1. Debt Administration Lecture 13 November 29, 2005 PA 546 Constantine Hadjilambrinos

2. Federal Debt PA 546 Constantine Hadjilambrinos Primarily used to finance government operations. Primarily used to finance government operations. Primarily short term. Primarily short term. Some debt is held by federal accounts and the Federal Reserve System (Social Security, Medicare/Medicaid). Some debt is held by federal accounts and the Federal Reserve System (Social Security, Medicare/Medicaid). Majority of debt held by private investors (60% in 2001). Majority of debt held by private investors (60% in 2001). Of this, a continually increasing amount (42.1% in 2001) is held by foreign investors. Of this, a continually increasing amount (42.1% in 2001) is held by foreign investors. This has serious implications for resource allocation.

3. State and Local Government (Municipal) Debt PA 546 Constantine Hadjilambrinos Primarily used to finance capital projects (infrastructure). Primarily used to finance capital projects (infrastructure). Primarily long term. Primarily long term.  “Full faith and credit debt”—used for projects that do not generate revenue. Often limited statutorily.  Non-guaranteed debt—Revenue bonds.  “Private” debt: Industrial Development Bonds.

4. Appropriate Debt Policy PA 546 Constantine Hadjilambrinos Debt is usually the most appropriate financing option for capital projects. If capital projects were to be financed from current budget, most would be impossible. If capital projects were to be financed from current budget, most would be impossible. Debt financing fulfills equity criteria: users pay for projects. Debt financing fulfills equity criteria: users pay for projects. Most appropriate length of financing is to coincide with useful life of project. Most appropriate length of financing is to coincide with useful life of project.

5. Mechanics of Bond Values PA 546 Constantine Hadjilambrinos Calculation based on equations for present and future values. FV n Future value in year n PV Present value r Rate of return/interest n Number of years

6. Mechanics of Bond Values PA 546 Constantine Hadjilambrinos Special terminology for bonds. PPrice (present value) FFace value (future value) cCoupon rate (bond interest rate) rMarket rate of return mCoupon period (annual or semi- annual) Annual Semi-annual

7. Debt Structure and Design PA 546 Constantine Hadjilambrinos Pursue least-cost marketability. Pursue least-cost marketability. Simplify debt management. Simplify debt management. Provide appropriate cost signals to decision makers. Provide appropriate cost signals to decision makers.

8. Credit Ratings PA 546 Constantine Hadjilambrinos Three major credit rating firms: Three major credit rating firms: o Moody’s (Aaa, Aa, A, Baa) o Standard and Poor’s (AAA, AA, A, BBB) o Fitch (AAA, AA, A, BBB) Ratings reflect level of risk. Ratings reflect level of risk. Lower ratings mean higher interest rates must be paid by bond issuers. Lower ratings mean higher interest rates must be paid by bond issuers.  Investment grade: Adequate safeguards against default.  Junk bonds: Lower than Baa or BBB rating (4%-6% above U.S Treasury).

9. Credit Enhancements PA 546 Constantine Hadjilambrinos State-credit guarantees. State-credit guarantees. Promise by the state to make up any shortfall in local resources. Bank letters of credit. Bank letters of credit. Promise by a bank to make principal and interest payments of specified amount and duration (there is a fee). Municipal bond insurance. Municipal bond insurance. Purchased from an insurer, takes payments on in case of trouble (there is a fee).

10. Bond Issue Costs PA 546 Constantine Hadjilambrinos Underwriting fees (Underwriter purchases bond issue and resells it). Underwriting fees (Underwriter purchases bond issue and resells it). Rate insurance (Provides security against rate increases). Rate insurance (Provides security against rate increases). Pricing (Depends on Rating and maturity)— can be complicated for composite bond issue (comprising of bonds of different maturities). Pricing (Depends on Rating and maturity)— can be complicated for composite bond issue (comprising of bonds of different maturities).

11. Creative Finance PA 546 Constantine Hadjilambrinos Lease-purchase financing. Payments part of current operations expenditures. Payments part of current operations expenditures. Gets around various restrictions on government borrowing. Gets around various restrictions on government borrowing.