Monday, June 25, 2012

Goodnews for Public Debt--the US Bond Maket

US Bond Market
In general, there are three types of bonds in the U.S system[1]. The following outlines the thee broad types:

a. General obligation bonds finance government projects like parks, streets, schools and public buildings. They usually use a full government guarantee, exempting them from taxes. They must be approved by referendum.

b. Revenue bonds are issued for special purpose projects or facilities for specific usage like development or improvement of sewer and water systems, public airports, toll roads, hospitals, housing and public parking facilities. They require repayment from usage fees or charges or sale of a project generated from the financed project. The government unit that issues the reserve bond is obligated to pay for the debt services from the revenue. The revenue bonds with government guarantees are called “double-barreled” bonds.  (These are the types that were used for the BABs and PACE).

c. Industrial development bonds are purposed to promote economic development and they serve both public and private benefit. They must include job creation and strengthening of the local tax based to create a multiplier effect to help the local economy. In general, these bonds were to expand, attract, or retain existing financing for hospitals, utilities and transportation services. In the US various laws have been in acted in order to monitor what type of entities can use the tax-exempt status.

U.S. bonds are each rated on a variety of factors. Rating agencies typically appraise municipal budgets  (or enterprise’s budgets) by evaluating their financial systems, operational activities, economic profiles and another eight rating criteria (such as economic, liquidity, debt, finances, systems support, etc.). The major rating entities include Standard & Poor’s, Moody’s, Fitch but many locality also have their own commercial rating agency. Each rating agency has a different methodology for determining their rate.

For example, Fitch Ratings have a two-step approach:
  1. judgment of the Transfer and Convertibility (T$C) risk as reflected in the country ceiling rating.
  2. assess the capacity of the entities and transactions to survive the economic and financial stress associated with sovereign debt crisis.

Sovereign risk vs. country risk  (They are not the same.)  The former is assessment of risk that the government of the sovereign nation will not honor its debt obligations. The later relates to risk to cross-boarder foreign currency lending and investment arising from events in a particular country, which are outside the control of the private sector.

Important notes:
  • A country ceiling rating strengthen is positively correlated with the sovereign rating (i.e. the higher the sovereign rating, the more likely a country ceiling is fortified).
  • Corporate, banks and structured transactions can only be rated sovereigns, up to the country ceiling, if their stand-alone credit quality is judged to be sufficiently strong to withstand a sovereign debt crisis

A “Sovereign ceiling” is the long-term foreign currency rating and entities’ stand-alone credit quality is particularly strong and above to withstand sovereign debt crisis, the will of financial institutions and corporations to pay the transaction cost of the sovereign.—This is either because of substantial export earnings, foreign assets, production overseas and/or foreign parents or strategic partners will and are able to provide financial support, may be rated above the country ceiling.

Furthermore, there are many factors that affect the marketability of bonds. This may include: bond denominations, coupon rates, credit ratings, maturity schedules, and call/redemption privileges.  In general, the higher the credit rating, the more profitable the maturity structure for investors, and the further the call feature is from the issuing date, the more appealing the issue will be to investors.[2]

There are four different principal repayment options for public debt: straight serial, serial annuity, balloon, and irregular.

The “Red Book” or the Directory of Municipal Bond Dealers of the United States is a listing of investment bankers and security dealers (which may include pension funds) that participate in the municipal bond underwriting. Note: of the 450 security dealers, few than 100 underwrite 90 percent of the bonds sold in the new market.[3]

[1] Thau, Annette. (2011). The Bond book Third Edition New York: McGraw-Hill.
[2] Designing a bond issue: A Guide “Municipal Bonds” an MIS Repot, published by ICMA Vol. 19 Number 6, June 1987. A good source for criteria considered by investors and rating agencies in determining rates, etc: Clark, Terry Nichols, G. Edwards DeSeve, and J. Chester Johnson, Financial Handbook for Mayors and City Managers (New York: Van Nostrand Reinhold Company, Inc., 1985), p. 79.
[3]ibid pg 13

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