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Series 7
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Textbook
Introduction
1. Common stock
2. Preferred stock
3. Bond fundamentals
4. Corporate debt
5. Municipal debt
5.1 Review
5.2 General obligation bonds
5.2.1 The basics
5.2.2 Issuance
5.2.3 Underwriting
5.2.4 Limited tax bonds
5.2.5 Analysis
5.3 Revenue bonds
5.4 Short-term municipal debt
5.5 Trading
5.6 Suitability
6. US government debt
7. Investment companies
8. Alternative pooled investments
9. Options
10. Taxes
11. The primary market
12. The secondary market
13. Brokerage accounts
14. Retirement & education plans
15. Rules & ethics
16. Suitability
Wrapping up
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5.2.5 Analysis
Achievable Series 7
5. Municipal debt
5.2. General obligation bonds

Analysis

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Analyzing the quality of municipal bonds matters, especially if you’re concerned about default risk. General obligation (G.O.) bonds don’t default often, but defaults do happen. According to Moody’s, there were only 21 G.O. bond defaults from 1970 to 2016. Even though they’re rare, a few recent, high-profile examples include:

  • Detroit’s default in 2014 (largest municipal default in history)
  • Puerto Rico’s default beginning in 2015

Corporate defaults often come down to a simple story: the company became less profitable, borrowed too much, or both. Municipal G.O. defaults are usually more complex. Because property (ad valorem) taxes are the primary source used to repay G.O. debt, analysts often focus on two broad drivers of credit quality: population and municipal finances.

Population

Property owners in the municipality are the ones who ultimately repay G.O. debt through taxes. That means the characteristics of the city’s population can tell you a lot about the bond’s creditworthiness. Analysts typically watch:

  • Population growth or decline
  • Income per capita
  • Economic diversity

Detroit is a useful example. One major contributor to Detroit’s default was its shrinking population. Detroit’s population has been in decline since 2001. When fewer people live in a city:

  • Demand for real estate tends to fall
  • Property values tend to decline
  • Property tax collections tend to drop
  • The municipality has less revenue available to service debt

That chain of events increases default risk.

Sidenote
Mill rate

Property taxes are assessed through mill rates. A property owner’s tax liability is based on the assessed value of the property multiplied by the applicable mill rate. First, here’s what a mill means:

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 other areas have lower mill rates.

Next, the assessed value is the municipality’s dollar value assigned to the property for tax purposes. In practice, assessment rules can be complex, but you can think of it as what the municipality says the property is worth for taxation.

Market value generally isn’t used directly for property taxes because it’s harder to pin down. You might estimate what your home could sell for, but you don’t know the true market value until you actually try to sell it.

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

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

Can you find the tax liability?

(spoiler)

Answer = $3,750

Only two inputs determine tax liability here: the mill rate (15 mills) and the assessed value ($250,000). Market value isn’t used.

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 mills is 0.015.

Income per capita is the average income of residents in the municipality. Higher incomes generally support stronger tax collections. If a large portion of residents can’t pay property taxes because incomes have fallen or jobs have been lost, the municipality’s finances can tighten quickly.

That’s why analysts watch collection ratios, which compare the amount of taxes assessed versus the amount actually collected. If the collection ratio starts to fall, it can signal that taxpayers are struggling to meet their obligations.

Economic diversity matters for the same reason. In the basics part of this chapter, we discussed how Detroit’s auto industry, which dominated its economy for decades, contributed to the default. A municipality with a diverse economy is usually better positioned to handle a downturn in any one industry.

For example, in 2018, WalletHub crowned Lawton, OK as the most economically diverse city in the nation. The city has employers across multiple industries, including education, food preparation, and health services. If one major industry weakened, other sectors could still support employment and tax collections.

Municipal finances

Municipalities generally aim to maintain a healthy, balanced budget. Unlike the federal government, cities and states don’t have their own version of the Federal Reserve that can create currency during economic downturns.

When the national shutdowns in early 2020 from COVID-19 began, many cities and states showed signs of financial stress. As of April 2020, five issuers of $407 million in municipal debt skipped required interest or principal payments. If tax revenues dry up, municipalities need reserves and financial flexibility to keep making debt payments.

When you analyze a G.O. bond, municipal finances are a key part of the credit picture. For example:

  • Has the city or state borrowed too much?
  • Do they have significant pension obligations?
  • Did an unexpected event (like COVID-19) force them to use up cash reserves?

Earlier in the issuance section of this chapter, we looked at the official statement for the Deschutes County education bond. Official statements include detailed information about an issuer’s financial condition. Highlights from the Deschutes County bond official statement include:

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

Several parts of an official statement include pieces of the municipality’s debt statement. Municipal 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

In general, higher debt levels increase default risk. At the same time, not all debt creates the same burden, which is why these categories matter. For example, a municipality’s direct debt might look high, but it may be less concerning if much of it is self-supporting revenue bonds (bonds that generate revenue to pay themselves off and aren’t supported by taxes).

You don’t need to be an expert at interpreting official statements, but you should know what they contain and what they’re used for. Because G.O. bonds are repaid with property taxes, population demographics, economic diversity, and municipal finances are central to evaluating credit quality.

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

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