DEBT ADMINISTRATION

Debt administration was relatively routine task when long-term debt was a small part of the overall fiscal commitments of local government. The basic requirement was to ensure that sufficient funds were set aside from general revenue sources to cover debt service obligations, or, in the case of term bonds, to cover annual interest charges and to build an adequate sinking fund. New and diverse bond offerings and a growing competition for investors, however, have resulted in increased responsibilities for the marketing of municipal bonds and the administration of public debt.

Marketing Municipal Bonds

Constitutional provisions, general statutes, special acts, and local charters that regulate the authorization and issuance of municipal bonds vary from state to state. Controlling laws are not always conveniently codified, and as a consequence, procedural steps necessary to secure bond authorization often are confusing to local officials and administrators. Expert legal advice is important to ensure compliance with all applicable legal requirements. Even minor errors may result in annoying delays, expensive litigation, and possible invalidation of the issue or sale.

Preliminaries to Marketing

Some form of popular referendum is required in most states for the authorization of general obligation bonds. In a few states, governing bodies are permitted to authorize bonds, within certain limits, without popular vote. Experience has shown, however, that this option should be used sparingly and held in reserve for emergencies.

Municipal bonds must be negotiable instruments, that is, they must contain an unconditional promise or order to pay. Bond ordinances or resolutions should be drawn with precision, setting forth the nature and limits of the security offered. Each issue must be approved by a bond counsel whose legal opinions satisfy the market where the bonds are to be sold. The official notice of sale should specify that the legal opinion will be furnished to the buyer. While final approval cannot be given until the sale is completed, preliminary approval before bidding assures prospective buyers (underwriters) that the legal opinion can and will be furnished without delay before the bond issue is distributed to investors. The sale is subject to the satisfactory provision of such legal opinion.

Notice of Sale

The official notice of sale should be published in The Daily Bond Buyer--the newspaper of the municipal bond industry--and perhaps in regional bond publications at least two weeks in advance of the date set for opening bids. In some states, notices must also be placed in the official state newspaper. In addition to notices of sale, The Daily Bond Buyer includes news articles, call notices, a new issue calendar and other announcements pertinent to the municipal market and financial community.

The following information should be included in the official notice of sale:

(1) The correct legal name of the issuing body, the special law (if any) under which it was organized, and the authority for the sale.

(2) Type of bonds to be issued.

(3) Amount and purpose of the issue, the maturity schedule, call features (if any), denomination, and registration privileges.

(4) Date, time, and place of sale; manner of bidding (sealed or oral); and basis for bidding (e.g., at par, discounts allowed, etc.).

(5) Limitations as to interest rate, payment dates of interest, and when and where principal will be paid.

(6) Amount of good faith check.

(7) Name of approving attorney.

(8) Provision made for the payment of principal and interest, i.e., from ad valorem taxes, special assessments, revenues of particular enterprise.

(9) Total tax rate in the governmental unit, rate for each levying body, and constitutional or statutory limits restricting debts or the taxes levied for their payments.

Adequate publicity through the notice of sale give prospective bidders the opportunity to form their bidding accounts and to secure information regarding the offering. It also eliminates any suspicion of collusion and demonstrates that the jurisdiction is willing to submit its financial condition to careful inspection.

If the enabling legislation permits, the best practice is to allow the rates of interest to be fixed by the bidding underwriters. When they can determine the coupon rate, underwriters can make a bid that best fits the market. If permissible under controlling state regulations, bidders should be able to bid different rates on various maturities or groups of bonds--known as split-rate bids--in order to obtain the most favorable overall net interest cost.

Supplemental coupons have been used to attract dealers where state requirements mandate that municipal bonds be sold at par. Supplemental coupons are additional coupons attached to a municipal bond and covering the same interest period as one or more regular coupons. When a supple-mental coupon is in force, the locality is required to make two interest payments for the period. Supplemental coupons are usually detached by the underwriter at the time of original delivery from the issuer and may be held until payment date or sold by the dealer at a discount. These coupons represent the underwriter's profit on the sale of the bond.

Timing of a Bond Issue

The bond market experiences minor fluctuations within the course of every few months, brought on by an excess of supply over demand, as well as economic and political trends. By following municipal bond publications and consulting investment bankers, the finance officer can often apply these fluctuations to the advantage of the jurisdiction.

The municipality should avoid setting the date of the sale in the midst of a general rush of new offerings (many large school bond issues, for example, reach the market in late spring or early summer), or immediately following large sales by other municipalities. It is unwise to set the sale date for the day before or after a holiday or on Mondays or Saturdays. It is unwise to enter the market too frequently (thus, the advantage of a consolidated issue). And if dealers have not completed the distribution of a previous issue, a less satisfactory price on a new issue may be anticipated.

The due dates for semi-annual interest payments are determined by the date on which the bond is sold. Since there are certain times of the year for each municipality when its funds are low, the timing of an issue should be scheduled so that interest and principal payments do not come due at a time when funds are not in hand to pay them.

Bond Prospectus

The availability of all essential facts concerning the financial condition of the municipality is fully as important as any other factor in the successful marketing of municipal bond. With the exception of certain revenue bond issues, however, no elaborate prospectus is necessary. The information that most investors seek regarding debt and the provision for payment includes an assessment of the adequacy of the community's revenue system and the effectiveness of its administration, the recent financial operations in the municipality, total tax rate and statutory limits restricting debts or the taxes levied for their payments, population according to latest census data, etc. This information is generally covered in the bond rating process, as outlined below.

Miscellaneous Requirements

The largest buyers of municipal bonds traditionally have been financial institutions which usually are exacting in their purchasing requirements. Failure to comply with their "rules of the game" tends to narrow the market with considerable impact in the interest cost to the municipality. Where bonds have a wide market, for example, principal and interest should be payable in a large financial center, preferably at a bank located in a city where there is a Federal Reserve Bank. Most large investors prefer to avoid the expense and inconvenience involved in collection of principal and interest payments outside such centers. The bond owner should have the privilege of registering bonds as to both principal and interest or principal only. To safeguard against counterfeiting, bonds should be printed by a firm that specializes in such work.

Costs Involved in Marketing Municipal Bonds

The cost of borrowing involves not only the interest payable over the term of the bonds, but also costs incurred in readying bonds for market and their actual delivery to the initial investors. Such costs reflect the expense of conducting a referendum, fees for various legal and financial advisors, and a variety of miscellaneous costs, including: preparation and publication of bond notices and the bond prospectus; printing the bonds; obtaining a bond rating; costs of renting signature machines; filing fees; court fees; registration or recording fees; certification costs; and costs of delivering the bonds. Some marketing expenditures may result in a broader sale, culminating in lower interest costs. Other expenses may add little to the marketability of a bond issue.

While no single cost incurred is large, in the aggregate, these costs can amount to a considerable sum. A survey by the Municipal Finance Officers Association of 481 governmental units in the United States and Canada revealed that in some instances, total marketing costs amounted to 5.5 percent of the value of the bonds. These costs usually are paid from the bond proceeds. This practice, however, reduces the amount available for the project or requires an increased borrowing to meet capital costs. In either case, interest costs also attach to that portion of the proceeds used to meet marketing costs.

Bond Insurance

Municipal bond insurance guarantees that the insurer will pay interest and principal on the insured bonds, as they become due, and make mandatory sinking fund payments if the bond issuer fails to make these payments for what ever reason. The insurance becomes part of the bond description, and the insurance premium is paid by the investor when the new issue of bonds is delivered. Insured bonds trade in the "insured paper" market which increases their desirability and salability. Insured bonds have a higher rating but usually a lower yield, since the cost of the insurance is passed on to the investor.

Municipal Bonds Ratings

Ratings have assumed considerable significance in determining interest rates and the eligibility of bonds for purchase by certain types of investors. Rating agencies assign a credit rating to bond issues that assesses the risk of nonpaymnent of borrowed funds. The better the bond rating, the lower the interest cost that the jurisdiction must pay. For a $1 million bond issued for 20 years at an interest rate of 5 percent, for example, one rating difference amounts to about $50,000 in interest costs.

Municipal bonds are rated only in terms of credit risk and not in terms of their investment merits. Bond ratings appraise two basic risk factors: (1) the risk that bond quality will be diluted by an inordinate increase in debt, and (2) the risk that ability to meet principal and interest payments may be impaired under depressed economic conditions. The first risk is within the control of the issuing government, whereas the second is related to the impact of general economic conditions on a given locality.

Rating analysts evaluate a wide range of information concerning economic, debt, financial, and governmental considerations to determine a bond rating. This information is supplied by the jurisdiction and derived independently by the analyst. Rating agencies do not explain completely their reasons for assigning a particular rating, nor do they provide a precise formula for obtaining better ratings.

Three nationally recognized rating services--Moody's Investors Service, Inc., Standard and Poor's Corporation, and Fitch Investor's Service --rate a wide variety of bonds: tax-supported, revenue or enterprise supported, lease-rental, hospital revenue, mortgage-backed housing, higher education revenue, student loan revenue, and refunded bonds. The rate service fees vary according to the size of the prospective bond issue, according to the following general schedule:

Issue Size Amount of Fee
Under $3 million $ 1,000 - $ 3,000
$3 million to $5 million $ 2,000 - $ 4,000
$5 million to $20 million $ 3,000 - $ 6,000
$20 million to $50 million $ 4,000 - $ 8,000
$50 million to $100 million $ 6,000 - $12,000
$100 million and over $10,000 - $25,000

The rating services use symbols, arranged in order from bonds with the least credit risk to those with the greatest risk (see Exhibit 1). Some issues rated by one service are not rated by the other, and the opinions of the rating services may differ on specific issues.

Rating analysts evaluate new bond issues and maintain surveillance over current ratings. If the lowering of a current bond rating may be forthcoming, a jurisdiction is placed on a Credit Watch. A rating committee reviews the recommendations of the rating analyst and assigns the actual rating. The jurisdiction may appeal the assigned rating by furnishing additional information to the rating service.

Analysts evaluate various economic factors, including the locational advantages of the jurisdiction, its population, wealth, labor factors, the diversity of employers, and the area's economic prospects. Economic variables that are most significantly related to bond ratings include the percentage of the economy dominated by the ten largest tax-payers (which is intended to measure the concentration and dependence of the local economy); the rate of unemployment; the tax base per capita; and the change in population. Of the various criteria included in the rating analysis, economic factors are the hardest to improve. Economic development often is a very long-term proposition for most jurisdictions.

Rating analysts examine various debt factors, including the jurisdiction's debt policy, debt structure, debt burden, debt history, and prospective borrowing, to assess the likelihood of meeting its commitments to the bondholders. Planning for future debt and having a solid infrastructure is looked upon favorably by analysts. If public indebtedness becomes too high, analysts are concerned that the jurisdiction may be unwilling or unable to honor its debt commitments. Moody's has compiled national averages of net debt per capita and the ratio of net debt to estimated full value of all taxable property. Such averages are used to evaluate the amount of debt burden. Communities with high net debt have cause for concern. On the other hand, low net debt may not necessarily be a good sign if such jurisdictions have ignored needed infrastructure improvements by not issuing bonds.

Two important governmental considerations are continuity in management and good fiscal control. An assessment is made as to determine the professionalism of the management team and how long it has been in place; whether or not managerial and policy-making responsibilities are clearly delineated; the jurisdiction's compliance with the Government Finance Officers Association standards regarding financial reporting and budgeting procedures; and the jurisdiction's independence in terms of overlapping or conflicting intergovernmental relationships.

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Exhibit 1. Comparison of Municipal Bond Rating Systems

Moody's Investors Service Symbol Symbol Standard and Poor's Corporation
Best quality, carrying smallest degree of investment risk; referrred to as "gilt edge" Aaa AAA Prime; obligor's capacity to meet its financial commitments on the obligation is extremely strong
High quality; rated lower than Aaa because margins of protection not as large Aa AA Differs from the highest-rated obligations only in small degree; obligor's capacity to meet its financial commitments on the obligation is very strong
Higher medium grade, many favorable investment attributes; some elements of future risk evident A A Somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rated categories; obligor's capacity to meet its financial commitments on the obligation is still strong
Lower medium grade; neither highly protected nor poorly secured; may be unreliable over any great length of time Baa BBB Exhibit adequate protection parameters; adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet the financial commitment of the obligation
Judged to have speculative elements; not well safe-guarded as to interest and principal Ba BB Speculative non-investment grade obligation; faces major ongoing uncertainties or exposure to adverse business, financial, or economic conditions which could lead to the obligor's capacity to meet its financial commitment on the obligation
Lacks characteristics of desirable investment B B More vulnerable to nonpayment than obligations rated BB; adverse business, financial or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitment on the obligation
Poor standing; issue may be in default Caa CCC Currently vulnerable to nonpayment
Speculative in high degree; marked shortcomings Ca CC Currently highly vulnerable to nonpayment
Lowest rated class; extremely poor prospects of ever attaining any real investment standing C C Bankruptcy petition has been filed or similar action has been taken, but payments on this obligation are bing continued.
Default D D Obligation in payment default

A number of financial factors are examined. Financial reports and budgets are reviewed to: (1) determine existing and future fiscal trends, (2) assess if revenues meet or exceed expenditures and if a sufficient fund balance is available to meet unforeseen contingencies; (3) evaluate the diversity of revenue sources; and (4) identify what the property tax collection rate has been. The analyst will also seek to determine the jurisdiction's policies regarding interfund transfers; if generally accepted accounting principles (GAAP) are followed; and if pension liabilities are properly funded.

Generally speaking, there is only one rating for all of the general obligation bonds of a particular governmental unit and for all the bonds of a specific revenue project. Some governmental units or revenue projects may have more than one rating because special security has been pledged for some of the bonds. New issues of a previously rated governmental unit or revenue project usually are assigned the same rating as the outstanding bonds unless there have been material changes in the credit situation. Therefore, new issues of a previously rated unit usually increase the dollar value outstanding in a rating category but rarely affect the number of municipal credits in a rating category. Jurisdictions can actively pursue better bond ratings by making improvements in one or more of the four areas of evaluation and by pro-actively selling the community through ongoing contacts with rating services.

Large institutional buyers are often limited by state law in the selection of their investments. Therefore, if a jurisdiction is now on the legal investment lists of leading investor states, it is very important that nothing be done to imperil this favored position.

The Bond Sale and Delivery

All bids made on a particular issue should be on a basis that permits a comparison of total cost to the issuer. Officials should insist that all bids comply strictly with the terms of the sale. All bids should be received and opened in public by the governing body at the designated hour, with the bonds awarded to the bidder on the basis of the lowest net interest cost. All paperwork required to complete the bond transcript should be forwarded to the bond attorneys as soon as possible thereafter.

Before the bonds are delivered, information required to establish the bond register (sometimes called the bond and interest record) should be recorded. At the time a bond issue is sold, the interest due on each date of maturity should be computed and recorded, as should the payments of principal or payments into a sinking fund. With such records, a complete schedule of debt service requirements can be readily prepared for the current budget and for all outstanding debt obligations.

Bonds should be delivered at the earliest practical date after the sale (no later than thirty days). The winning bidder usually has the option to cancel his obligations if delivery is not made on or before the date specified in the contract. The purchaser should stipulate where the bonds should be delivered. For bonds that are delivered as certificates, the issuer may prefer to have at least one official sign the bonds at point of delivery and to have the municipal seal imprinted at the time. Large bond issues usually are signed at the place of delivery because the travel expenses of officials frequently are less than the insurance on the delivery of signed bonds.

The issuer of the bonds provides a disclosure statement on the new issue, called an Official Statement, which summarizes the issue, giving information on ratings, authority for issue, delivery date and place, security for the issue, maturity amounts, dates, coupon rates, and reoffering yields or prices. The Municipal Securities Rulemaking Board requires that a final Official Statement must be sent to every person who purchases a new issue bond during the underwriting period. A preliminary official statement frequently is distributed to prospective buyers before the sale of larger bond issues.

Summary

The marketing of municipal bonds is a complicated process, the mysteries of which, insofar as the uninitiated is concerned, are comparable to that of the stock market. Local officials must be mindful of the procedures for marketing bonds, from the planning of the issue through the actual delivery of the bonds to the winning bidder. Failure to adhere to these procedures can result in unnecessary delays, higher interest costs, and possible legal ramifications. As a practical matter, almost any bond issue that is in proper technical form can be sold at any time. However, whether a particular offering is "successful" at the date of sale depends on the congruence of many factors.

The municipal finance officer is caught in the middle--faced on the one hand by uncertainties as to the political and economic structure of the community and, on the other, by uncertainties of a marketplace that he may not fully comprehend. Adherence to accepted marketing procedures can go a long way to reducing the uncertainties that confront the municipal officials on both sides. The success of a given issue may be determined by forces in the marketplace beyond the control of local officials. An awareness of these factors, however, can provide important insights in the overall planning of long-term bonds for capital facilities.

Debt Administration

Debt administration is one of the most significant responsibilities of local government officials. Comprehensive and systematic procedures must be established for the maintenance of records, for annual financial reporting, and for the accountability of public funds. Such procedures are essential to develop confidence on the part of investors and the general public as to the overall management of the financial affairs of the municipality.

Capital Project Funds

Capital project funds account for the resources required to build or buy specific capital facilities. These resources come from the issuance of bonds or other long-term obligations, from intergovernmental grants, or as transfers from other funds. The capital project fund is terminated when the project is completed, and the accounting results are transferred to the debt service fund which is used to track the payment of interest and principal of the long-term debt on each capital project.

Bonds often are not sold on the date of issue. [1] Assume, for example, that bonds with an issue date of July 1, 1996, were not sold until September 1, 1996. The purchaser of these bonds receives semi-annual interest payments from the date of issue (that is, on January 1, 1997, on July 1, 1997, and every six months thereafter) and not from the date of purchase. Therefore, when the bonds are sold, the buyer must pay the seller the equivalent of interest for the period from the issue date to the date of purchase (which, in turn, will be included in the interest payment received by the buyer on January 1, 1997).

Accrued interest received on the sale of the bonds cannot be used in the capital project fund to pay for construction. It must be transferred to the debt service fund to be used as part of the resources for the first interest payment--that is, as a partial offset to the amount needed from the general fund for the first interest payment. Therefore, only funds sufficient to pay the interest from the purchase date to the interest payment date will have to be transferred from the general fund to the debt service fund.

At the time a bond issue is authorized, it often is difficult to determine exactly what the interest rate will be on the date the bonds are sold. The actual date of sale can seldom be predicted accurately. The possibility exists, therefore, that bonds will be sold at either a premium or a discount--that is, above or below the face value. [2]

Some states do not permit bonds to be issued at a discount (below face value, or par). This prohibition may force the issuing authority to pay a higher interest rate on the bonds to ensure their sale. When a discount is allowed, the full face value of the bonds is still required to complete the authorized project, and the difference may have to be made up from the general fund or the debt service fund. When bonds are sold at a premium (higher than face value), the difference is usually transferred to the debt service fund and used with other resources to pay off the bonds.

The capital project fund often receives proceeds from the sale of bonds or transfers of moneys from other sources (such as, state or federal grants) before these resource are needed to acquire the capital asset. These resource should be invested to produce additional revenue. This investment revenue, in turn, is transferred to the debt service fund for payment of the principal or interest of the debt.

The administration of a capital project fund can be best understood by tracing a typical set of transactions. Assume that the City of Rurbana proposes to buy land and construct a new administration building at an estimated cost of $1,600,000. Matching grants of $300,000 from the state and $500,000 from the federal government are available for this project. The Rurbana taxpayers have approved a bond issue referendum for $800,000 to meet the local share of the project's financing.

Regardless of the method by which moneys are transferred from one governmental unit to another, the results are the same: the capital project fund receives cash from the granting agencies. Assume that the grants are received at the outset of the project and are invested in short-term, sixty-day certificates of deposits at 6 percent interest. The resulting earnings of $7,890 ($800,000 x 0.06 x 60/365) should be deposited in the debt service fund.

Land is purchased for the building site. Two landowners agree to purchase prices, totaling $90,000. A third landowner cannot obtain his desired price; his land is condemned, with a court-ordered settlement of $35,000. These transactions are not encumbered because of the relative short time between purchase and payment.

In governmental fund accounting, capital assets are recorded as expenditures in the capital project fund and as fixed assets in the general fixed assets account group. The land sales and the judgment are paid on a proportional basis from three sources: the state grant (3/16), the federal grant (5/16) and the proceeds of the bond sale (8/16). The entry to record this transaction in the fixed assets account group is:

Land Acquisition $125,000
State grant $23,438
Federal grant $39,062
General obligation bonds $62,500

Grant funds are thus reduced to $737,500. This amount plus previously earned interest is invested in a thirty-day CD, at 5 percent. The resulting earnings of $3,063 [($737,500 + $7,890) x 0.05 x 30/365] are deposited in the debt service fund.

The bonds, dated July 1, 19X6, are issued as 20-year general obligation bonds with an interest rate of 5 percent, payable semiannually on December 31 and June 30. For illustrative purposes, it will be assumed that the issue is for term bonds, wherein interest on the full amount of principal is payable over the twenty-year period to maturity.

On September 30, the bonds are sold at a premium of 2 percent, or $16,000, plus accrued interest of $10,000 ($800,000 x 0.05 x 3/12). Total receipts of $826,000 are recorded in the capital project fund.

The accrued interest and premium on the sale of the bonds are transferred to the debt service fund. From the sale of the bonds, $62,500 is paid toward land acquisition, and the balance of $737,500 is combined with the balance of the grant funds ($737,500 + $7,890 + $3,063), for a total of $1,485,953. This amount is invested in a ninety-day CD at 6.5%, yielding $23,816 on December 29, 19X6.

On October 1, 19X6, a construction contract is let for a building designed to be built for $1,300,000, including a contingency allowance of $100,000 to accommodate any necessary plan changes. The contract calls for completion of the building by November 1, 19X7. The Public Works Department will make the necessary land improvements and landscape the grounds at the completion of the construction phase. The estimated cost of $75,000 is encumbered at the outset of the project.

The Sunshine Construction Company is to receive quarterly payments on the basis of percentage of completion of the building and approval by the construction supervisor. During the first year, the following payments are approved, based on invoices submitted by the company:

December 31, 19X6 $350,000
March 31, 19X7 $225,000
June 30, 19X7 $225,000

Individual entries are made to record each of these amounts when the invoices are received and approved. The balance of the grant funds and bond proceeds continues to be available for short-term investment in certificates of deposit or other securities.

Only $575,000 of the accounts payable is actually paid during the fiscal year (the June 30, 19X7, payment is made early in the next fiscal year). The capital project fund still has $900,000 in cash at the start of the second fiscal year (July 1, 19X7), offset by accounts payable of $225,000, a fund balance of $100,000, and reserve for encumbrances of $575,000 ($500,000 on the construction contract and $75,000 for site improvements). Thus, $675,000 is available for short-term investment.

On July 10, 19X7, a contract change is approved that increases the construction contract to $1,350,000. The third quarterly payment of $225,000 is also made on that date. On September 30, 19X7, another payment is approved for $400,000.

The project is not completed until December 1, 19X7, because of the addition to the contract. At that time, an invoice was received for the balance of the contract. The retained percentage on this project (pending final approval) is 5 percent of the contract price, or $67,500. Therefore, the December payment to Sunshine Construction is $82,500 ($150,000 - $67,500).

The Public Works Department completes its work at a cost of only $60,000, releasing $15,000 of the $75,000 encumbrance back to the fund balance. By February 28, 19X8, the corrections to the project needed for final approval are made by the contractors, and the retained percentage ($67,500) is paid. The fund balance account is then closed, and the balance of cash on hand--the $15,000 unused encumbrance plus $50,000 unused contingency allowance--is transferred to the debt service fund as a residual equity transfer.

Debt Service Funds

Debt service funds are used to account for: (1) the accumulation of resources from which the principal and interest on long-term debt is paid and (2) the investment and expenditure of those resources. Whenever possible, several debt issues should be accounted for in a single fund, since the fewer the number of funds, the less complicated the accounting for long-term debt. One fund needs only one set of financial statements; many funds need many sets of financial statements.

The money required for the repayment of debt, as well as the interest on the bonds, may come from several sources. If the locality or authority earmarks a special source for the repayment of bonds, then a special revenue fund may be set up to collect the money and transfer it to the debt service fund. Often revenue is collected from various sources in the general fund and then transferred to the debt service fund. Many bond indentures require that the money needed for servicing the bonds has first claim on the general revenue of the governmental unit.

Since the resources needed to service the principal and interest on serial bonds is received and expended each year, there is no accumulation of resources on which interest can be earned. The resources needed to service the principal on term bonds, however, are not needed until the debt matures and, therefore, can be invested. Thus, the assets and the fund balance increase annually, providing a sinking fund that eventually will be used for payment of the debt.

A sinking fund spreads the repayment costs over the life of the bond issue, thereby avoiding large, irregular demands on the annual budget. The amount that needs to be earmarked each year for the sinking fund is deter-mined by: (1) the dollar value of the bonds to be retired, (2) the number of payments to be made into the account, and (3) the anticipated rate of earnings on the invested funds. Sinking fund requirements should be recomputed each year. Should a surplus in excess of actuarial requirements develop, it may be possible to lower future requirements. It is sound debt management practice, however, to absorb any significant surplus gradually over several fiscal periods rather than making a large reduction in payments in a single year. Should a deficit arise, adjustments should be made as soon as possible by increasing the level of payments into the sinking fund. New investment opportunities should also be sought to produce a greater return.

The same example used to explain the administration of a capital project fund can also be used to illustrate the operations of a debt service fund. Term bonds with a face value of $800,000 were issued at 5 percent for twenty years. Semi-annual interest payments on these bonds are $20,000 ($800,000 x 0.05 x 1/2). Since the bonds were sold three months after the date of issues, however, only $10,000 is needed for the first interest payment. The other $10,000 will come from the accrued interest received upon sale of the bonds. Often interest payments are made to bondholders by a fiscal agent on behalf of the locality. In that case, the handling charges made by such agents (usually 1 percent or less) must be included in the annual transfers to the debt service fund for interest payments.

The estimated amount needed to build up the sinking fund can be developed from an annuity table or from the annuity formula. For example, if the fund can earn 6 percent each year on its investments, then an annuity table shows that one dollar invested annually for twenty years at 6 percent will return $36.786. Thus it would take $21,747.40 added to the sinking fund each year, invested at 6 percent, to equal $800,000 at the end of twenty years ($800,000 divided by $36.786 = $21,747.40). No long-term investments are purchased in the first year because the payment, as an annuity, is generally not received until the end of the year. During the second and all succeeding years, however, the transfers as well as any earnings made in prior years will be invested.

Exhibit 2. Interest Earnings on Short-Term Investments

Investment Period Funds Available Rate Interest Earned Drawdown
7/03 - 8/31 $800,000 6.0% $7,890 $62,500
9/01 - 9/30 $745,390 5.0% $3,063 $62,500
10/01- 12/29 $1,485,954 6.5% $23,816 $350,000
12/30 - 3/31 $1,159,770 6.5% $18,588 $225,000
4/01 - 6/30 $953,358 6.5% $10,187 $225,000
7/01 - 9/30 $748,544 6.5% $13,260 $400,000
10/01 - 11/30 $350,381 6.0% $3,456 $82,500
12/01 - 2/28 $271,337 6.5% 4,349 $127,500
Fund Balance $148,186
Totals $83,186 $1,535,000

The interest earned from short-term investments during the construction period is summarized in Exhibit 2. The $65,000 fund balance, transferred to the debt service fund when the capital project fund is closed, is added to the $83,186 in earned interest for a total of $148,186. These funds, invested on March 1 at 6 percent, earn $2,963.72 through June 30. The year-end balance of $16,960 from the first year of the sinking fund (see Exhibit 2) earns $1,017.60 during the second year. Thus, at the end of the second year, the sinking fund has a substantial balance of $169,127. This fund balance invested at 6 percent would total $482,747 at the end of twenty years when the bonds reach maturity. Therefore, the balance that must be accrued in the sinking fund is reduced to $317,253. Annual payments of $10,265, invested at 6 percent over the eighteen-year period, will yield the sum required in the sinking fund to cover the balance of the principal payment, as detailed in Exhibit 3.

Exhibit 3. Sinking Fund Requirements on 20-Year Term Bonds

Year Transfer for

Bond Payments

Fund

Earnings @ 6%

Yearly Fund

Balance Increase

Year-End

Fund Balance

1 $16,000.00 $960.00 $16,960.00 $16,960.00
2 $148,186.00 $3,981.32 $152,167.32 $169,127.32
3 $10,265.00 $10,147.64 $20,412.64 $189,539.96
4 $10,265.00 $11,372.40 $21,637.40 $211,117.36
5 $10,265.00 $12,670.64 $22,935.64 $234,113.00
6 $10,265.00 $14,046.78 $24,311.78 $258,424.78
7 $10,265.00 $15,505.49 $25,770.49 $284,195.27
8 $10,265.00 $17,052.72 $27,316.71 $311,160.76
9 $10,265.00 $18,690.72 $28,955.72 $340,467.70
10 $10,265.00 $20,428.06 $30,693.06 $371,160.76
11 $10,265.00 $22,269.65 $32,534.65 $403,695.41
12 $10,265.00 $24,221.72 $34,486.72 $438,182.13
13 $10,265.00 $26,290.93 $36,555.93 $474,738.06
14 $10,265.00 $28,484.28 $38,749.28 $513,487.34
15 $10,265.00 $30,809.24 $41,074.24 $554,561.58
16 $10,265.00 $33,273.70 $43,538.70 $598,100.28
17 $10,265.00 $35,886.08 $46,538.70 $644,251.30
18 $10,265.00 $38,665.08 $48,920.07 $693,171.37
19 $10,265.00 $41,590.28 $51,855.28 $745,026.65
20 $10,271.75 $44,701.60 $54,973.35 $800,000
Totals $348,962.75 $451,037.25 $800,000.00

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