FINANCING III

DEAL STRUCTURE/TERMS

When and how will the bonds be repaid?  What security will be provided to bondholders?

Once sources of capital and revenue have been identified, the issuer and underwriter develop a detailed plan for how the bonds will be sold, repaid and secured.  The goal is to craft a plan that is both attractive to investors and affordable for the issuer.  Among the items in the plan are: the timing and amount of debt service payments; the interest rate and date when the bonds mature (yield, term); whether and when bonds can be paid off early at the option of the bondholder (early redemption); and the security interest bondholders will have in the property and/or revenue sources earmarked for bond repayment.

RECOMMENDATION: Examine repayment schedule and security provisions to determine how they might impact the project and community

In terms of repayment, it is important that the terms of the bond not extend beyond the useful life of the project, leaving the community with a broken-down, debt-ridden facility down the road.  The level of debt service over the life of the bonds should also be examined to make sure that high levels of debt service are not back-loaded onto later years.

In terms of the security provisions, residents should examine the rights of bondholders in the event of a default.  If bonds are backed by a project’s assets, a default will almost certainly result in the community losing control of the project to bondholders, who will try to sell or operate it as they see fit.  There is no guarantee that any agreements made concerning project operation will be honored by the new owners, who will seek to recover as much of their original investment as possible. Further, some issuers seek lower interest rates by using separate assets to secure the bonds.  If revenues are insufficient, however, the issuer must either make up the difference with its own funds or lose control of the assets in question.

Example: Reeves County, Texas, successfully operated a 2,000-bed detention center for several years before deciding to finance the construction of an additional 1,000 beds.  In order to obtain bond insurance and a favorable rating, the county gave bondholders a security interest in the existing facilities.  When expected contracts for the new beds failed to materialize, however, the county faced the prospect of losing control not only over the new beds but also over the entire complex.  The complex was only saved by turning over operations to a private prison company and its future remains in doubt.
 

Will the bonds be rated? Will they be insured in the event of a default?

In order to attract investment and obtain the lowest possible interest rates, the investment banker and issuer will generally attempt to secure a favorable rating from one or more agencies that rate municipal bonds (S & P, Moody’s, Fitch, etc.).  The process for obtaining a rating begins with conversations between the investment bankers and rating agency analysts in which the bankers pitch the deal and the analysts give feedback on the likelihood of a favorable rating and what factors they think would weigh positively or negatively in the final determination. 

If analysts indicate that an issue is unlikely to secure an investment-grade rating (or a stronger target rating for a well-established bond issuer), the investment bankers and issuer may restructure the deal, seek better ratings from other agencies or (if neither of the first two alternatives is feasible) forego a rating altogether.  When meeting with rating agencies, the investment banker seeks information on steps that could be taken to strengthen the case for a favorable rating, which might include securing credit enhancements (i.e., bond insurance), pledging a backup source of revenue or giving bondholders a lien on assets.

The most common step taken to improve a bond rating and attract investors is securing bond insurance, which generally guarantees full payment of principal and interest in the event of a default by the issuer.  The leading “triple-A” bond insurers have very little appetite for risk and will not offer insurance unless the risk of default is considered very small; however, there are bond insurers such as American Capital Access willing to provide “single-A” insurance for riskier projects.  Like rating agency analysts, bond insurance analysts must be persuaded by the investment banker and issuer to provide bond insurance at a price the issuer can afford.

RECOMMENDATION: Communicate with rating agencies and bond insurers and make sure they have all relevant information concerning the proposed issue

While rating agency and bond insurance analysts often have specialized knowledge of types of projects (e.g., water and sewer) and/or geographic regions (e.g., the northeastern U.S.), and access to extensive information on the performance of bonds issued by the issuer and others in the area, they may depend heavily on the issuer and investment banker to provide specific information on the project to be financed.  Since both issuer and investment banker have an interest in making the project look as creditworthy as possible, their presentations to the analysts may not include or fully explore all of the potential risks.

However, if a deal goes bad, it may be local communities that suffer the most, so officials and community residents that have concerns about a project can contact leading rating agencies and bond insurers to find out whether their concerns are warranted.  They can also provide information to the agencies or insurers that may not have been included in the pitch. Neither rating nor insurance analysts are accustomed to dealing with community groups, but if the information is new, solid and relevant to their concerns, it will probably be taken seriously.