What is Underlying Debt?
Underlying debt is a term in municipal bonds that refers to an implicit agreement that smaller governmental entities may leverage the creditworthiness of larger governing bodies within the same jurisdiction. This often occurs without explicit legal agreements but through an understanding that higher-level entities will support the smaller ones if financial trouble arises.
Key Takeaways
- Underlying debt relates to an agreement where larger government bodies back the debt of smaller entities within the jurisdiction.
- This concept is most commonly applied to general obligation municipal bonds.
- Financial troubles in smaller entities can adversely affect the credit ratings of the larger supporting entities.
Deep Dive into Underlying Debt
Small entities often struggle to raise funds due to a weaker financial standing. The implicit support from larger government bodies can greatly enhance their borrowing abilities, often resulting in lower interest rates. This scenario is usual in smaller municipalities with limited taxing power, and they depend heavily on the perceived backing of larger city or state governments for issuing bonds to fund essential services and infrastructure projects.
In practice, when smaller entities like school districts or towns face financial hardships, higher-level government bodies typically step in to prevent insolvency. This support maintains continuous operation and essential services, reinforcing the idea of underlying debt, where citizens and investors consider municipal bonds as implicitly backed by stronger financial center entities.
Underlying debt primarily affects general obligation municipal bonds. These bonds rely on the issuer’s ability to impose taxes. When underlying debt plays a role, this might extend to the larger government’s taxing power. Credit rating agencies, such as Standard & Poor’s and Moody’s, account for these dynamics when assigning ratings, reflecting both the standalone financial conditions of the smaller issuers and the implicit backing by larger entities.
The considerations also affect ratings for the larger municipal issuers. These agencies evaluate their capacity to fulfill all financial obligations, including those debts they implicitly support. Struggles in the smaller entities’ obligations can thus impact the ratings of these larger entities.
Examples and Associated Risks
In diverse regions, like Illinois, separate jurisdictions within a city or county might issue debt to fund various public projects such as roads, schools, and public health facilities. Frequently, the broader-state or city tax authority carries these bonds as underlying debt.
A historical example is the situation in New York State in the 1970s when New York City’s looming insolvency pressured the state due to its underlying support for the city’s debt. This event highlighted the significant risks that large entities face when their other smaller jurisdictions struggle financially.
Investors must thoroughly understand which entities are involved in the underlying debt agreements and assess both potential benefits and risks these arrangements introduce.
Related Terms: municipal bond, general obligation bond, credit enhancement.
References
- Standard & Poor’s. “S&P Global Ratings Definitions”.
- Moody’s. “Moody’s Investors Service Products”.
- Federal Deposit Insurance Corporation. “The 1970’s”.
