Debt Administration

1
Debt Administration
PA 546 Constantine Hadjilambrinos

• Lecture 13
• November 29, 2005

2
Federal Debt
PA 546 Constantine Hadjilambrinos

• Primarily used to finance government operations.
• Primarily short term.
• Some debt is held by federal accounts and the
  Federal Reserve System (Social Security,
  Medicare/Medicaid).
• Majority of debt held by private investors (60
  in 2001).
• Of this, a continually increasing amount (42.1
  in 2001) is held by foreign investors.
• This has serious implications for resource
  allocation.

3
State and Local Government (Municipal) Debt
PA 546 Constantine Hadjilambrinos

• Primarily used to finance capital projects
  (infrastructure).
• Primarily long term.
• Full faith and credit debtused for projects
  that do not generate revenue. Often limited
  statutorily.
• Non-guaranteed debtRevenue bonds.
• Private debt Industrial Development Bonds.

4
Appropriate Debt Policy
PA 546 Constantine Hadjilambrinos

• Debt is usually the most appropriate financing
  option for capital projects.
• If capital projects were to be financed from
  current budget, most would be impossible.
• Debt financing fulfills equity criteria users
  pay for projects.
• Most appropriate length of financing is to
  coincide with useful life of project.

5
Mechanics of Bond Values
PA 546 Constantine Hadjilambrinos

• Calculation based on equations for present and
  future values.
• FVn Future value in year n
• PV Present value
• r Rate of return/interest
• n Number of years

6
Mechanics of Bond Values
PA 546 Constantine Hadjilambrinos

• Special terminology for bonds.
• P Price (present value)
• F Face value (future value)
• c Coupon rate (bond interest rate)
• r Market rate of return
• m Coupon period (annual or semi- annual)

Annual
Semi-annual
7
Debt Structure and Design
PA 546 Constantine Hadjilambrinos

• Pursue least-cost marketability.
• Simplify debt management.
• Provide appropriate cost signals to decision
  makers.

8
Credit Ratings
PA 546 Constantine Hadjilambrinos

• Three major credit rating firms
• Moodys (Aaa, Aa, A, Baa)
• Standard and Poors (AAA, AA, A, BBB)
• Fitch (AAA, AA, A, BBB)
• Ratings reflect level of risk.
• Lower ratings mean higher interest rates must be
  paid by bond issuers.
• Investment grade Adequate safeguards against
  default.
• Junk bonds Lower than Baa or BBB rating (4-6
  above U.S Treasury).

9
Credit Enhancements
PA 546 Constantine Hadjilambrinos

• State-credit guarantees.
• Promise by the state to make up any shortfall in
  local resources.
• Bank letters of credit.
• Promise by a bank to make principal and interest
  payments of specified amount and duration (there
  is a fee).
• Municipal bond insurance.
• Purchased from an insurer, takes payments on in
  case of trouble (there is a fee).

10
Bond Issue Costs
PA 546 Constantine Hadjilambrinos

• Underwriting fees (Underwriter purchases bond
  issue and resells it).
• Rate insurance (Provides security against rate
  increases).
• Pricing (Depends on Rating and maturity)can be
  complicated for composite bond issue (comprising
  of bonds of different maturities).

11
Creative Finance
PA 546 Constantine Hadjilambrinos

• Lease-purchase financing.
• Payments part of current operations expenditures.
• Gets around various restrictions on government
  borrowing.