Financial Management Series Number 5 DEBT MANAGEMENT

1. Financial Management Series Number 5DEBT MANAGEMENT Alan ProbstLocal Government SpecialistLocal Government CenterUniversity of Wisconsin - Extension

2. Capital Financing Strategy • A Capital Financing Strategy is essential for any local government to effectively plan for major projects and expenditures • Debt Management is one of the key components of a financial strategy.

3. Guiding Principles • Borrowing for operating expenditures is generally unsound • Borrowing for capital projects is considered essential financial decision-making • Borrowing for capital projects requires effective debt management

4. Guiding Principles • Effective debt management can minimize interest costs and even stabilize local government financial positions • Periodic review of debt and re-financing when conditions are favorable are essential to effective debt management and capital planning

5. Guiding Principles Manage debt to borrow for the right projects at pre-determined borrowing points that maximize the government’s borrowing efficiency

6. State Limitation Wisconsin Constitution limits county, municipal, and town borrowing and other debt to 5% of equalized taxable property

7. Local Debt Capacity • Some commonly used ratios can provide guidance on debt affordability • Ratios allow you to compare your situation to statewide averages or similar-sized communities

8. Common Ratios For a local government to decide how much debt it can afford to issue, it must look at bond and debt ratios. Common ratios are: • Net debt per capita • Net debt as a % of taxable or market valuation • Annual debt service on net debt as a % of general fund revenues or spending

9. Local Debt Capacity • All ratios refer to “Net debt” • Net Debt is debt that is paid for from general revenues or taxes • Includes General Obligation bonds

10. Debt Service The Wisconsin Constitution also specifics HOW and WHEN local government debt must be repaid

11. Financial Status Before a governmental body decides to borrow or sell debt, it needs to determine its financial status, i.e. whether it can afford to incur debt • Is the General Fund balance adequate? • How close to the Constitutional debt limits are you before incurring additional debt? • What is your ability to borrow, such as bond rating?

12. General Fund Balance • General Fund balance must be adequate to ensure continued positive cash flow • A common guideline is to maintain six (6) months operating expenditures as a reserve • If you have an insufficient General Fund balance, you cannot be assured of your ability to continue operations and service new debt

13. Debt Limit • By law, you cannot borrow additional funds if your borrowing will place your debt beyond the Constitutional debt limit • If you borrow to your debt limit, you have no recourse for additional funds in the case of emergencies

14. Bond Rating Bond ratings are an evaluation of the insurer's credit quality rated by: • Moody’s Investors Service • Standard & Poor’s (S&P) • Fitch Ratings

15. Bond Rating • Bond rating is determined by your financial stability and perceived ability to repay debt • A rating of “AAA” is most desirable • Any rating of less than “A” will probably incur an unacceptable interest rate. • A rating of “C” or “D” effectively places you in the “junk bond” range

16. Bond Rating Your bond rating is influenced by such factors as: • General Fund Reserve • Audit findings • Revenue projections • The stability of your local government • Past payment performance • State and local policies

17. Types of Financing • “Pay-as-you-go” Financing • “Pay-as-you-use” Financing • Debt Financing

18. “Pay As You Go” Financing Pays for capital projects and acquisitions from sources other than debt such as current taxes and revenue; funds from Capital Reserves; special assessments or impact fees; and grant revenue from federal, state, or foundation sources

19. “Pay As You Go” Financing • Saves interest charges • Capital projects must be evenly spaced over time • Needed projects have to be delayed until necessary funds can be accumulated • Not equitable if the population is relatively mobile

20. “Pay as You Use” Financing Every long-term improvement or expenditure is financed by serial debt issues with maturities arranged so that retirement of debt coincides with the depreciation of the project When a projects' useful life finally ends, the last dollar of debt is paid off

21. “Pay as You Use” Financing • Avoids many of the problems of “pay as you go” financing • Everyone pays for the capital improvements they use • Ideally, all long-lived projects should be financed by debt that is retired over the course of the project’s life

22. Debt Financing • Money obtained by incurring debt and used to build or acquire capital assets or other purposes • Debt financing for local governments comes mainly from the issuance of long-term bonds or other debt

23. Debt Financing • Commonly used for capital projects • Issuing debt to finance cash flow needs or deficits in operating budgets is sometimes done but should be restricted to extraordinary situations

24. Debt Financing When using debt financing, a Financing Plan should be set up to show a project’s anticipated effect on the local mil rate, the community’s financial position, and credit rating.

25. Expenditures • Current expenditures: for goods and services used within 1 year and reflected in the operating budget • Capital expenditures: represent fixed assets that will provide services for a number of years • Virtually all long-term debt financing is used to fund capital improvements, i.e. Capital Financing

26. Capital Improvement Program (CIP) • Used to manage capital financing needs • Identifies capital projects to be funded over the next five or six years • First year of CIP serves as Capital Budget

27. Capital Improvement Program (CIP) Serves as a financial planning tool: 1. Establishes priorities that balance capital needs with available resources 2. Pairs projects with their intended funding sources

28. Capital Improvement Program (CIP) 3. Ensures orderly improvement or replacement of fixed assets 4. Provides an estimate of the size and timing of future bond sales

29. Debt Policy A written debt policy establishes guidelines for the use of debt Specifies: • Maximum amount of debt that can be issued • Purposes for which debt can be issued • Types of debt that can be issued • Debt maturity structure

30. Types of Debt Long-term debt: • General Obligation (GO) Bonds • Revenue Bonds Short-Term Notes

31. General Obligation (GO) Bonds • Secured by the full faith, credit, and taxing powers of the issuing government • Legally obligate the local government to assess taxes as necessary to meet debt service payments • For capital projects that benefit the community as a whole

32. General Obligation (GO) Bonds • Limited only by statutory limitations • Normally require voter approval

33. Example A municipality issues a $12,000 General Obligation Bond to build a state-of-the-art community recreation center, projected to last for 25 years plus, which was approved in an advisory referendum The bond is issued at 4.15% interest over a 20 year period

34. Revenue Bonds • Secured by the revenues of the project being financed • Their credit depends upon the financial strength of the financed project • Typically do not require voter approval

35. Revenue Bond examples • Airport revenue bonds • Hospital or nursing home revenue bonds • Industrial development revenue bonds • Public power revenue bonds • Resource recovery revenue bonds • Sports complex and convention center revenue bonds • Water and sewer revenue bonds

36. Other long-term financing vehicles Special assessment bonds • Finance capital improvements that benefit a specific area • User fee levied on property Tax increment financing bonds • Promotes economic development in a specific area • Paid from the increase in property tax revenues generated as a result of the economic growth

37. Short-term notes Governments may issue short-term notes which have maturities of less than thirteen (13) months • Bond anticipation notes • Tax anticipation notes • Revenue anticipation notes • Grant anticipation notes • Tax and revenue anticipation notes

38. CAUTION! If considering whether to borrow between funds, remember: • In your local government accounting processes, you can NEVER cover deficits in unrestricted fund balances with restricted funds • This can be a “go to jail” issue • You can “borrow” by resolution but must have a plan for repayment and stick to it

39. Debt Maturity Structure Determined by: • Type of project being financed • Financial position of the issuer • Statutory constraints

40. MaturityGuiding Principle A bond issue should not exceed the useful life of the project being financed

41. Bonds • A bond is a single security, typically with a principal amount of $5,000 • A $1 million bond issue consists of two hundred bonds, each with a principle of $5,000

42. Bonds • In a serial bond issue, portions of the total issue mature at different times • Most sold in serial form with maturities between one and fifteen years or longer

43. Debt Service • Each year’s debt service must be included in the annual budget • Commonly under a debt service fund

44. Debt Service • Debt service will include and should identify principle, interest, and fees on separate budget lines • Do not forget to budget for the annual fee on bonds

45. Basic Debt Management Questions • Does the project need to be done now or can it wait for a more advantageous time? • Is our financial condition such that it can support additional debt service? • What are the current trends with interest rates? • What is our current bond rating? • What kind of maturity structure is most desirable at this time?

46. Sources “Management Policies in Local Government Finance,” ICMA University, 5th Edition, 2004 “Capital Budgeting and Finance: A Guide for Local Governments,” A. John Vogt, International City/County Management Association, 2004