Capital appreciation bonds and the cost of borrowing

A Capital Appreciation Bond (CAB) is a financial instrument that is most attractive as a resource-flow management instrument. It bridges multiple fiscal years for jurisdictions experiencing rapid growth, potentially stretching for decades, but may also be used by localities experiencing fiscal distress. Using debt issuance data by independent school districts in Texas, who utilized almost all such bonds in the state, we present empirical evidence that CABs are associated with both the service and fiscal pressure factors. We further observe that, though the threat from CABs in terms of borrowing costs may have been exaggerated, enacting limits on debt repayment ratios (ratio of payment size at maturity to premium size) was likely the right legislative intervention.     

Is Management Performance a Factor in Municipal Bond Credit Ratings? The Case of Texas School Districts

Municipal bond ratings are an important determinant of interest costs that a bond issuer must pay. The three major bond rating firms profess that economic and management factors are considered in assigning a bond rating. The management component is of particular interest to public administrators because they can exert more direct control over management factors. Management factors have not been studied empirically in the literature because management performance is generally difficult to quantify. However, the public education sector has seen advances in performance measures and at the same time has increasingly relied on municipal bonds to finance construction. The ordered probit estimation provides support that management performance, as measured in the districts performance on standardized test scores and success in student college admission rates, does influence Texas school district bond credit ratings.     

“Robin Hood” and Texas School District Borrowing Costs

The “Robin Hood” system of school financing in Texas takes property tax funds from wealthy school districts and gives them to poorer districts. This paper examines Permanent School Fund‐insured, school district debt and discovers that under the “Robin Hood” system, Texas school districts with either Aa or A1 underlying credit ratings have higher borrowing costs than districts with lower ratings. Also, the borrowing costs of Texas school districts with underlying credit ratings of Aa and A1 are higher than those for non‐Texas, privately insured school districts with the same ratings, while the borrowing costs of A and Baa‐rated Texas school districts are lower.     

Now You See It, Now You Don't: The Mysterious Case of the Vanishing Split Bond Rating in States

Bond ratings on state-issued debt provide a signal to credit markets that help them charge an appropriate interest rate, based on the risk of payment default. Though actual default may occur only in extreme circumstances, observed differences in ratings and interest costs across states and time demonstrate that a sound economy, strong financials, and stable policies matter. When data on the factors that presumably affect ratings is public and easily accessible, making sense of differences of opinion between bond rating agencies is difficult. We suggest that such differences—observed as so-called split bond ratings—are often ephemeral. Utilizing a simulation method to uncover the latent credit risk presented by each state, we show that split ratings on state bonds are often due to the fact that presumed category overlap between rating agencies is absent when evaluated on a common latent scale. Most observed state bond rating splits from 1997 through 2006 can be explained by this category mismatch. Our approach has broad implications for pricing state debt, as well as pricing rated debt in other capital market sectors.     

No Guaranties: The Decline of Municipal Bond Insurance

The credit crisis that roiled the financial and housing markets in late 2007 and early 2008 resulted in well‐publicized budget challenges for state and local governments. Less visible has been a dramatic change in the bond insurance market, which alters how governments issue long‐term debt. Debt issuance data from Texas are used to model bond insurance premiums and examine utilization following the crisis. The results provide evidence that insurance premiums rose dramatically following the fiscal crisis, even when controlling for widening credit spreads and changes in the underlying credit quality of issuers.     

The Impact of Budget Stabilization Funds on State General Obligation Bond Ratings

This study examines the impact of budget stabilization funds (BSFs) on state general obligation (GO) bond credit ratings. While a number of past empirical papers have examined the effect of various fiscal institutions on state GO bond ratings; to date, BSFs have been largely ignored in the literature. Model estimates show that neither the choice to have a statutory BSF versus a constitutional BSF or the size of a BSF has any apparent impact on credit ratings. However, weak deposit rules are associated with lower credit ratings while weak withdrawal rules are associated with higher credit ratings.     

The Interest Cost Implications of the Financial Advisor Turned Underwriter

The Municipal Securities Rulemaking Board (MSRB) does not prohibit municipal financial advisors from participating in the bidding process to serve as underwriter on issues for which they provided advisory services. Some municipalities prohibit the practice, viewing such an arrangement as a conflict of interest. Using data from nearly one thousand competitively sold municipal debt issues in the state of Texas from 1991 to 1995, I test whether or not competition alone in the bidding process is sufficient to protect the interests of the issuer. For general obligation debt and state-backed school district debt these data indicate that there are no interest cost implications for the practice. For municipal and special district revenue debt I find weak evidence of some additional interest (about six basis points) when the advisor serves as underwriter, but the effect is not consistent enough throughout the data to reach statistical significance at the p<0.001 level (see note 10). What I do find is that unrated issues are much more likely to be bid on and won by the advisor, indicating that cities should be concerned about the guidance of their advisor when that advice is to take an unrated issue to market.     

State Debt Limits: How Many Are Enough?

There is a growing concern among state policy makers that unrestrained debt may exceed politically acceptable or financially sustainable levels of debt. Many states have established limits to restrict debt, but many of these limits are circumvented through issuing more complex and specialized bonds. In this article, we focus on the use of debt limits as an instrument to manage a state's debt in context of two key questions: (1) under what circumstances should a state consider multiple debt limits and (2) if multiple limits are established, what factors should be considered in setting such multiple limits. In addressing these issues, we consider the theoretical and conceptual issues associated with setting debt limits, we highlight current state debt limit policies, and discuss factors that appear to be influencing decisions to establish and set multiple limits.     

Dueling Revenue Caps and Municipal Bond Yields: The Case of Houston,Texas

Two competing revenue cap proposals, one from a citizen's group and the other proposed by the mayor, were on the November 2004, election ballot of the City of Houston, Texas. Both propositions passed, yet the citizen's group had to sue to have their initiative enforced. This study examines the effect on Houston bond yields of the series of events (from June 2004 through March 2006) surrounding these dueling revenue cap propositions. The empirical findings suggest that the budget‐related events can have a significant effect on yields demanded by investors in the secondary market for outstanding uninsured tax‐exempt general obligation debt.     

Fiscal consequences of public corruption: Empirical evidence from state bond ratings

Empirical analyses of public corruption focus predominantly on international differences; regional differences in public corruption within a single country receive little attention. We empirically investigate the effect of public corruption in the United States on state bond ratings, which previous research shows are inversely related to net interest costs on public debt. After controlling for various economic influences on bond ratings, we find that more corrupt states have lower bond ratings, which implies that taxpayers in more corrupt states face a negative pecuniary externality by paying a premium for debt.     

Risk Aversion and the Pricing of Municipal Bonds

Risk aversion in the municipal bond market has been an assumption of most discussions regarding the municipal bond market, but has not been formally documented. The research in this article tests for the presence of risk aversion through comparing a risk-neutral bond yield with the observed yields on municipal bonds. A significant level of risk aversion is found to exist in the municipal bond market.     

Which Nonprofit Organizations Borrow?

The tax benefit, bankruptcy value, and pecking-order theories of corporate capital structure are discussed in context of nonprofit organizations. A bivariate probit model shows that coefficients differ between models meaning mortgages and tax-exempt bonds are not equivalent forms of debt. Organizations with proportionally more program revenues, contributions, total assets, total revenues, and executive compensation are more likely to have a mortgage. Nonprofits that rely on special event fund-raising or contributions have a lower probability of using bond financing. The use of debt is also influenced by the nature of the organization's mission as measured through the NTEE classification.     

Municipal Bond Insurance: Trends and Prospects

Privately sold bond insurance is the most common form of credit enhancement for municipal bonds. Research generally finds that bond insurance reduces interest costs for lower rated, long–term debt issues. Researchers have concluded that these results are consistent with presumed investor risk aversion, as well as more "rational" risk management behaviors, and with theories concerning the efficiency–enhancing properties of financial intermediation in imperfect markets. We propose a research agenda based both on traditional theories and on additional hypotheses that seek to account for the observed use of bond insurance where net savings would not normally be predicted.     

What Types of School Capital Projects are Voters Willing to Support?

In many states, investments in school capital must be approved by bond referenda. Consequently, voter preferences can directly impact the quality of school facilities and their infrastructure. Researchers have often analyzed the causal mechanisms of referendum passage, but they have not examined whether the type of capital project affects the outcome of the referendum itself. In this paper, we use data from the state of Michigan to examine whether voters are willing to provide more or less support for specific types of capital investments. We focus on the relationship between voter support for maintenance versus the construction of a new building or additions to existing buildings. Our analysis suggests there is a higher approval rate for maintenance of existing facilities than the construction of new school buildings or additions.     

State Debt Management Policy: A National Survey

The amount of outstanding, long-term, tax-exempt state debt has grown precipitously over the last decade, from $87 billion in 1977 to $264 billion in 1987. But there have been few attempts to carry out broad studies of basic state debt management policies, using comparative state data. As a result, policy-makers lack guidance as they attempt to adjust policies and procedures to meet the rapidly evolving requirements associated with public borrowing. This paper reports on a national survey of state debt manage ment policies - policies devoted to the planning, preparation, sale, and repayment of debt for which states consider themselves responsible.     

Effects of Federal Tax Reform on Local Finances

The federal Tax Reform Act of 1986 promised to be fair, simple,and revenue neutral to the federal treasury. Tax reform, however,was not revenue neutral with respect to all state and localtreasuries. Indeed, tax reform entailed a restructuring of thebalance of power in federal-state-local relations. In particular,new restrictions on the tax-exempt bond authority of state andlocal governments are requiring significant shifts in traditionallocal debt policy. Furthermore, the Supreme Courts recent decision,South Carolina v. Baker, raises additional concerns about thestatus of state and local tax-exempt bond issues. The natureof future relations between the federal government and localgovernments is likely to be molded more by the federal tax codeand by erosion in state authority over fiscal matters than byfederal grant-in-aid programs of the kind that have characterizedthe past quarter century of intergovernmental relations.     

Debt Diligence: How States Manage the Borrowing Function

State-level indebtedness is large and persistent and bond issuance has become increasingly complex. In light of these conditions, professional standards have been proposed by some organizations (including the Government Finance Officers Association) seeking to persuade members to codify sets of desirable practices into policies for debt issuance. We surveyed state government debt managers to assess the comprehensiveness and prevalence of debt policies. We find little evidence of the adoption of comprehensive formal debt policies. Instead, states rely more heavily upon the guidance provided by their own sets of standard practices or "rules of thumb."     

Fiscal Institutions,Credit Ratings,and Borrowing Costs

This paper investigates the impact of fiscal institutions on state government borrowing costs. We find that institutions have both a direct and indirect effect on interest costs paid by state governments. Revenue limits are associated directly with higher interest costs; expenditure limits, stricter balanced budget rules, and restrictions on state debt issuance are indirectly associated with lower interest costs because they lead to higher credit ratings. It appears that investors and bond raters incorporate information on fiscal institutions into their assessment of state government credit quality.     

Accounting for Natural Disasters: The Impact of Earthquake Risk on California Municipal Bond Pricing

While Katrina has raised awareness of the potential impact of hurricanes on municipalities along the Gulf Coast, it remains unclear if the municipal bond market considers other types of natural disaster risk in other areas. We attempt to fill this gap by conducting an analysis to determine if underlying geologic earthquake risk affects interest costs for municipal bond issuers in California. We find that earthquake risk does matter in determining the interest costs for municipalities issuing debt, but not universally—only for municipal bonds issued after Hurricane Katrina and only in relation to underlying geologic earthquake risk.     

The Impact of State Debt Management on Debt Activity

This article addresses the impact that state debt management has on the debt activity of a state debt program. A quantitative measure of state debt management is developed and used in analysis of state debt activity. The study finds that states with decentralized debt management issue more long-term debt as compared to states with other forms of debt management. The study also investigates the impact other institutional variables have on state debt activity and highlights the interaction effects of these variables with the institutional debt management variable. The study finds that the effects of previously tested variables such as the number of public authorities and constitutional debt limitations on debt activity are altered if the form of debt management is considered.