Issuer Insight: Some Flexibility in Debt Affordability Measures Can Be a Good Thing

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Editor’s Note: The following is the first of a new series of commentaries written for municipal issuers. Colin MacNaught, a former issuer and member of the GFOA and State Debt Management Network, will be contributing regular commentary on bond market events, policy and regulation, and debt financing strategies from an issuer’s perspective.

In terms of interest rates, it's not a bad time to be an issuer of municipal bonds. Interest rates remain at or near historically low levels. Current 30-year MMD is 2.58%, only 11 basis points higher than the all-time low interest rate of 2.47% (hit in November 2012). Over the past 30 years, long-term interest rates have been higher roughly 99% of the time.

From a debt financing perspective, there are two obvious strategies to pursue for an issuer in this environment: first, look at every opportunity to refinance portions of the outstanding debt portfolio. And second, accelerate the capital plan. By this I mean to borrow more today in this low interest rate environment and accelerate the borrowings already planned for future years. This is not increasing the amount of total borrowing expected to be undertaken, just accelerating debt issuance. If a city or state was to accelerate to take advantage of such low cost of capital, it still should do so prudently and within some form of debt affordability plan.

Debt affordability is still a threshold test that an issuer must pass before issuing any bonds. A big part of almost every municipal issuer's capital finance program is a debt affordability analysis. It's something that's expected of an issuer – and its management team – by both rating agencies and bond investors. These studies are almost always done in connection with the regular development of an issuer's capital budget, so as to inform policy makers of the capacity of the organization to finance its infrastructure needs now and in the future. In today's low interest rate environment, with rates continuing to bounce along at historic or near historic levels, it's a reminder that some amount of flexibility should be built into a debt affordability analysis to reflect market conditions in order to benefit both issuers and their taxpayers.

The main purpose of a debt affordability analysis is to calculate debt capacity over some forecasted period of time – typically 10 or 20 years into the future. In a nutshell, an issuer is conducting the analysis to ensure that the decision to borrow today by issuing bonds – locking in their budgets for 20 or 30 years of debt service repayments – does not prove to be unaffordable to the issuer in the future. It seeks to compare the amount of debt service that the issuer will owe to bondholders per year over the forecast period versus the projected resources that may be available to make those debt service payments. It's such an important exercise that market participants expect all issuers to undertake such an analysis. Those that don't run a real and potentially costly risk of getting locked into too much debt today, impacting future government services and operations, impacting its bond rating, and ultimately jeopardizing its market access.

A standard debt affordability requirement may include two or three limits on the debt or debt service of an issuer. The first, and the most common, is a flat limit on the amount of debt that the issuer may have outstanding at any one point in time. You can think of this as a stock limit or a ceiling that may be codified in the issuer's authorizing covenants. The second affordability measure is typically a limit on the amount of debt service as a percent of operating revenues or expenditures that may be owed in any single fiscal year. For example, an issuer may limit the amount of annual debt service over its forecast period to 10% of forecasted operating revenues. This is a flow limit and guides issuers to sell bonds with steady, amortizing debt service repayments. A third, and a less common feature, is a limit on the amount of additional debt that may be added from one fiscal year to the next. A good debt affordability plan will feature all three measures because they collectively encompass all of the different ways that a growing debt burden could hinder an issuer in the future.

However, another important feature that issuers should consider in analyzing its future debt affordability is the use of debt capacity targets instead of static, flat limits. Debt service targets would provide an issuer with flexibility to take into account market interest rate levels as it manages its debt program and plans for the future. For example, in a period of economic expansion when interest rates may be higher than normal, an issuer could reduce the amount of debt being issued below its debt capacity benchmark or target. Because it's a period of economic expansion, tax revenues may be higher and the issuer can offset issuing bonds for more pay-as-you-go capital financing. By keeping debt issuance below a targeted level in this type of rate environment, the issuer is avoiding expensive interest rates and essentially 'banking' debt capacity for a future interest rate environment when rates are much lower. When the environment does change to one in which rates are lower than average, like during periods when the economy is weaker, an issuer could ramp up its debt issuance plans and exceed its targeted debt capacity to accelerate its capital spending plans. Periods of lower interest rates can often coincide with economic recessions in which state and local tax revenue collections can be depressed. By accelerating its capital plan and issuing more bonds amidst lower interest rates, the issuer would be locking in lower debt service costs, freeing up tax-dollars for its operating budget needs by shifting from pay-as-you-go to bond financings, and managing its capital program much more efficiently by adjusting to market conditions.

The key to a strategy like this is three-fold: the debt capacity targets should be well defined in advance and should not be unlimited – there still should be some limits to the 'flex' borrowing up and down; second, an issuer should communicate its strategy to investors by posting its policy to its investor website so that investors and rating agencies are not caught off guard as the capital program shifts gears in different interest rate environments; and third, the issuer's financial management has to maintain the discipline to stick to the parameters of the flexible debt affordability plan through different economic cycles and changes in administration.

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