Ballot measures and municipal bonds

November 5, 2018

Elections are coming up. I sat down with my roommates yesterday and perused the California General Election Official Voter Information Guide. In particular, we talked about the propositions on this years ballot, of which there are 11. A few questions came up during the conversation.

Why would the government choose to fund something with general obligation bonds versus with tax increases? How much can a federal/state/municipal government issue in debt? What decides this? What’s the difference between federal/municipal bonds in terms of investment?

There are two types of municipal bonds, as described by Investopedia. The first are general obligation bonds, bonds paid back by your future taxes. These are the types of bonds that get people riled up, the stuff that your children end up paying for. The other type of bond is a revenue bond, which is the type of bond that seemingly only municipalities can issue. A revenue bond is paid back through revenues from the projects that are built (ie bridge tolls, entrance fees to park).

Typically, revenue bonds are more risky as an investment than general obligation bonds, because there is no guarantee that the revenue paying back the bond will be consistent. Since general obligation bonds are issued by those who have the power to levy taxes, these investments are more safe.

The amount of debt a municipality can feasibly loan out depends on several factors. For example, changes in incomes, property values, and tax rates affect the rate at which loans are paid back. Detroit defaulted on its debt in 2013 due to corruption, a declining population, and a declining automotive industry. In San Francisco, a tech boom may drive future tax revenues to be higher. In fact, San Francisco revenues are higher than the majority of other major US cities, in particular thanks to the tech boom.

One thing about passing a general obligation bond issue through a referendum is that it’s very difficult to change. California in particular has a rule that requires that lows passed by referendum can only be changed through referendum. This leads to particularly convoluted and confusing ballot measures that the average American should not be expected to understand. This year, California proposition 2 was to redirect funds from a mental health services act to a housing program for those suffering from mental health issues. For the investor, this does not change the return on investment, but does change the thing you are lending for. Whether or not this ballot measure passes should be fairly uncontroversial for the investor. However, you can imagine a situation where an investor loans money in a bond issue for Tesla thinking that they can change the world by funding solar power. When Tesla turns around and uses the loan to, say, buy SpaceX, that socially conscious investor may feel cheated out of their social goodness.

In 2009, as one of many measures to dig the economy out of the Great Recession, President Obama launched the Build America Bonds program, a program in which the federal government paid 35% of the interest owed to loaners (buyers of bonds). This reduced the cost of borrowing for cities and towns, allowing for more investment on a local level.

In general, the credit risk for municipalities in the United States is fairly low - Detroit is your biggest example of municipal default, and Puerto Rico defaulted on general obligation bonds in 2016. Less than a tenth of one percent of municipal bond issues have defaulted since 1970. Recently, pension obligations are a particular source of pain for municipalities. In Chicago, pensions plans and benefits would cost over 60% of net revenues for the city. This is a significant debt burden, and the city will need to make structural changes in the future to better finance their plans going forward.

All in all, there is a limit on how much debt a municipality can issue (and a much more tangible limit than that of the federal government). On the other hand, if a city continues to develop and produce revenue (and doesn’t get locked into unsustainable cycles of debt), the debts are generally safe investments.

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