Bond Financing?
April 8, 2022 10:57 AM Subscribe
Can someone explain how cities or states deal with bonds when they reach maturity? I get that issuing the bond allows a city to get a lot of cash up front for a project, but if the entire principal is due at the end of the bond how is this helpful?
Specifically why is having a large expense in the future + paying a bunch of interest better than just paying now assuming the city is not growing its tax base? Is the idea that inflation will make paying off the principal less painful? Or do cities start setting aside tax revenue to pay back the principal when they issue the bond?
It just seems like if a state like California is always issuing new bonds for things it must also be constantly paying back old bonds and wouldn't it make more sense to just stop this cycle and not pay the financing costs?
Specifically why is having a large expense in the future + paying a bunch of interest better than just paying now assuming the city is not growing its tax base? Is the idea that inflation will make paying off the principal less painful? Or do cities start setting aside tax revenue to pay back the principal when they issue the bond?
It just seems like if a state like California is always issuing new bonds for things it must also be constantly paying back old bonds and wouldn't it make more sense to just stop this cycle and not pay the financing costs?
Generally, cities or states issuing bonds are borrowing against future tax revenues. The current cash on hand or the current year's tax revenues may not be enough to pay for major expenditures like infrastructure improvements - i.e., they can't "just pay now" out of cash, so they borrow against future revenue. That's the same reason people borrow money - most people can't buy a house with current cash/current income, but they can buy a house by taking out a mortgage and paying it off with future income.
As far as what happens when bonds reach maturity - the city/state pays the bond off, either by paying the bond with tax revenue and/or by raising money through a new bond offering and rolling over the debt.
posted by Mid at 11:21 AM on April 8, 2022 [2 favorites]
As far as what happens when bonds reach maturity - the city/state pays the bond off, either by paying the bond with tax revenue and/or by raising money through a new bond offering and rolling over the debt.
posted by Mid at 11:21 AM on April 8, 2022 [2 favorites]
Best answer: Cities/states don't issue massive "spikes" of bonds - they deliberately spread bond issuance out over time so that bond maturity is more or less constant over time. As a result, paying off the bonds becomes more or less the same as paying off interest, and can be accounted for in the budget of the town. If there are cash-flow problems for a particular period, cities/states are also not necessarily obligated to increase taxes or issue new bonds - increasingly, cities/states are going to private lenders, or the federal government, for additional short term funding sources, which may have different terms. It's also fairly common for cities/states to have lines of credit that can be paid down slowly over time to account for short term funding gaps.
The broader question you're asking about why bonds are issued is more of an economics and political question. Cities borrow money so that they can add value to their cities. Money is borrowed to add assets to the cities - roads, bridges, buildings, schools, etc. Such a city brings more value to its residents, and hence, can demand additional taxes from its residents (and presumably more residents) without those residents getting upset and leaving the city in favor of other cities that don't overtax them. However, until those assets are built, the value isn't present in the city. Without bonds, taxpayers would have to pay taxes now for value in the future. With bonds, taxes pay taxes later for value in the future. For the vast majority of taxpayers, the latter option is much more appealing. So long as the city is able to add value at a rate that exceeds the interest paid on the bond, the bond is actually economically and politically advantageous to the city.
Of course, that doesn't always happen, which is why some cities lose residents and lending credibility by borrowing money that doesn't add value to residents - but that's the challenge of city management.
posted by saeculorum at 11:25 AM on April 8, 2022 [4 favorites]
The broader question you're asking about why bonds are issued is more of an economics and political question. Cities borrow money so that they can add value to their cities. Money is borrowed to add assets to the cities - roads, bridges, buildings, schools, etc. Such a city brings more value to its residents, and hence, can demand additional taxes from its residents (and presumably more residents) without those residents getting upset and leaving the city in favor of other cities that don't overtax them. However, until those assets are built, the value isn't present in the city. Without bonds, taxpayers would have to pay taxes now for value in the future. With bonds, taxes pay taxes later for value in the future. For the vast majority of taxpayers, the latter option is much more appealing. So long as the city is able to add value at a rate that exceeds the interest paid on the bond, the bond is actually economically and politically advantageous to the city.
Of course, that doesn't always happen, which is why some cities lose residents and lending credibility by borrowing money that doesn't add value to residents - but that's the challenge of city management.
posted by saeculorum at 11:25 AM on April 8, 2022 [4 favorites]
The financing costs aren't very high (2-5%), compared to the upfront costs. And they are paid back month to month (or year to year), like a mortgage. You could ask the same about mortgages and the answer is the same - they don't have the money. Most city bond packages are around $1billion dollars now, which is far more cash on hand that most cities have.
You might ask why cities can't just save a bunch of money and then pay $1b for the bond package later, but there are often municipal laws which prevent that, and even if there aren't politicians roll in and out every 2-4 years, so financial priorities can change, and the politician that delivers the pool vs the one who says "pay your taxes for the next 10 years, and then we'll get a city pool" is voted out.
Here is the financials of a CA city I'm aware of: 2020 debt service is $6.8m worth of interest payments on $538m of long-term debt. (if I'm reading correctly). Yearly revenues are only $270m, of which the vast majority is allocated on current expenditures.
Huntington Beach CA financial report
posted by The_Vegetables at 11:33 AM on April 8, 2022 [3 favorites]
You might ask why cities can't just save a bunch of money and then pay $1b for the bond package later, but there are often municipal laws which prevent that, and even if there aren't politicians roll in and out every 2-4 years, so financial priorities can change, and the politician that delivers the pool vs the one who says "pay your taxes for the next 10 years, and then we'll get a city pool" is voted out.
Here is the financials of a CA city I'm aware of: 2020 debt service is $6.8m worth of interest payments on $538m of long-term debt. (if I'm reading correctly). Yearly revenues are only $270m, of which the vast majority is allocated on current expenditures.
Huntington Beach CA financial report
posted by The_Vegetables at 11:33 AM on April 8, 2022 [3 favorites]
And they are paid back month to month (or year to year), like a mortgage.
Municipal bonds, like the vast majority of bonds, are non-amortizing - ie, they are interest-only loans for the entire term of the loan. No principal is paid back at all until the entire loan is paid off as a lump sum at the maturity of the bond (or sometimes municipal bonds are "called" by the issuer and paid back in its entirety earlier than maturity).
Mortgages are amortizing, even if the first few years are interest-only. So no, bonds are not paid back like mortgages.
posted by saeculorum at 11:38 AM on April 8, 2022 [1 favorite]
Municipal bonds, like the vast majority of bonds, are non-amortizing - ie, they are interest-only loans for the entire term of the loan. No principal is paid back at all until the entire loan is paid off as a lump sum at the maturity of the bond (or sometimes municipal bonds are "called" by the issuer and paid back in its entirety earlier than maturity).
Mortgages are amortizing, even if the first few years are interest-only. So no, bonds are not paid back like mortgages.
posted by saeculorum at 11:38 AM on April 8, 2022 [1 favorite]
A better question to ask is, why do governments issue bonds instead of raising more revenue through taxes? And the answer is, they shouldn't, because bonds benefit rich private citizens, not the public. Reading Piketty's Capital will clear up a lot of these bigger questions for you.
posted by shadygrove at 11:57 AM on April 8, 2022
posted by shadygrove at 11:57 AM on April 8, 2022
Best answer: Typically a bond re-issue will be proposed if a significant issue is coming due at once. Since there is never a generation where both the government and the public wants to move to paying for new buildings etc. out of cash reserves, the cycle never stops.
posted by michaelh at 1:38 PM on April 8, 2022
posted by michaelh at 1:38 PM on April 8, 2022
why do governments issue bonds instead of raising more revenue through taxes?
Issuing bonds does not reduce the need to raise revenue, it just defers it. That's not always a good decision, but there are times when it clearly makes sense. For example, if a town anticipates a large influx of young families and needs to build a new school, it would generally be infeasible to raise enough revenue to pay for the building. But if they issue a bond to pay for the school, then they can repay it with higher taxes over the coming decades, while the school is in use, paid in part by the new families.
posted by Mr.Know-it-some at 5:52 AM on April 9, 2022
Issuing bonds does not reduce the need to raise revenue, it just defers it. That's not always a good decision, but there are times when it clearly makes sense. For example, if a town anticipates a large influx of young families and needs to build a new school, it would generally be infeasible to raise enough revenue to pay for the building. But if they issue a bond to pay for the school, then they can repay it with higher taxes over the coming decades, while the school is in use, paid in part by the new families.
posted by Mr.Know-it-some at 5:52 AM on April 9, 2022
wouldn't it make more sense to just stop this cycle and not pay the financing costs?
Here's what happens when a town pays cash: https://www.governing.com/archive/gov-crystal-minnesota-libertarians.html
posted by Former Congressional Representative Lenny Lemming at 6:55 AM on April 9, 2022 [1 favorite]
Here's what happens when a town pays cash: https://www.governing.com/archive/gov-crystal-minnesota-libertarians.html
posted by Former Congressional Representative Lenny Lemming at 6:55 AM on April 9, 2022 [1 favorite]
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posted by Rash at 11:17 AM on April 8, 2022 [1 favorite]