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Weekly UpdatesWith debt issuance continuing to reach peak levels, local governments--particularly small to midsize issuers--are being bombarded with information and inquiries about opportunities in the tax-exempt market. Local governments preparing to issue debt to finance buildings, infrastructure, or other public projects need to understand the economy, market conditions, credit rating and insurance underwriting criteria, federal and state laws and tax regulations governing debt issuance, and a host of other important considerations. This article outlines many of these considerations and offers some insights into the current market environment in an effort to help local government issuers obtain the most favorable financing terms possible.
MARKET DYNAMICS
How does a small or midsize size issuer receive an appropriate level of attention from marketplace participants in today's market environment? With the forward weekly supply approaching $10 billion and the issuance pace for the year to date leading forecasters to predict a $400 billion annual total issuance for municipals, it is a wonder how any issuer will be received in this market. We do not profess to have all of the answers; however, a somewhat disciplined approach with attention to detail continues to be a sound approach.
One source of reassurance for local government issuers is that the average municipal transaction is still around $25 million--relatively small compared to other segments of the credit markets. Despite the relative insignificance of the municipal market, it generally meets the financing needs of the tens of thousands of local governments in the United States. Most international business people are envious of how well our municipal market works for small to midsize issuers. The U.S. municipal market continues to be the beneficiary of the tax exemption for public projects. There have been several efforts over the years to curtail the tax exemption, but these have been largely unsuccessful. Despite ongoing discussions about modifications in tax policy that would affect the municipal market, there appears to be no serious support for changing the tax exemption--a move that would result in much higher borrowing costs for state and local governments.
Credit ratings play a central role in the issuance process, since these assessments largely determine the interest rate an issuer will pay on its bonds. It is the enterprise of the rating agencies to weigh all of the relevant factors behind an issuer's ability to meet its debt service requirements and then issue an opinion on the likelihood that the issuer will pay the principal and interest on the obligations in a timely manner. Ultimately, a rating assignment is a simple and straightforward summation of a very complex process.
The process is not simplified any by the fact that there are three major rating agencies. Each rating agency examines a nearly identical set of data on a particular issuer. This data comes from the issuer itself and from generally available sources. The recent explosion of financial information on the Internet has facilitated the ratings process. Whereas just a few years ago only a select group of local governments posted financial information on their Web sites, this practice has now become commonplace for governments of all sizes.
The greatest challenge in pursuing ratings is differentiating among the three major rating agencies. While they generally examine the same set of factors, they often place a different level of emphasis on these factors. What matters greatly to one rating agency may not concern another. The issuer, in consultation with its financial advisor, may decide to obtain a rating from just one rating agency or from all three, depending on the market and whether individual investors require a minimum number of ratings.
RATING FACTORS
What are the so-called rating factors? There are differences in the factors for different sectors of bonds. For example, revenue bond factors differ from tax-backed bond factors, particularly when it comes to the consideration of coverage. Yet despite such differences, there are still many common rating factors to all sectors of bonds. There are four primary categories of rating factors, each of which is discussed below.
Economic Factors. Most of the considerations here are well known and accessible. Employment and unemployment trends and rates are especially critical. How fast employment is growing annually and the direction of the trend in the unemployment rate are even more important considerations than the static levels for each. The rating agencies will also want to know which industries or businesses are expanding or contracting, whether the local economy is considered a leader in a particular industry, and whether the economic base is diversified. Other important considerations include trends in personal income, retail sales, bank deposits, and building permits and housing starts.
Over the years, there has been an effort to measure quality of life considerations in bond ratings. Sometimes the analysis focuses on variables such as the quantity and quality of parks, sporting venues, cultural outlets, and crime rates. Other times the assessment may involve more straightforward matters such as the availability of downtown parking or the attractiveness of shopping areas.
Clearly, a growing economy with relatively low unemployment and a diversified economic base will enhance an issuer's credit rating. When such is not the case, however, issuers should be straightforward in explaining the particulars of their situation. In most cases, being candid about economic challenges and sharing plans for overcoming these challenges will play to the issuer's advantage--if not immediately then in the future.
Tax and Administrative Factors. For tax-backed credits, the basic considerations are assessed valuation, tax rates, and tax collections. When considering assessed valuation, the rating agencies pay particularly close attention to growth and the quality of ongoing development. How quickly is assessed valuation increasing? How frequently does the issuer conduct a reappraisal? Is growth being sustained by value-added enterprises as opposed to other, less-productive enterprises? The latter is somewhat tempered by the prevailing view that any growth is positive. In some cases, however, growth may be limited by the fact that the issuer is a mature community with fixed boundaries. The relative rates of growth for industrial, commercial, and residential development may also be an important consideration. The rating agencies want to know if the mix of development is working to grow and diversify the economy and the issuer's tax base.
For obvious reasons, tax rates are a key consideration in any rating decision on tax-supported debt. Whether tax rates are increasing or decreasing depends on many variables. Trends in tax rates may reflect the budgetary goals of the administration more than other inputs. Of critical importance is whether the issuer is subject to any legally imposed limits on its ability to raise tax rates. The rating agencies view such limits negatively in that they reduce financial flexibility. Examples of tax limits that have had a profound influence on issuers include Proposition 13 in California, Proposition 2 1/2 in Massachusetts, TABOR in Colorado, and Measure 50 in Oregon.
The question of who is responsible for assessments and collections may also have a considerable bearing on the rating process. Assessments and collections are usually assigned to specific levels of government. In many parts of the U.S., counties have considerable tax assessment and collection responsibilities. In some cases, counties remit taxes in full to other government entities regardless of the amount actually collected, thus assuming responsibility for delinquent revenues. Clearly delineating the responsibilities and risks of the various layers of government in the collection process will facilitate greater understanding by the rating agencies of the issuer's specific role in the process.
Debt Factors. Information on outstanding debt is among the most accessible data points in the rating process. Placing the nominal debt amounts into context is the most important component of this factor. This usually involves comparing the issuer's debt profile to that of a peer group. Debt per capita and debt to true valuation are the most frequently quoted nominal measures used. These ratios are more meaningful when the peer group is comprised of issuers from the same state. Moody's publishes what it calls Moody's Medians--a consistent set of debt ratios by state. In addition, Moody's and the other rating agencies periodically publish samples of debt ratios for local issuers, usually on a regional basis.
Despite the prevalence of peer group comparisons, debt ratios are among the least predictive factors in the rating process. Such comparisons are further complicated by the issue of overlapping debt--the outstanding debt of other governments for which the issuer's taxpayers are responsible in whole or in part. More meaningful measures of debt burden include debt service as a percentage of the budget and debt to total personal income. The rating agencies have established ranges for what they consider to be a low, medium, and high debt service burdens. While these benchmarks are useful, debt service ratios must be considered in the context of the issuer's overall economic and fiscal picture.
Financial Factors. Financial factors are the most familiar to issuers. The analysis primarily relies on generally available documents such as the comprehensive annual financial report and the budget document. Analysts pay particular attention to the income statement, the balance sheet, and the notes to the financial statements.
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