Portfolio Management - Municipal Bond Analysis
Having looked at securities analysis for equities and mutual funds, it is time to take a closer look at municipal bonds. As you learned in Section 5 "Municipal Securities", these are divided into revenue bonds and general obligation or GO bonds. Let's look at GO bonds first.
GO bonds are backed entirely by the issuer's ability to repay debt, based on its ability to levy and collect taxes and to use those funds to pay interest and principal. Therefore, the characteristics of the issuer are of primary importance to the muni investor and, thus, to the muni analyst. They include the following:
- Tax base, meaning the assessed value of the taxable property, assets and income within a specific area. Analysts look at total asset value and taxable values per capita. Growth potential is also considered: if pretty much every square foot of real estate in a municipality is occupied, then there is no room for growth; if the town is only about 10% built out, however, there remains considerable land available for development.
- Diversification of economic activity, which indicates the degree to which the municipality is leveraged to one employer or one industry. Analysts consider the proportion of the total asset value accounted for by the top few taxpayers, as well as the mix of employment opportunities available to the town's residents. One-factory towns often see their credit ratings plummet when the plant shuts down. Such infrastructure elements as airport gates, hotel rooms and highway exits are also counted.
- Budgetary practices, which involves looking at whether the capital budget is separate from the operating budget and to what degree the municipality chooses to float bonds as opposed to fund activities directly from current tax revenues.
- Unfunded liabilities, which are often related to pensions, but could also relate to mandatory social service payments for which there are no designated revenue streams.
- Population trends, which involves looking at whether per capita or per household income is going up or going down.
- Tax collection record, which is crucial because the tax base and the tax rate are only as good as the municipality's ability to deposit receipts.
All these factors speak to a municipality's current financial condition. Furthermore, a strong history of debt repayment suggests the town is likely to meet its current and future obligations, with positive implications for its credit rating and, thus, for its ability to borrow at lower interest rates.
Muni analysts also focus on the nature of the GO bond issuer's debt. Factors here include the following:
- Debt trends, or how the municipality's obligations are growing or shrinking in relation to available resources. If debt is growing faster than the tax base, this bodes poorly for the town's long-term economic viability.
- Schedule of debt service requirements, or the maturity dates. This is a factor that has more impact on GO bonds than on revenue bonds because GO bonds are usually offered on a serial rather than a one-time basis, and thus tend to have more than one maturity date.
- Contemplated financing, which means bond issues that are in the pipeline but have not yet made it to market. If these issues materialize, they could erode the creditworthiness of the issuer.
- Relation of debt to the life of improvement, which ensures that bondholders are not stuck financing an obsolete asset. If a municipality has to decide between making its payments on bonds funding current construction or on bonds that are refunding some white elephant that outlived its usefulness years ago, it is obvious which one the municipality will default on.
Of course, factors affecting the issuer's ability to pay are of paramount interest. They include the following:
- Tax limitations: These are imposed by local law, and not all municipalities have these limits. However, for those that do, analysts must determine how much debt capacity remains and how much flexibility the government has to pass temporary measures to sidestep these limits.
- Priority of claim: In other words, is one particular issue subordinate to another? To assess local debt properly, all borrowing supported by the same tax base must be included. Lease obligations must likewise be considered.
- Non-tax revenues: These are a local government's other sources of income. Traditionally, municipalities depend on property taxes but take in a small proportion of their revenue from user fees - marriage licenses, golf course greens fees, parking permits and so on. Fines issued from local traffic and code violations count toward this as well. Few localities also offer a sales or income tax, but if they do, these might for practical purposes be considered "non-tax revenues".
- Tax rates: This is the local governmental budget divided by the total assessed value of real estate in the taxing district. Tax rates are usually expressed as millage, or dollars per thousand. A rate of 50 mills means that for every $1,000 in property value, the owner would have to pay the town $50 per year in taxes.
- Overlapping debt: This refers to the debt of other jurisdictions having the same tax base. School districts, water-and-sewer authorities and county governments, for example, often have debt overlapping that of a city or town.
Finally, just as fundamental stock analysts are concerned with the risk of bankruptcy - represented by debt-to-equity ratios - of the companies they follow, muni analysts have their own debt ratios:
- Net debt per capita: This indicates the ability of local residents to support their government's debt burden through taxes. However, it does not factor in corporate taxpayers or the resources of wealthy individuals.
- Net debt to assessed valuation: This corrects the shortcoming of net debt per capita by comparing debt to the assessed value of real estate within the municipality. Its own shortcoming is that assessed values are often out-of-step with actual values.
- Net debt to estimated valuation: This ratio corrects the shortcoming of net debt to assessed valuation by comparing debt to prevailing market values of real estate within the municipality.
The bottom line of all this analysis of GO bonds is that the tax base multiplied by the tax rate should cover all of a municipality\'s current and anticipated obligations.