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TYPES OF DEBT AVAILABLE FOR FINANCING WATER-SEWER PROJECTS IN NORTH CAROLINA Jack Vogt, UNC School of Government February, 2005 A. General obligation (GO) bonds 1. Security or collateral for GO bonds is the unlimited legal authority of the issuer to levy property taxes. If the issuer stops making payment on this type of debt, the unit is in default. The creditors or investors may bring suit and force the unit to levy taxes to repay the debt. 2. Periodic payment of interest and principal (debt service) on GO bonds may come from taxes or other sources, e.g., water-sewer system charges. 3. The voters must approve GO bonds 4. The Local Government Commission (LGC) must approve all GO bonds. GO bonds are generally sold by competitive bid. 5. GO bonds are retired over a term of up to 20 years, depending on the useful life of the project. A longer term is possible if Federal or state loans are involved 6. GO bonds have the lowest interest rates of any types of debt Once the voters approve GO bonds, they are the simplest and easiest to issue. 7. GO bonds continue to be major method of debt financing for N. C. local water-sewer infrastructure, e. g., Cary B. Installment or lease-purchase (security interest) debt authorized by G.S. 160- 20 in N. C. The N. C. Supreme Court ruled that local government use of such debt is constitutional in Wayne County Citizens v. Wayne County Bd. of Commissioners 328 N. C. 24, 399 S. E. 2d 311 (1991). 1. Security or collateral for installment or lease-purchase debt is the property being financed and/or other property. If the issuer stops making payments on such debt, creditors may seize the property and attempt to satisfy the debt they are owed by sale or use of the property. The creditors may not obtain a judgment requiring the issuer to levy taxes to pay the debt. 2. Debt service may be paid from any revenue source, including taxes levied by the issuing unit that is not otherwise restricted by law. Capital Finance 122 3. The voters do not have to approve lease- or installment-purchase debt, because taxing power is not pledged to secure the debt. 4. The Local Government Commission must approve lease- or installment purchase debt involving the construction or repair of real property, or the acquisition of personal property if the debt is outstanding for five years or more and requires payments over the life of the debt that exceed 1/10 of 1% of its tax value or $500,000, whichever is less. 5. Lease- or installment purchase debt is issued in two general forms a) Simple lease- or installment purchase debt for equipment or for buildings that are modest in size. b) Certificates of participation (COPs) issued for major projects. The financing is divided into shares or certificates that are sold to investors. COPs are typically placed initially in a negotiated process with an investment banking firm that then re-sells the COPs to the public. Break even point is currently about $10 million. 8. Simple lease- or installment purchase debt is often the most economical method of financing equipment acquisitions. COPs for major projects generally carry higher interest rates than GO debt. 9. Local governments have commonly used simple lease- or installment purchase debt for many years. Cities and counties in North Carolina have increased their use of COPs since the Supreme Court decision in 1991. 10. Brevard County, Florida and Richmond School District cases C. Revenue bonds 1. The security or collateral for revenue bonds is the net earnings of a self- supporting utility or enterprise, e.g., a water-sewer system. Coverage is an important concept in revenue secured debt--investors typically require that net earnings cover maximum annual debt service by some coverage ratio: 125% for water, 130% or more for riskier enterprises. 2. The debt service for revenue bonds is paid from utility or enterprise system revenues. 3. Voter approval is not required for revenue bonds, because taxing authority or power is not pledged as security for the bonds. Capital Finance 123 4. The Local Government Commission must approve the issuance of and sell revenue bonds The bonds are placed initially in a negotiated process with an investment banking syndicate that then re-sells the bonds to the public. 5. Revenue bonds can be issued over terms that are longer than 20 years. 6. Revenue bonds have higher interest rates, much higher issuance costs, and are much more complex debt instruments than GO bonds. Revenue bonds usually require reserve funds for debt service and certain other purposes. 7. In the past, revenue bonds were not widely used by cities and counties in North Carolina. However, this is changing, as more and more cities are issuing revenue bonds for utility system improvements. Revenue bonds have been much more extensively used in other parts of the country. D. Special obligation (SO) bonds may be issued to finance solid waste management and water-sewer projects. 1. The security or collateral for SO bonds is one or more revenue sources other than taxes levied by the unit issuing the bonds. For instance, SO bonds issued by a city may be secured by sales tax revenue, utility system revenue, or state shared revenues. 2. Debt service on SO bonds may be paid from any revenue source, including taxes levied by the issuing unit, that are not otherwise restricted by law. 3. Voters do not have to approve SO bonds. Taxing authority or power is not pledged 4. The Local Government Commission must approve SO bonds and sells the bonds in North Carolina. The bonds are typically placed via a negotiated process. 5. SO bonds have term or maturity structures related to the useful lives of the facilities being financed with the bonds. Such terms generally do not exceed 20 years. 6. Interest rates for SO bonds are higher than for GO bonds. SO bonds tend to be complex debt instruments. 7. SO bonds are used selectively by local governments for solid waste projects. 8. Illustrations: Fayetteville, Arkansas and Junction City Kansas. Capital Finance 124 E. Tax increment bonds. In N. C., also called project development or self-financing bonds. A city or county establishes a tax increment district and issue bonds to build public facilities and infrastructure needed to support private development within district. Growth in property tax valuation occurring after district is formed secures and pays debt service on the tax increment bonds. Other revenues from within the district may be pledged to secure and pay debt service on the bonds. Used widely in Midwestern states and many southern states (S. Carolina). Approved for N. C. by voters in a constitutional amendment in November, 2004. In N. C., LGC must approve all tax increment bonds. F. Variable rate demand debt (VRDD) and interest rates swaps 1. Debt that is issued to finance a capital project that has a long-term, e. g., 20 years, but for which interest rate resets or is subject to resetting weekly or month based on changes in interest rate index in market 2. VRDD takes advantage of the “normal yield curve” for interest rates. Normally, interest rates on long term debt are lower than on long-term debt. There is more risk associated with longer term debt. 3. VRDD must be accompanied by liquidity support and a remarketing agent. 3. Disadvantage for local issuer of VRDD. Issuer assumes risk associated with changes in interest rate. Yield curve can invert; short term rates sometimes rise above long-term rates. 4. Because of risk, LGC recommends that only AA rated local governments use VRDD and that such debt not exceed 20 % of issuer’s debt portfolio. 5. An interest rate swap allows an issuer to swap its obligation to make interest payments on its variable rate debt into an obligation to make payments on a “synthetic” fixed rate debt. The converse can also be done.
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