priority. For leases as mentioned above, understanding “abatement” and “essentiality” will help you sleep at night.
4) How are the local and regional economies doing?
The body of the OS often summarizes information on property taxes, sales taxes, hotel taxes, new construction, and median income and other economic indicators. In some cases, you may also need to check the issuer’s appendix to its comprehensive annual financial report. Because government data can sometimes lag, it doesn’t hurt to buttress your OS review with a quick internet search to see how local and regional economic growth or contraction might influence your investment. And as you read over the comprehensive annual financial report, do read the footnotes. Footnotes can flag issues that otherwise may not show up in the body of the document and also give you great insight into how the issuer is managing itself.
If there are third-party reports or appraisals, read them. And ask yourself how qualified and how independent are the third-party reports.
5) How capable is management? Electeds? Professional staff?
When the going gets tough, hard decisions need to be made. Is the issuer’s professional staff experienced? Are the elected officials capable of making a challenging political decision? Understanding the experience and professional backgrounds of the elected officials and their staff may provide very valuable insight.
Final thoughts:
Do the legal and tax-exempt opinions come from a reliable legal firm that understands state and local legal authority, as well as federal tax law?
If there is a reserve fund, in what is it invested? Can it be substituted out with a surety bond and, if so, what counterparty risk is injected into the investment?
Are the bonds insured? Is there value to the balance sheet being offered by the insurer and has the insurer ever failed or struggled?
Keep in mind rating agencies are first and foremost publishing companies. There are more than 85,000 issuers in the roughly $4 trillion municipal bond market. Keeping track of credit in both good and bad times can be a challenge. As an investor you need to be the first line of defense in protecting your assets. While rating agencies provide surveillance on rated credits and broker-dealer regulatory rules require disclosure of important credit events, it is in your best interest to stay informed and always read the fine print.
Additional resources:
MSRB
IRS
Tom Lockard is a Co-Founder, Managing Director and heads originations at 280 Securities LLC. Mr. Lockard has structured more than 500 municipal bond new issuances, representing more than $6 billion in value over his 30+-year career.
© 280 Securities LLC
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