Municipal Credit Analysis

General Obligation Bond Credit Analysis

Credit analysis for municipal bonds involves evaluating the likelihood that the issuer will make timely payments of principal and interest. The approach differs significantly depending on whether the bond is a general obligation bond or a revenue bond, because the security and repayment sources are fundamentally different. For the Series 52 exam, you must understand the key factors analysts examine for each type.

For general obligation bonds, credit analysis focuses on the issuer's overall economic health, fiscal management, and debt burden. Since GO bonds are backed by the taxing power of the issuer, the analysis centers on the strength and stability of the tax base and the issuer's ability and willingness to levy sufficient taxes to meet its obligations.

Economic and Demographic Factors

The economic base of a municipality is the foundation of its creditworthiness. Analysts evaluate several interconnected factors that determine the health and trajectory of the local economy:

• Population Size and Trends: A growing population suggests economic vitality and an expanding tax base. Population decline signals potential economic distress, loss of employment opportunities, and a shrinking base of taxpayers to support debt obligations. Analysts look at both historical trends and population projections.
• Income Levels: Per capita income and median household income indicate the wealth of residents and their ability to bear tax burdens. Higher income levels generally correlate with higher property values and greater tax-paying capacity.
• Employment Diversity: A community that depends on a single employer or industry is more vulnerable to economic shocks. Diversification across multiple industries reduces risk. Analysts examine the top employers, the percentage of the workforce employed by the largest employer, and the range of industries represented.
• Property Values: Since local GO bonds are typically backed by property taxes, the total assessed value of taxable property is a critical measure. Analysts track both the total assessed valuation and the trend over time. Rising property values expand the tax base, while declining values shrink it.
• Building Permits and Construction Activity: New construction activity indicates economic growth and will expand the tax base as new properties are assessed. Declining construction activity may signal a weakening economy.

Key Debt Ratios

Analysts use several ratios to evaluate the debt burden of a municipality relative to its economic base. These ratios provide a standardized way to compare issuers of different sizes and to assess whether a municipality's debt level is sustainable:

Overlapping Debt

Overlapping debt is one of the most important and commonly tested concepts in municipal credit analysis. It refers to the total debt burden that is shared by taxpayers within a jurisdiction due to multiple governmental entities levying taxes on the same properties. For example, a homeowner may pay property taxes to the city, the county, and the school district. Each of these entities may have outstanding GO debt.

When analyzing a city's credit, analysts must consider not only the city's own direct debt but also its proportionate share of the debt of all overlapping jurisdictions. The calculation involves determining what percentage of each overlapping jurisdiction's tax base falls within the city's boundaries and allocating that proportion of the overlapping entity's debt to the city.

Revenue Bond Credit Analysis

Revenue bond credit analysis focuses on the specific project or enterprise whose revenues secure the bonds. Unlike GO bond analysis, which examines the broad economic base and taxing power, revenue bond analysis is project-specific and centers on the adequacy and reliability of the revenue stream.

Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) is the single most important metric in revenue bond analysis. It measures the ratio of available net revenue to annual debt service requirements. A DSCR of 1.0x means that net revenues are just barely sufficient to cover debt service, leaving no margin of safety. Most revenue bond covenants require a minimum DSCR, commonly 1.20x to 1.50x, meaning net revenues must exceed debt service by 20% to 50%.

The formula is: DSCR = Net Revenue / Annual Debt Service, where Net Revenue = Gross Revenue minus Operating and Maintenance Expenses, and Annual Debt Service = Principal + Interest payments for the year.

Feasibility Studies

For new projects that have no operating history, a feasibility study by an independent consultant is a critical component of the credit analysis. The feasibility study projects future demand for the project's services, estimates revenues and expenses, and evaluates whether the project will generate sufficient revenue to cover operating costs and debt service. Key elements of a feasibility study include:

• Demand Analysis: Projections of how many users the facility will attract, based on demographic trends, economic conditions, and competition.
• Revenue Projections: Estimated user fees, tolls, or charges based on demand projections and pricing assumptions.
• Expense Projections: Estimated operating and maintenance costs, including staffing, utilities, insurance, and capital maintenance.
• Sensitivity Analysis: Testing how the project's financial performance would be affected by changes in key assumptions, such as lower-than-expected demand or higher-than-expected costs.
• Comparable Analysis: Comparison with similar projects in other locations to validate assumptions.

Additional Revenue Bond Factors

Beyond the DSCR and feasibility study, analysts consider numerous other factors when evaluating revenue bonds:

• Rate Covenant Compliance: Is the issuer meeting its commitment to set rates sufficient to cover costs and debt service? Has the issuer had to raise rates significantly, and do users have alternatives?
• Additional Bonds Test: How restrictive is the additional bonds test? Could the issuance of additional debt dilute coverage for existing bondholders?
• Reserve Fund Adequacy: Is the debt service reserve fund fully funded? The reserve typically holds an amount equal to one year's maximum annual debt service.
• Management Quality: Does the project have experienced, competent management? Has there been significant turnover in key positions?
• Essentiality of Service: Projects providing essential services (water, sewer, electricity) generally have more reliable demand than those providing discretionary services (stadiums, convention centers).

Credit Events, Downgrades, and Defaults

While municipal bond defaults are relatively rare compared to corporate bonds, they do occur, and credit deterioration is more common. Understanding the factors that lead to credit problems is important for Series 52 candidates.

Warning Signs of Credit Deterioration

• Declining Population and Employment: Loss of major employers or sustained population decline reduces the tax base and economic vitality.
• Budget Deficits: Persistent operating deficits suggest the issuer is spending beyond its means and may have difficulty meeting debt obligations.
• Fund Balance Depletion: Drawing down reserves to cover operating expenses is a red flag that indicates financial distress.
• Deferred Maintenance: Failure to maintain infrastructure suggests the issuer is cutting costs in ways that may lead to larger problems in the future.
• Pension Obligations: Large unfunded pension liabilities represent a significant claim on future revenues and can strain budgets.
• Reliance on One-Time Revenues: Using asset sales, legal settlements, or other non-recurring revenues to balance the budget masks structural problems.

Continuing Disclosure

SEC Rule 15c2-12 requires issuers of municipal bonds (for offerings over $1 million) to enter into continuing disclosure agreements. These agreements require the issuer to provide annual financial information and timely notice of certain events, including rating changes, payment defaults, defeasances, and adverse tax opinions. This information must be filed on EMMA and helps investors monitor the ongoing credit quality of their holdings.