Understanding How Bonding Works
Long-term borrowing through the issuance of bonds is often viewed as an equitable way to spread out the burden of paying for long-term capital projects such as the acquisition of buildings or land, and construction or improvements of capital facilities that will be enjoyed by future residents. Capital expenditures, including land acquisition, generally have an expected useful life of twenty years or more, although the terms of any bonds must be within the periods authorized by the General Statutes. Bond authorizations are adopted by resolutions of the Town Meeting.
What is a Bond?
A bond is an interest-bearing certificate of debt representing the obligation of the Town to repay a certain sum by a specific date. A bond is simply a loan with different terminology: The issuer is equivalent to the borrower, the bond holder to the lender, and the coupon to the interest. Interest rates are generally fixed for the term and each annual principal payment will bear its own interest rate.
The most important features of a bond are:
- Principal - the amount on which the issuer pays interest, and which has to be repaid in annual payments, or upon final maturity, depending on whether the bonds are serial or term bonds.
- Maturity Date - the date on which the issuer has to repay the nominal amount. As long as all payments have been made, the issuer has no more obligations to the bond holders after the maturity date. The length of time until the maturity date is often referred to as the term or tenor or maturity of a bond.
- Coupon - the interest rate the issuer pays to the bond holders.
- Coupon Date - the interest payment date.
What Types of Bonds are Used?
The two most common types of municipal bonds are:
General obligation bonds are backed by the full faith and credit (i.e. the taxing power) of the issuer. Because of this, they are the least expensive form of credit available to governments because the issuing government is obligated to raise taxes or to take whatever action is necessary to ensure payment.
Revenue Bonds are secured by the revenues of the improvement or facility being financed by the bonds. To enhance marketability of these bonds, the issuer will sometimes provide a “full faith and credit” pledge if the facility revenues are insufficient to pay debt service.
What is the Debt Service?
The debt service consists of principal and interest payments on bonds and interest on bond anticipation notes. For a typical general obligation bond principal is paid annually and interest is paid semiannually.
An important factor influencing the cost of municipal bonding is a town's bond rating. One or more of the credit rating agencies assigns a bond rating to municipal bond issuers that reflects the rating agencies’ level of confidence in their ability to pay back the debt. Ratings are alpha-numeric, the highest being AAA. The higher the bond rating, the lower the relative interest rate and the higher the ratio of money available for capital expenditure rather than for servicing the debt.