Articles

Understand and Manage Government Debt: An Introduction

US Capitol at night image

Governmental entities making major investments in infrastructure such as roads and bridges, new facilities, transportation systems and utilities often do not have cash on hand to pay for these sometimes multi-million dollar investments and must rely on borrowing to fund these critical projects. Before issuing debt for such projects, it’s often helpful to rely on a checklist of factors to consider for the best results in a bond issuance.

Is this project in your capital budget?

  • If yes, your planning might just be paying off. You and your staff have likely done a good job of anticipating major expenditures – allowing you to also try to avoid multiple major projects at the same time, which could cause cash flow issues.
  • If no, why? Is it an emergent and unforeseen event that is causing a sudden need for capital expenditures? Was this a situation where elected officials may feel pressured to respond to public needs or demands? Unexpected capital expenses do occur, but if they occur regularly, you may need to reassess your capital improvement planning process, conduct budget education with your elected officials, or otherwise seek to determine why the project was not already in your plans.

Where will the money to repay the debt come from?

  • If cash on hand will be sufficient to cover debt payments, should you consider whether you borrow at all, or look at shorter-term options?
  • If all general revenues could be used, your lending source might be considered a general obligation (GO) bond and highly creditworthy.
  • If revenues from utilities or a specific source will be used, the bonds might be considered a revenue bond. Revenue bonds typically are evaluated on a different scale than a GO bond, and come with a credit evaluation and interest rate different than that of a GO bond.
  • Other revenue sources, such as non-essential services or leases, may receive (if any) lower credit ratings from lenders if their projected revenue stream is less steady and predictable – and your cost of borrowing might rise. Even a fraction of a percentage point over the life of a loan can mean significant cost savings or additional expense.

Does the debt under consideration fall within your debt policy limits for issuing bonds?

  • If yes, you can sometimes avoid the time-consuming process of elected official review and approval if you’re simply working within standard policies for your entity. This may allow you to act more quickly to borrow, capture advantageous market conditions, and get the project started sooner.
  • If no, you undoubtedly recognize that your electeds will require additional justification for working outside policy guidelines, and you run the risk of having the project rejected altogether. In this situation, you may need to consider options such as breaking the project into smaller phases, looking for shorter-term options, or potentially reformulating the project as a public-private partnership if that option exists. Additionally, if your debt policy limits are outdated or need another look, this may be the time to act on that review.
  • If “What debt policy?” was your answer, can we talk? As background, I’ll offer this (brief) white paper on why governments need fiscal policies. In a nutshell, every governmental entity should have policies in place that reflect the level of risk and debt the entity is comfortable in managing. That allows more efficient and consistent decision-making, better risk management, and empowers finance professionals to move ahead on projects while knowing that they are within preapproved limits for taking on debt.

    While every governmental entity should tailor its debt policy to its own needs, the following factors are a few of the many that should be considered for inclusion in the policy:
    • What is the total ceiling on debt the entity can borrow (debt capacity)? This may be tied to the government’s total revenues in a specific ratio than cannot be exceeded.
    • When can debt be considered as a tool to fund projects?
    • What types of debt is the entity willing to use, and what are the individual limits on each type of debt? (for example, general obligation, essential services, etc.)
    • What types of debt are prohibited from use by the entity? (for example, some entities do not allow the use of derivatives).
    • What legal restrictions are in place based on your entity’s state and local laws and other regulatory requirements?
    • What is our established process for issuing bonds? Does that process differ for different types of bonds?
      • Do we hire a financial advisor?
      • Do we pay for a bond rating agency?
      • Do we engage an underwriter through a competitive or negotiated sale?
      • Do we use credit enhancement?
    • What monitoring ratios will we use to evaluate use of debt?

For more information about developing your entity’s policy if one is not already in place, see the Government Finance Officers Association best practices for a debt management policy online.

Have we done everything we can to get the most competitive interest rate for our bond issue?

Similar to how an individual’s loan rate will vary based on his or her credit ratings and income level, a governmental entity’s bond rating will vary based on several critical factors:

  • Projected revenue stream
    • Is the revenue stream you’ll use to repay the debt predictable, sizable in comparison to the debt obligations, and ideally, growing?
  • Demographics
    • Is your entity’s population and income level on the rise, or waning? An entity seeing a population boom and with strong economic development and entrepreneurial tendencies over time will tend to see better bond ratings and interest rates.
  • History of good financial management
    • Do you have emergency reserves? Do you get a clean audit annually, or is your management letter filled with major suggested changes? Does your entity receive the GFOA Certificate of Excellence in Financial Reporting and always issue its financial reports on time? That kind of proof of strong financial management demonstrates attention to financial controls.

Summary

Managing debt in the public sector, just as for an individual, is a vital process that can be complicated – but it also allows critically important projects that serve the entity’s citizens and community to become reality. A government that doesn’t invest in good roads, a robust and effective water and storm sewer system, and civic infrastructure may reduce its debt – but at the cost of keeping its community vibrant and growing.

If you'd like further information, we encourage you to contact Mike Lowry using the information below.

 

Mike Lowry, CGFM

Senior Vice President
Assurance/Public Sector Team Leader

Mike Lowry specializes in governmental and not-for-profit clients. Prior to joining AGH, Mike’s experience included nearly 20 years of financial and technology leadership positions in hospitality management and software companies. He is a certified public accountant who has earned the designation of Certified Government Financial Manager from the Association of Government Accountants, and he is also a member of the American Institute of CPAs, the Kansas Society of Certified Public Accountants, and the Association of Government Accountants. He is a frequent presenter and member of the Kansas, Missouri, and Great Plains Financial Officers Association, and serves as a CAFR reviewer for the GFOA.