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VIII. FINANCING CAPITAL FACILITIES

Pay-As-You-Go Financing

"Pay-as-you-go" financing: (1) encourages local government to "live within its income;" (2) minimizes premature commitments of funds; (3) eliminates the cost of borrowed money; and (4) conserves credit for times of emergency when ample credit may be vital.

Pay-as-you-go is more feasible when capital expenditures are recurrent, either as to purpose or amount--i.e., paving of streets, acquisition of neighborhood parks, etc.

The pay-as-you-go approach may place an undue burden on present taxpayers to finance future improvements from which they may not fully benefit.

o Achieving user-benefit equity may require that the financial burden be spread over the life of the improvement.

o Projects providing public services over many years should be paid for by people according to their use or benefit--financed on a "pay-as-you-use" basis.

Few governments have the capacity to finance major facilities strictly on a pay-as-you-go basis.

Reserve Funds: Saving for the Future

Under a reserve fund (or capital reserve) a portion of current revenue is invested each year in order to accumulate sufficient funds to initiate some project in the future.

The amount (S) in a reserve fund generated by a fixed investment (N) placed annually at compound interest (r) for a term of n years can be expressed by the following formula:

S = {N [(1 + r)^n] - 1} /r

Borrowing

The ability to borrow when necessary on the most favorable market terms is an objective that applies to governments just as it does in business and industry. Local governments often borrow on the assumption that future economic and population growth will make the debt service payments (principal and interest) more feasible.

States often impose borrowing limits on local governments, typically stated in terms of dollars of outstanding debt as a percentage of the jurisdiction's real property tax base.

Government borrowing practices can be divided into three categories:

o Short-term borrowing (a year or less) takes various forms--bills, certificates, or notes sold to banks or other investors; bank loans; warrants paid out in lieu of cash--and is used to smooth out irregularities between expenditure and income flows and to finance governmental operations temporarily when tax receipts fall off unexpectedly.

o Loans of intermediate maturities (one to five years) may be used by jurisdictions operating largely on a pay-as-you-go basis when exceptional expenditures cannot be met from current revenues.

o Long-term borrowing is appropriate under the following conditions:

(1) the project will not require replacement for many years, such as a city hall, auditorium, major health facility, or sewage disposal plant;

(2) the project can be financed by service charges to pay off bond commitments;

(3) needs are urgent for public health and safety purposes or other emergencies;

(4) special assessment bonds are the only feasible means of financing improvements in the absence of subdivision regulations or other controls;

(5) intergovernmental revenues may be available on a continuous basis to guarantee the security of the bonds; and

(6) for financing projects in newly annexed areas or areas of rapid expansion where the demands on local tax resources are comparatively large and unforeseen.

Choice of Debt Form

A bond is a promissory note ensuring that the lender will receive interest payments (at some predetermined rate) and at maturity, repayment of the original sum (principal) invested.

The total debt service on a municipal bond varies considerably in terms of the interest rate and duration (see Exhibit 1).

Exhibit 1. Total Debt Service Costs for Annuity Serial Bonds

(Face Value = $1 million)

Municipal bonds carry lower interest rates than taxable corporate bonds because the interest earned is exempt from federal taxation, and usually from state taxes in the state in which the bond is issued (see Exhibit 2).

Exhibit 2. Taxable-Equivalent Yields

Municipal bonds possess three significant features in addition to their tax-exempt status:

(1) Security of municipal bonds is generally considered second only to that of federal government bonds.

(2) Marketability of municipal bonds is high, assuring that investors can always sell them if they wish to do so.

(3) Diversity of municipal bonds enables investors to obtain bonds in geographic areas and at maturities of their preference.

General obligation bonds are backed by the "full faith, credit, and taxing power" of the issuing jurisdiction.

Limited tax bonds are general obligation bonds secured by the taxing power of the issuing authority which is limited to a specified maximum tax rate.

Special Assessment or Special Tax Bonds are payable only from the proceeds derived from a special assessment levies against those who benefit from the facilities constructed (e.g., special assessments for curbs and gutters in residential areas) or from a special tax (such as highway bonds payable from a gasoline tax).

Revenue bonds are backed by a pledge of revenues to be generated by the facility being financed and do not carry the "full faith and credit" pledge.

Revenue bonds are best suited to projects that (1) can operate on a service charge or user-fee basis; (2) have the demonstrated potential to be self-supporting; and (3) can produce sufficient revenue without jeopardizing other important economic or social objectives of the community.

Municipal bonds can also be classified according to the method of redemption.

(1) Term bonds. All of the bonds in the issue reach maturity and must be paid off at the same time, with the lump-sum principal payment met by making annual payments to a sinking fund , which when invested at compound interest, should produce the amount of principal required at maturity.

(2) Serial bonds are retired by annual installments directly from tax revenues, or in the case of revenue bonds, from earned income (see Exhibit 3).

o Annuity serial bonds. The debt service payment is approximately the same each year (as with a home mortgage); the portion of the annual payment devoted to interest is higher in the early years of the issue but declines as payments toward principal are made (as the outstanding principal is retired).

o Straight serial bonds. Annual payments of principal of approximately equal amounts. Interest payments are large in the early years and decline gradually as the bonds approach maturity.

o Deferred serial bonds. First annual payment of principal is postponed for several years from data of issue to permit project to generate sufficient revenue to service the debt.

Callable bonds are issued with the provision that they can be paid off prior to their maturity date. The callable feature can be used to avoid overly rigid fiscal responsibilities, while at the same time permitting more rapid retirement if the project's revenue capacity expands.

Exhibit 3. Debt Service Charges on $1 Million for Ten Years

Straight Serial Bonds (6 percent on declining principal)

Annuity Serial Bonds (6 percent on outstanding principal)

REVENUE BONDS

Both principal and interest of revenue bonds are paid exclusively from the earnings of the enterprise.

Revenue bonds are not ordinarily subject to statutory or constitutional debt limitations.

Appropriate Uses of Revenue Bonds

The following principles should be observed in planning revenue bonds:

(1) Bonds should be scheduled for retirement well within the useful life of the project.

(2) The retirement of bonds should allow a comfortable margin of revenue coverage for debt service without the need to charge abnormal rates or fees.

(3) The amount of combined annual interest and amortization should follow an even or slightly rising trend in order to coincide with the prospective pattern of revenues.

(4) The first payment on principal should be deferred until the operations of the facility have become well established.

(5) Assurances must be evident to the investor that: (a) the project will receive business-like management, (b) bond funds will be properly expended, (c) construction will be carefully inspected, (d) the plant and equipment will be properly maintained after the project is operational, (e) the rate structure or fee schedule is designed to keep the project self-supporting, and (f) adequate financial safeguards are met to assure the maintenance of adequate working capital and reserves.

Sources of Revenue

Sources of revenue in support of revenue bonds include: (1) user charges; (2) tolls, fees, and concession revenues; (3) special taxes derived from an additional levy on such items as tobacco, alcoholic beverages, and other goods and services considered semi-luxuries; (4) lease-back arrangements.

Industrial revenue bonds have issued (mostly in the South) to finance the construction of factories or other business facilities that are then leased to private business.

Covenants on Revenue Bonds

Rate covenant pledges the issuing body to fix rates, with revisions when necessary, sufficient to meet operation and maintenance charges, annual debt service requirements, and to provide for certain reserves.

Nondiscrimination covenant guarantees that charges will be equitable to all users.

The issuing body must covenant to maintain the properties in good repair and working condition.

Insurance must be carried on the facility corresponding in amount and in kind to that which is normally carried under private enterprise.

Revenues must be deposited in a special fund and kept separate from all other funds of the jurisdiction, and records and financial reports must be provided for annual audits by independent certified public accountants.

Consulting engineer must be placed on a retainer to perform certain "watchdog" duties over the operations of the facility.

Distribution of Revenues

Operation and maintenance costs, as set forth in the annual budget, have first claim on the reserve fund.

Bond service account constitutes an amount that, with other monthly payments, will be sufficient to pay the next semiannual interest payment, as well as the next maturing principal.

Debt service reserve funds are usually accumulated and maintained--in the case of serial bonds, equivalent to one year's maximum principal and interest requirements; in the case of term bonds, usually two years' interest.

Renewal and replacement funds are established to replace equipment or provide necessary repairs beyond normal maintenance.

Payments are made into a reserve maintenance fund to meet unusual or extraordinary maintenance charges that have not been budgeted.

Moneys remaining in the reserve fund after the foregoing distributions are made may be placed in the surplus fund, to be divided into various categories, such as: (1) redemption account used to retire bonds in advance of maturity; (2) payment in lieu of taxes; (3) other lawful payments including extensions of the facility, support of other bond interest, etc.

Issuance of Additional Bonds

Closed-end trust indentures do not permit the issuance of parity bonds other than those necessary to complete the project where initial financing proves insufficient.

Open-end indentures permit the issuance of additional bonds but provide a formula prescribing the conditions to be met.

Revenues generated by the proposed project must be sufficient to: (1) cover the cost of operations, maintenance, and debt service; (2) provide a comfortable margin of working capital; and (3) create a reserve fund for emergencies and to cover possible declines in income.

Revenue bond defaults can be traced to mistakes in planning and management such as:

(1) underestimation of operating costs or overestimation of anticipated revenues;

(2) failure safeguard revenues in accordance with the bond covenants;

(3) insufficient care in engineering studies;

(4) excessive expenditures for property acquisition;

(5) failure to allow sufficient time for project completion before bond payments begin to come due; or failure to adhere to appropriate state enabling legislation..

NEW FIDUCIARY AND FISCAL INSTRUMENTS

A number of new fiduciary and fiscal instruments have been devised to make bond yields more attractive to buyers.

Stepped Coupon Bonds

Stepped coupon bonds use a serial maturity schedule, with coupon rates that start at lower levels and progressively increase to higher levels.

o All stepped coupon bonds in the issue are sold at par.

o Stepped coupons give bondholders more paper money to keep pace with inflation.

Zero Coupon Bonds

Zero coupon bonds sell at substantial discounts from the customary face value of $1,000 because they pay no interest.

o By paying par upon maturity, zero coupon bonds offer capital gains as much as 25 times the original investment, depending on the length of the issue.

o Federal tax laws entitle bondholders who forego tax free income over the life of their investment to receive tax-exempt capital gains upon maturity.

Compound Interest Bonds

Compound interest bonds (also called capital appreciation bonds, accumulators, or municipal multipliers) return to the investor at maturity the principal plus interest compounded at a specified rate.

o Compound interest bonds sell at face value (par), unlike zero coupon bonds, which sell at a discount.

o The current rate of return is guaranteed for fifteen to twenty years, and therefore, an investor knows exactly what the total return will be.

Cost impact of compound interest bonds is deferred until more direct beneficiaries of the facility can participate in the payment of costs (e.g., through increased tax revenues).

o Impact of interested on "appreciated capital" can be partially absorbed if investments in a sinking fund are carefully managed.

o Capital appreciation bond can cost 2.5 times as much when compared to more conventional term bond.

Flexible Interest and Variable Rate Demand Bonds

A floating interest rate provide stability for both the issuer and the bondholder throughout the life of the bonds, particularly during times of interest rate volatility.

o The yield changes over the life of the bond, based on some interest index printed on the bond itself--most often used is the average weekly rate of Treasury bills or bonds issued during the preceding interest period.

o A swing limit provides a pre-established range within which the interest may vary.

Flexible interest bonds usually have call and/or put features, specifying the earliest dates at which the bondholder can get his/her money back at par.

Bondholders may elect either (1) to accept a new interest payment date at the same rate as the previous month, or (2) to tender the bonds for purchase at par.

The interest rate on variable rate demand bonds is reset periodically based on a specified index.

The most common variable rate demand bond is the "lower floater," in which the interest rate is adjusted weekly relative to a specified index.

Holders of lower floater bonds can require redemption of the bonds after seven-days notice.

The issuer usually enters into an agreement with a credit facility, typically a commercial bank which provides the debt issuer with a letter of credit.

o Should a bondholder exercise the put option before maturity, the issuer enlists the services of a remarketing agent who resets the interest rate and tries to remarket the bonds.

o If some bonds remain unsold, the issuer's remaining cash needs are met by the agreement with the credit facility, which either purchases the unsold bonds or makes a loan to the issuer.

Tender Option Bonds

The investor is offered the option of submitting the bond for redemption before maturity--usually five years after the date of issue or on any anniversary date thereafter.

o In return for this option, the issuer pays a lower rate of interest (usually about 1% less than for conventional bonds of the same maturity), lowering the jurisdiction's cost.

o A simultaneous call date provides the issuer and the bondholder equal rights to cash in the bonds when market conditions and interest rates are favorable.

Detachable Warrant Bonds

A warrant gives the holder the right to purchase more of the same securities to which the warrant is attached at the same price and rate of return as the original bond.

In exchange for that right, the issuer pays a lower rate of interest (about one-half percent less) than offered on otherwise comparable securities.

Private Activity Bonds

Private activity bonds are used either entirely or partially for private purposes and must meet the test of qualification outlined within federal tax law to obtain tax-exempt status.

To qualify, the debt must fit into one of the seven categories, meet volume cap requirements, and satisfy several other requirements outlined in section 147 of the federal statutes.

The 1986 Tax Reform Act placed substantial limitations on the use of private activity bonds, including restrictions on the amount of private activity debt issued within a state to the greater of either $50 per capita or $150 million.

The cap was put in place for all private activity bonds except for veterans mortgage bonds; qualified 501(c)(3) bonds; exempt facilities bonds for airports, docks and wharves; and 75 percent of high-speed intercity rail facilities.

Inflation Protection Bonds

Buyers of inflation protection bonds accept a lower stated rate of return in exchange for a guarantee that their buying power will not be diminished by inflation alone.

The principal amount of these so-called "bullet" instruments will be adjusted for inflation--as measured by the Consumer Price Index--while the interest rate remains fixed during the investment period.

Since the adjustment for inflation in the principal is subject to capital gains, an investor could face adverse tax consequences should inflation surge.

Lease-Purchase Financing

In a lease-purchase agreement, a government acquires an asset by making a series of lease payments considered to be installments toward the purchase of the asset.

o The government may obtain title to the asset either at the beginning or at the end of the lease term.

o The lessor often will assign the rights to the lease payments to a number of investors.

Certificates of participation (COPs) are a widely used type of lease-purchase financing mechanism, whereby individual investors purchase fractional interests in a particular lease.

o Certificates are generally issued in $5,000 denominations and can receive investment ratings from a rating agency.

o COPs can be traded in the secondary market, making them more marketable; issuers are able to obtain a lower interest rate on COPs than on other types of lease-purchase financing.

The non-appropriation clause of a lease-purchase agreement distinguishes it from general obligation tax-exempt debt.

Lease purchase financing avoids the commitment a large share of operating revenues to cash purchases of assets, preserves general obligation debt capacity, and avoids some of the referendum costs associated with general obligation bonds.

Under a master lease-purchase program individual lease purchases are consolidated into a single lease-purchase program in order to achieve lower interest rates, tighter controls, and lower administrative costs.

Tax-Exempt Leveraged Lease Financing (TELL)

Under TELL, a private investor buys a public building by making a down payment and, over a five-year period, contributing equity equal to 25 to 30 percent of the sales price.

o Tax-exempt revenue bonds issued by a qualified financing authority (e.g., an industrial development authority) are used to finance the balance of the sales price.

o The municipality then leases back the building on a long-term basis, with the lease serving as collateral for the loan which, in turn, secures the bond issue.

o The lease is written to provide the government with maximum flexibility and control over the use and final disposition of the building.

o The results are sharply reduced financing costs, a new pool of unrestricted funds for capital projects, and greater financial flexibility for borrowers.

More conventional approaches to financial capital facilities should not be abandoned unless public officials are satisfied that sufficient benefits will accrue compared to the risks.

The development of more innovative approaches stems from the willingness and ability of state and local governments to deal with the uncertainty of future markets for financing capital facilities.

Funding Capital Facilities as a Development Cost

Developers may be required to pay the infrastructure costs created by their developments.

The shift to private sector financing has been most pronounced in high-growth states, especially those faced with strict limitations on public bonding or taxes.

The recent trend has been to require developers to finance more and more of the "off-site" capital costs.

The courts have upheld off-site dedications that can be shown to be "reasonably related" to the public capital costs attributable to development.