Analysis | General obligation bonds | Municipal debt

Analyzing the quality of municipal bonds is important, especially for investors that are worried about default risk. While general obligation bonds don’t default regularly, they do occur. According to Moody’s, there were only 21 G.O. bond defaults from 1970 to 2016. While rare, there are a few recent real-world examples of big defaults:

Default with corporate debt usually boils down to one of two issues - the company became less profitable or borrowed too much money (or both). Municipal G.O. defaults are a little more complicated. With property (ad valorem) taxes being the primary source of paying back borrowed funds, defaults can usually be boiled down to two main factors: population and municipal finances.

Population

Property owners in the municipality are the ones that pay back borrowed G.O. funds. Therefore, the characteristics of the city’s population can be used to determine the creditworthiness of the bond. Analysts pay close attention to the following:

Population growth or decline
Income per capita
Economic diversity

One of the many reasons for Detroit’s default was its dwindling population. In fact, Detroit’s population has been in decline since 2001. When there are fewer people in the city, there’s less demand for real estate, which drives down property values. When property values fall, the city collects less in property taxes. Less in taxes means less money to pay off borrowed funds, leading to default.

Sidenote

Mill rate

Property taxes are assessed through mill rates. The amount of tax liability for a property owner can be found with the assessed value of the property by the applicable mill rate. First, let’s establish what a mill is:

1 mill

0.1%
0.001 in decimal form
$1 paid per $1,000 of assessed value

Mill rates vary from municipality to municipality. Heavily taxed parts of the country (like New Jersey and Illinois) have high mill rates, while it’s low in other parts of the country.

Next, the assessed value is the municipality’s dollar value assigned to the property for tax purposes. While it’s more complicated than this, you can assume it’s what the municipality thinks the property is worth. Market value does not factor into property taxes mainly because it’s difficult to define. You may have an idea of what your home is worth while you’re living in it, but you can’t confirm that value unless you attempt to sell your home.

To calculate overall property tax liability, multiply the mill rate by the assessed value. For example, let’s assume the following:

Assessed value = $250,000
Market value = $300,000
Mill rate = 15 mills

Can you find the tax liability?

(spoiler)

Answer = $3,750

Remember, the only two factors used to determine tax liability is the mill rate (15 mills) and the assessed value ($250,000). Market value is not considered.

$Taxes due = assessed value x mill rate$

$Taxes due = $250,000 x 0.015$

$Taxes due = $3,750$

If 1 mill is 0.001, then 15 must be 0.015

Income per capita is the average income of citizens in the municipality. Obviously, the more made, the more taxes paid. Not paying taxes is not an option, and can lead to forfeiting property to the municipality or even jail. Regardless, the municipality may be in a tough situation if a large portion of its population is unable to make property tax payments because of lost or falling income levels. Because of this dynamic, analysts will pay close attention to collection ratios, which compare the amount of taxes assessed versus taxes collected. If the collection ratio starts to fall, it indicates that taxpayers are having a tough time paying their obligations.

In the basics part of this chapter, we discussed how Detroit’s auto industry, which dominated its economy for decades, contributed to the default. When a municipality has a diverse economy, it’s better prepared for declines in specific industries. In 2018, WalletHub crowned Lawton, OK as the most economically diverse city in the nation. The city has employers from various industries, including education, food preparation, and health services. If a major industry collapsed in Lawton, there are plenty of others to keep the citizens employed.

Municipal finances

Municipalities aim to always have a healthy, balanced budget. Cities and states don’t have their own version of the Federal Reserve that allows the creation of currency in the event of economic downturns. When the national shutdowns in early 2020 from COVID-19 started, many cities and states started showing signs of distress. As of April 2020, five issuers of $407 million in municipal debt skipped required interest or principal payments. Municipalities must be prepared for unknown challenges, or they risk defaulting on debt when tax revenues dry up.

When analyzing a G.O. bond, municipal finances are an important factor to consider. What if the city or state borrowed too much money? Do they have a significant amount of pension obligations? Did an unexpected event (like COVID-19) force them to deplete their cash reserves? These are all considerations to factor when determining the creditworthiness of a general obligation bond.

Earlier in the issuance section of this chapter, we looked at the official statement for the Deschutes County education bond. Investors can find plenty of information relating to the issuer’s financial health. Here are some highlights from the Deschutes County bond official statement:

Debt limits (pg. 8)
Revenue forecasts (pg. 21)
Balance sheet (pg. 28)
Pension liabilities (pg. 33-34)

Contained in several parts of the official statement are components of a municipality’s debt statement. Debt is measured in different ways:

Direct debt

All debt directly issued by the municipality

Net direct debt

Direct debt minus self-supporting debt (revenue bonds)

Overlapping (coterminous) debt

Debt shared with other municipalities

Net overall (total) debt

Net direct debt plus overlapping debt

The higher a municipality’s debt levels, the more default risk applies. Not every debt is the same, which is why it’s important to categorize different forms of debt. A municipality’s direct debt may be very high, but it’s not a problem if the majority of the debt is related to self-supporting revenue bonds (make revenue to pay themselves off; not supported by taxes).

You won’t need to be an expert in interpreting official statements, but it’s important to know what they contain. General obligations are paid off with property taxes, so things like population demographics, economic diversity, and municipal finances are important considerations.

Key points

Used to analyze G.O. bonds

Population demographics
Economic diversity
Municipal finances

Mill rate

Used to assess property tax obligation
1 mill = 0.1% = 0.001 (decimal form)

Property tax liability calculation

Assessed value x mill rate
Does not utilize the market value

Debt statement

Reports and categorizes various forms of municipal debt
Direct debt
- All debt directly issued by a municipality
Net direct debt
- Direct debt minus self-supporting debt (revenue bonds)
Overlapping (coterminous) debt
- Debt shared with other municipalities
Net overall (total) debt
- Net direct debt plus overlapping debt