Financial Management Series
Number 12
BONDS & BOND
RATINGS
Alan Probst
Local Government Specialist
UW-Extension Local Government Center
(608) 262-5103
Long-Term Debt
Bonds are the primary source
of long-term debt for local
governments
Bonds
A bond is a debt instrument issued for a
period of more than one year with the
purpose of raising capital by
borrowing. The Federal government,
states, cities, corporations, and many
other types of institutions sell bonds.
Generally, a bond is a promise to repay
the principal along with interest
(coupons) on a specified date
(maturity).
Types of Bonds
There are commonly two types
of bonds:
 General
Obligation (GO) Bonds
 Revenue
Bonds
General Obligation (GO)

Unlimited-tax GO bonds are secured by
the full faith, credit, and taxing powers
of the issuing government

Legally obligate the local government
to levy taxes on all assessable property
within its jurisdiction to a level
necessary to meet the bond payment
obligation
General Obligation (GO)

GO bonds are an appropriate financing
vehicle for capital projects that benefit
the community as a whole.

May be limited by constitutional and
statutory restrictions.

Normally require voter approval
Revenue Bonds

Revenue bonds are secured by the
revenues from the project being
financed

Their credit strength depends upon the
financial strength of the capital project
Revenue Bonds
Common types of revenue bonds
include:
 Airport revenue bonds
 Hospital and nursing home revenue
bonds
 Public power revenue bond
 Water and sewer revenue bonds
 Sports complex and convention center
revenue bonds
What is a Bond Rating?

Bond Rating is an independent assessment

It is associated with purchase and holding a
particular bond

It assesses relative credit risk

Ratings indicate likelihood that the obligation
will be repaid
What is a Bond Rating?
In essence, a local government’s bond
rating is the government equivalent of
your personal credit score or credit
rating.
Both indicate the likelihood of the
borrowed money being paid back.
Who determines Bond Rating?

Ratings are given by independent rating agencies

Ratings are independent source of information and
analysis for capital markets

Primary agencies rating municipal debt – Fitch IBCA
Inc., Moody’s Investors Service and Standard &
Poor’s Rating Services
What factors determine Bond Rating?

Debt management using key financial ratios such as
debt per capita

Administrative issues relating to direct authority of
government’s responsibility

Financial performance analyzing revenues and
expenditure trends

Economic outlook based on tax base, income,
population, employment and others

Service Base also included for Revenue Bonds
What do different ratings mean?
 Ratings
compare relative risks of
different debt issues
 Ratings scale is a consistent
framework for comparisons
 Each agency has it own rating
scale
Example: Rating Scale of Fitch IBCA
AAA
AA (+ or - )
A(+ or -)
BBB (+ or -)
BB (+ or -)
B (+ or -)
CCC, CC, C (+ or -)
D
- Highest credit quality
- Very high credit quality
- High credit quality
- Good credit quality
- Speculative
- Highly speculative
- High default risk
- In default
How does rating affect
cost of borrowing?

A high bond rating (e.g. AAA) indicates low credit
risk to investor

Borrowing will be less costly for an issuer with
higher rating than with lower rating

For each drop in ratings, bond issuers pay additional
basis points (a basis point is 1/100 of a percentage point)

When in millions, a few basis points can translate
into thousands of dollars
Bond Pricing
Bonds can be priced at a premium,
discount, or at par. If the bond’s price is
higher than its par value, it will sell at a
premium because its interest rate is
higher than the current prevailing rates.
If the bond’s price is lower than its par
value, the bond will sell at a discount
because its interest rate is lower than
current prevailing rates.
Example
The quoted price is usually based on the bond
maturity at a price of par, or 100.00. In the
case of a bond 6% of June 1, 2008, if the
price is $105.13, this means the bond is at a
5.13% premium to its maturity price (par or
100.00). An investor who pays $105.13 for the
bond will receive only $100.00 back on
maturity. Conversely, bond selling at a price
that is less than its par value is selling at a
discount.
Example: City A issues 30-year bond
with a 10 million face value
With AAA Bond rating
With BBB Bond Rating

Pays 2% annual interest

Pays 7% annual interest

Issues bonds at premium at
$15,000,000

Issues bonds at discount at
$7,000,000

Total Interest cost over 30
years
15,000,000 x 0.02 x 30

Total Interest cost over 30
years
7,000,000 x 0.07 x 30
= $9,000,000
= $14,700,000
Why does Local Government
need Bond Rating?

Investors use bond ratings as they are easy
to access and understand

Investors consider ratings as indication of
government’s overall fiscal health

Local Government will find it more difficult to
sell an unrated bond
Why does Local Government
need Bond Rating?

Even if the local govt. sells the bond,
investors will pay less to compensate for
uncertainty

Bond ratings necessary only if issue is larger
than $1million

Bond Ratings give access to national debt
market
How long does a rating last?

Until the Bond expires

Changes if there is an upgrade or
downgrade in the ratings over time

Rating agency withdraws ratings due to
insufficient information
How do rating agencies evaluate
Local Governments?

Rating agencies use debt indicators

They study both debt outstanding and debt service
as indicators of debt burden

Current year and long term financial projections

News and other publicly available information
What indicators of debt outstanding
are used in Bond Rating?
Debt outstanding measures total dollar amount of principal to be
repaid
Indicator 1:
Debt as a % of fair market value (FMV) of taxable property
Example:
County A has General Obligation Debt of $40,000,000 on a Fair
Market Value of 1,000,000,000 of taxable property.
Debt as a % of FMV = 40,000,000 /1,000,000,000
= 0.040 or 4%
Uses:
 Important measure of local government’s wealth available to
support present and future tax taxing capacity to meet debt
obligations
What indicators of debt outstanding
should be used in Bond Rating?
Indicator 2:
Debt as a % of per capita income
Example:
The per capita income of the citizens of County A is $35,000 per
year. The total amount of debt is $4,000,000. The population is
20,000.
Debt as a % of per capita income = $4,000,000/$35,000
= .875%
Uses:
 Realistic estimate based on the assumption that all taxes and
therefore the total principal debt are paid by the citizens
What indicators of debt outstanding
should be used in Bond Rating?
Indicator 3:
Debt per capita as a % of personal income per capita *****
Example:
The per capita income of the citizens of County A is $35,000 per
year with personal income being $70,000,000. The total amount
of debt is $40,000,000. The population is 20,000.
Debt per capita:$40,000,000/20,000= $2,000
Personal income per capita:$70,000,000/20,000=3,500
Debt per capita/Personal income per capita:
=2,000/3,500 =
Uses:
 More practical than debt per capita method as it incorporates
citizens’ ability to pay
What typical indicators of debt
service are used in Bond Rating?
Debt service (ie principal & interest payments) is an allocation of current
resources that are otherwise unavailable for other expenditures
Indicator 1
Debt service as a % of property tax revenue
Example:
County A has Property Tax Revenue of $10,000,000 and debt service
amount of $4,000,000.
Debt as a % of Property Tax Revenue:
= 4,000,000/10,000,000 = 0.40 or 40%
Uses:
 Particularly useful for evaluating cities that rely heavily on property
taxes
What typical indicators of debt
service are used in Bond Rating?
Indicator 2:
Debt service as a % of per capita income
Example:
The per capita income of the citizens of County A is $35,000 per
year. The total amount of debt service is $40,000,000. The
population is 20,000.
Debt as a % of per capita income = $40,000,000/$35,000/20,000
= 5.7%
Uses:
 Annual per capita burden on the citizens based on the
assumption that all taxes and therefore the principal and
interest payments are paid by the citizens
What typical indicators of debt
service are used in Bond Rating?
Indicator 3:
Debt service per capita as a % of income per capita
Example:
The per capita income of the citizens of County A is $35,000 per
year with personal income being $700,000,000. The total
amount of debt service is $40,000,000. The population is 20,000.
Debt service per capita = $40,000,000/20,000=$2,000
Income per capita:$700,000,000/20,000,000=$35,000
Debt per capita/Personal income per capita:
= $2,000/35,000 = 5.7%
Uses:
 More practical than debt per capita method as it incorporates
citizens’ ability to pay
What typical indicators of debt
service are used in Bond Rating?
Indicator 4:
Debt service as a % of General Funds (GF) Revenue
Example:
County A has General Funds (GF) Revenue of $200,000,000 and debt service
amount of $40,000,000.
Debt as a % of Property Tax Revenue:
= 40,000,000/200,000,000 = 0.20 or 20%
Uses:

Reflects relatively narrow measure of resources that are available for the local
government operations . Appropriate when debt service is essentially paid for
with GF revenues
What typical indicators of debt
service are used in Bond Rating?
Indicator 5:
Debt service as a % of General Funds (GF) Budgeted Expenditures
Example:
County A has General Funds (GF) Budgeted Expenditures of $275,000,000
and debt service amount of $40,000,000.
Debt as a % of General Funds Budgeted Expenditures
= 40,000,000/275,000,000 = 0.10 or 10%
Uses:
 Reflects that total resources appropriated by local government can
exceed revenues due to transfer from another fund, balance due to
other borrowings. Also identifies relative spending priorities such as
how much is spent on debt service vs current services like public
safety
What typical indicators of debt
service are used in Bond Rating?
Indicator 6:
Debt service as a % of Operating Expenditures
Example:
County A has Operating Expenditures of $40,000,000 and debt service
amount of $400,000.
Debt as a % of Operating Expenditures:
= 400,000/40,000,000 = 0.01 or 1%
Uses:
 Eliminates budgetary and accounting glitches by encompassing
expenditures from GF, special revenue funds and debt service funds
What fiscal indicators should be
included in Bond Rating?









General Fund Balance
Cash Flows
Net Operating Position
Revenue Structure
Revenue & Spending
Growth Rates
Revenue Forecasts
Property Tax Collection
Rates
Local Tax Burden
Tax Cap & Limitations







Expenditures by
function
Labor Settlements &
Litigations
Unfunded Pension
Obligations
Capital Improvement
Plan Trends
Debt Ratios
Debt Capacity
Number of Employees
What economic indicators should be
included in Bond Rating?






Population
Per Capita Income
Unemployment
Education Levels
Median Age
Vacancy Rates for
Downtown Buildings






New Housing Rates
Building Permits
Construction Value
Major Construction
Projects
Largest Employers
Fair Market Value of
Property
Oriented on the Future
Rating agencies do NOT want to hear
about what has happened in your
government in the past but want to
focus on FUTURE actions!!!
How to Improve Your Bond
Rating
1.
2.
3.
4.
Establish “rainy day” and budget
stabilization reserves
Review economic and revenue trends to
identify potential budget problems
Prioritize spending and establish
contingency plans for budget shortfalls
Develop a formal capital improvement
program and a debt affordability model
How to Improve Your Bond
Rating
5.
6.
7.
8.
Incorporate pay-as-go financing in
capital plans and operating budgets
Anticipate the impact of capital and
operating budgets in a multiyear
financial forecast.
Establish benchmarks and priorities
Establish and maintain effective
management systems
How to Improve Your Bond
Rating
9.
10.
Consider the affordability of actions
and plans before they become a part
of the budget
Have a well-defined and coordinated
economic development strategy
References
1.
2.
“Capital Budgeting and Finance: A Guide for Local
Governments” A. John Vogt, International
City/County Management Association, 2004
“Management Policies in Local Government
Finance” Fifth Edition, International City/County
Management Association, 2004
2.
http://www.investorwords.com
2.
“Investopedia”http://www.investopedia.com/univer
sity/advancedbond/advancedbond2.asp
http://lgc.uwex.edu/