Government Borrowing And Debt Management

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2 approaches to debt financing

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-Pay-as-you-use: revenue bonds are repaid with revenues generated by the projects being financed
-Pay-as-you-go: Advantages: no interest cost, no issuance cost, no over-issuance of debt, and no burden on future generations

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Why do governments borrow?

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Infrastructure finance- purchase assets that will provide a flow of returns for many years
-Subsidize business development
-Manage cash flow gaps within the year
-Finance operating deficits-violates the principle of fiscal sustainability(future taxpayers have to pay for both services for themselves and for services rendered in the past)

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Why FEDERAL government borrows?

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-War financing
-economic stabilization: to pay unemployment expenses, to mitigate slow economic growth
-Failure to budget within expected or actual revenue

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Top 3 major foreign holders of U.S. treasury

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China, Japan, Oil Exporters

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Municipal bonds

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Represent a promise of the issuer to repay to lenders/investors an amount of money borrowed- principal, along with interest according to a fixed schedule

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Type of Municipal bonds

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-Full-faith-and-credit bonds
-Revenue bonds
-tax-backed bonds
-double-barrel bonds
-Moral obligation bonds

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Municipal short term securities

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-Tax anticipation notes, revenue anticipation notes, bond anticipation notes, grant anticipation notes, general obligation notes
-Tax-exempt commercial paper

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Variable-rate demand bonds

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-Long dated nominal maturities that have short term demand features
- Coupon is adjusted frequently. At each reset, bond holders have the option to either hold the bonds at the new rate or put the bonds back to the issuer at par
-Requires a liquidity facility
-Offer the issuer a means of borrowing at lower rate

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Auction rate securities

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-Interest rate is reset regularly in a Dutch auction process. A rate is set at the lowest interest, at which buyers are willing to purchase all of the securities of potential sellers.
-ARS owners have the option to hold bonds regardless of the interest rate set at the auction

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Net Interest Cost (NIC)

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Interest paid/bond dollar years
- Ignores time value of money

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True interest cost

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Interest rate that balances present value of amount received by issuer with present value of debt service
-Recognizes the time value of money

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Debt maturity term

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All bonds mature at the same time, at the end of the life of the project, with money accumulated in a sinking-fund along the way to repay the principle

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Debt maturity serial

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Multiple maturities in a single issue, may be structured with greater long-term bonds issued to keep debt service constant, also may make the issuance more marketable

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call provisions

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if written into the bond contract, allows the borrower to repay the debt before the normal maturity

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zero-coupon bonds

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Pay no periodic interest. Interest and principal are paid at maturity

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Primary Market

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Authority: some authorities can issue bonds on their own behalves (transportation or power authority), others on behalf of their qualified non-governmental parties, such as non-for-profit hospitals, private colleges, etc.

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Credit rating

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A high credit rating indicates a high quality of an asset and vice versa.

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Credit rating agencies

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Moody's Investors Services- 1909 John Moody
Standard & Poor's- 1916 Henry Poor
Fitch Investors Service- 1913 John Knowles Fitch

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Factors that Affect Credit Ratings

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-Fiscal Factors
-Economic Factors
-Demographic Factors
-Political factors
-Managerial Factors

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Municipal-bond insurance

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-Legal commitment by an insurance company to make payments of principal and interest on debt in the event that the issuer is unable to make those payments on time- the premium is paid when the bond is issued

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Bank letters of credit

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An unconditional pledge of the bank's credit to make principal and interest payments of a specified amount and term on an issuer's debt- the premium is paid annually
-Issues with bond insurance receive the rating of the bank

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State-credit guarantees

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-Explicit promise by the state to a local unit bondholder that any shortfall in local resources will automatically be assumed by the state- can include full-faith-and-credit of the state and can cover all or part of the debt issuance

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Underwriters

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Purchase entire or agreed upon portion of a bond issuance and then resells the issue at a profit (hopefully) to investors

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competitive sale

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Type of underwriting
Sealed bid for the bonds is submitted to the issuer at a specific time on a specific date. The bonds are awarded to an underwriter who offers to pay the issuer the lowest interest cost.
-Often bid as a part of a syndicate, a group of underwriters from competing firms who agreed to bid together

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Negotiated sale

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Type of underwriting
The issuer prior to the public sale date selects the lead underwriter, whose job will be to coordinate and manage the financing. The lead underwriter makes an offer to purchase the bonds from the issuer at a price that will both produce the lowest interest cost to the issuer and sell the bonds to investors

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Competitive sale advantages

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-low capital cost
-low underwriter's spread
-more fair process on underwriter's selection

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Competitive sale disadvantages

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-May contain a risk premium as bidders do not know if they will be awarded with a bond
-Less flexibility for an issuer
-Less control over the composition of an underwriter's syndicate
- The terms of the offering may not be the best possible

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Negotiated sale advantages

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-Negotiating underwriter may perform origination tasks, eliminating the need for and cost of an outside advisor
-A higher presale search is possible, so there is a higher chance of finding an underwriter with the highest offer price
-More flexibility for an issuer
-Better control over the composition of an underwriter's syndicate

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Negotiated sale disadvantages

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-No direct competition among underwriters
-More difficult to be determined if the gross underwriter's spread is appropriate as a wider range of services is provided
-May be favorism toward firms that are selected to underwrite the bonds

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Bond issue documents

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Official statement providing information about the borrower's ability to repay the debt and a description of the proposed bond issue