With all the talk of government debt recently — Toronto, $4.7 billion; Ontario, $240 billion; the U.S., $14.6 trillion — the spectacular figures and the concept of debt itself have become so abstract many people don’t even understand the conversation.Sure, costs might have to be cut at some point, but what does it really mean when a city carries debt? When is debt good or bad, who holds the debt, how does debt affect a city’s credit rating, and what happens if there’s a default?
The Star spoke with Dr. Enid Slack, director of the University of Toronto’s Institute on Municipal Finance and Governance, Ryerson urban planning professor and municipal finance expert David Amborski and senior staff in the City of Toronto’s finance department to answer the ABC’s of how municipal debt works.
Why do cities take on debt?
Mainly to spread capital costs out over a period of time. (In Ontario, legislation forbids municipalities from taking on debt for operating costs, such as salaries, though provincial and federal governments may do so.) This is called “matching”: by issuing a bond or debenture guaranteeing the loan will be paid back with a set interest amount, the government borrows over the length of an asset’s life so costs are paid by all the people who will use it. This prevents severe spikes in property taxes or user fees that would be needed to pay costs over a short period of time without borrowing. Cities also borrow for projects if there is not enough capital available. Most project costs involve a combination of debt, provincial and/or federal grants, funds from city reserves, user fees that include future project financing and sometimes revenues from property tax increases.
Are GTA cities currently at high debt levels, compared with historic levels?
No. Toronto, for example, under legislation cannot have debt costs (interest and principal payments on its overall debt obligations) that amount to more than 15 per cent of the property tax bill. Roughly 11 per cent of the tax bill currently goes to making payments on the debt. However, Toronto will reach its limit in less than three years. The rate was at about 7.5 per cent of the tax bill in 1998. Today, less than 5 per cent of the city’s current gross operating budget (which includes salaries, fuel costs and a small portion of capital costs) goes toward debt payments.
Is borrowing good fiscal policy?
Yes. Rates right now are historically low (the yield on some Canadian municipal bonds has been less than 4 per cent recently). The rate is fixed for up to 40 years, so as inflation rises, the cost to pay for an asset does not, even if its value goes up. Borrowing means capital costs can be spread out fairly (for large projects, debentures or bonds are usually issued for about 30 years). It helps ensure that property taxes and user fees don’t spike and that reserves can grow through investment, to be used only when needed. GTA municipalities have strong tax bases and valuable assets. Property values are strong, creating an ideal climate for borrowing right now, especially with the recent volatility in global markets. Sharp stock market declines, such as the current one, commonly send investors to the relatively safe haven of municipal bonds.
Why do some cities choose not to borrow?
It’s mostly a political decision, to keep taxes down, especially in election years. However, some cities don’t like a fixed debt cost on their budget that crowds out other expenditures — a debt obligation has to be paid. Some debt free cities such as Mississauga and Brampton will likely have to take on debt soon.
Do GTA regions borrow?
Yes. In fact, York Region had $1.4 billion at the end of 2010 and $300 million more is approved for 2011. That compares with Peel’s $890 million debt, Durham’s $246 million and Halton’s $151 million. (See the chart for a comparison of debt across Ontario).
Does size matter?
Yes. Toronto, because of its large tax base and vast number of valuable assets, can find more investors willing to buy its debt at lower borrowing costs because there is less risk. Smaller cities, even if they have the highest credit rating, would probably pay more interest because the loan is not as safe, secured by a much smaller revenue and asset base.
Who holds a city’s debt?
GTA cities issue debentures or municipal bonds through the markets. They can be purchased by banks, insurance companies, pension funds, other institutional investors or even private investors. Toronto has a debt “syndicate” made up of some of the major Canadian banks that advise on and arrange transactions to purchase debt at the most affordable rates available. Although Canadian municipalities can issue bonds to foreign investors or private investors, the vast majority are issued within the domestic capital market.
How are the bonds (debts) issued?
Usually through a financial institution that is paid a commission for acting as the middleman between the buyer and seller of the debt. Rates are largely dependent on a city’s credit rating through agencies such as Moody’s and Standard and Poor’s (GTA cities have the highest rating possible: triple-A, or close to it). A debenture or bond issuance can be parceled off to numerous investors, but at the same rate. Toronto’s $350 million debenture issued in June, to cover some costs for major infrastructure projects over 30 years, was parceled out to about 20 investors.
What is the likelihood of GTA municipalities defaulting on their debt?
It is highly unlikely. None is close to their debt threshold. All have strong tax bases, valuable assets and high credit ratings (which consider the likelihood of default). And the province would probably step in before a large city defaulted.
DEBT DICTIONARY
Some common terms
Bond or debenture: a loan by an investor to a city for a capital project, with the understanding that regular interest payments will be made.
Credit rating agency: Companies such as Moody’s, Standard and Poor’s, and Dominion Bond Rating Service, which analyze and rate the financial strength of a government, company or institution.
Credit rating factors: Ratings change depending on financial strength; they determine the risk involved when investing and help set the borrowing rate for the entity. Factors considered by the credit rating agencies include: local economic condition; a city’s financial framework, including revenue streams, spending and borrowing habits; its current financial position, including interest load, level of assets and its operating balance; and a city’s debt management history.
Credit rating: There are about 20 credit rating levels, from the highest, triple A (prime), to C or D (in default). There are seven A-level ratings; nine B-level ratings; two agencies have five C-level ratings and one of the major agencies has one C-level and three D-levels. Toronto has either the second or third highest with each agency. Greece and Portugal have close to the lowest (near junk status). Canada has the highest, a triple-A rating. The U.S. was downgraded to the second highest by Standard and Poor’s a week ago, but still has the highest rating with the other agencies.
Letter ratings: Here’s what those credit rating opinions generally mean:
‘AAA’ — Extremely strong capacity to meet financial commitments. Highest rating.
‘AA’ — Very strong capacity to meet financial commitments.
‘A’ — Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
‘BBB’ — Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.
‘BBB’ — Considered lowest investment grade by market participants.
‘BB+’ — Considered highest speculative grade by market participants.
‘BB’ — Less vulnerable in the near-term but faces major ongoing uncertainties due to adverse business, financial and economic conditions.
‘B’ — More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.
‘CCC’ — Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.
‘CC’ — Currently highly vulnerable.
‘C’ — Currently highly vulnerable obligations and other defined circumstances.
‘D’ — Payment default on financial commitments.
Origin
Source: Toronto Star
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