Opinion: The Bond Prospectus — What It Is and What It Tells You

Richard F. Keevey | January 22, 2020 | Opinion
Learning how to navigate a bond prospectus can yield a trove of data about New Jersey’s financial and economic condition — and much more
Credit: Amanda Brown
Richard F. Keevey

If one wants to know about the finances of a state or local government — do not go first to the annual budget or the annual financial statements. Instead, obtain the latest bond prospectus — also referred to as the official statement (OS). Its contents must meet certain disclosure standards set by the U.S. Securities and Exchange Commission (SEC) and other regulatory bodies, so its financial contents, including pension obligations and pending legal claims, must be explicitly detailed and explained. No “rosy” projections or misleading statements are permitted, and their presence could lead to unpleasant discipline.

Now, if it is a small jurisdiction that issues few bonds, its currency and availability are limited. But most states, especially large ones, sell bonds frequently. For example, New Jersey just issued an OS in January, 2020 — and the state’s Transportation Trust Fund and the Economic Development Authority issued OSs in November and December 2019. Each OS contains revised, current and historical financial information as well as a wealth of other data. More details shortly about those contents, but first, what is a bond prospectus and who are the players in the process?

A prospectus (also known as an OS) is the document prepared in conjunction with the sale of bonds to provide information to prospective purchasers of those bonds. An OS is prepared for the sale of corporate bonds and municipal bonds. Our focus is on municipal bonds, which include debt issued by a non-federal unit of government, such as a state, municipal, county or public authority.

Bonds can be sold on a competitive basis or a negotiated basis. The pros and cons of each option would require extensive discussion. General-obligation bonds (GO) must be sold competitively, but revenue bonds can be and usually are sold on a negotiated basis.

In simple terms let’s review the two options: In a competitive sale the state offers the bond for sale by issuing a notice in newspapers and financial periodicals. The announcement sets forth the size, maturities, purpose of the proceeds and structure of the proposed bond sale, along with instructions for submitting bids. And the OS is made available for bidders to review. At a designated time, bids are opened in public by state officials and bonds are awarded to the firm (banks, investment firms, and so forth) that submits the lowest interest cost.

In a negotiated sale the issuer (state) retains a specific underwriter or underwriting syndicate to work on its behalf — under state parameters — to contact a wide range of investors with the goal of negotiating to obtain the best interest cost.

Who else is involved with an OS?

There are other players in the process, but two are critical: bond counsel and rating agencies. Bond counsel is a specialized and independent lawyer or law firm retained by the state. The responsibilities and the role of bond counsel have a long history and have been continuously redefined by the SEC, court decisions and self-regulation. Books are written about what the bond counsel does and why it exists, including the legal authority of the transaction, full-disclosure requirements, bond documentation and a host of other responsibilities. Suffice to say, bonds cannot be sold without a favorable opinion of bond counsel.

The rating agencies are another major player. There are three principal rating agencies — Moody’s, Standard and Poor’s and Fitch. Each issuer pays for a rating from one or all of these agencies. The rating is intended to provide an independent assessment of the relative creditworthiness of the debt obligation in the market.

The rating is based on information in the OS as well as the agency’s independent research. All things being equal, the higher the credit rating (AAA) assigned to the bond offering the lower the interest-rate bid; likewise, a lower credit rating (A-) would signal greater risk to the buyer, leading to a higher bid and higher cost to the government.

For all practical purposes, it would be very difficult for a government or corporation to sell a bond without a credit rating.

What is in an OS?

There are usually six major components to an OS and then 15 subcomponents to the financial sections:

  1. Authorization of the bond. For example, if this is a GO bond, when did the voters approve?
  2. Application of bond proceeds. Terms and provisions of the bonds and what they are being used for;
  3. Sources of payment of the bonds and security provisions for the bond holder;
  4. Bond counsel’s legal opinion;
  5. Tax matters — federal tax exemption status and the like;
  6. Bond rating(s).

 

The financial sections typically include:

  • description of budget and accounting systems and processes used by the state;
  • description of debt provisions, including judicial decisions;
  • most recent audit report;
  • financial results and estimates of the previous five-year history (budget year and four prior years);
  • summary of revenues, appropriation and surplus, including current economic outlook, demographic information, revenues, appropriations, expenditures, description of major spending items in budget;
  • federal aid;
  • long-term “general-obligation debt” by bond purpose;
  • long term “appropriation debt” by bond purpose;
  • debt-service projections;
  • other obligations — short-term debt, moral-obligation debt, and the like;
  • state employee count, including status of contracts and negotiations;
  • status of pension funding, including funding policy and status of funding levels;
  • status of health-benefit funding;
  • pending litigation — up to 17 court cases;
  • narrative description of major taxes.

Final observations

Since the OS must have full disclosure at the time of the bond sale, the financial section of the most recent New Jersey OS is sprinkled with interesting facts and narrative. Here are 10:

  • The unemployment rate declined to 3.5%, which was below the national average of 3.7%. (That was the rate as of June 30, 2019; the numbers have since declined to 3.4% and 3.5% respectively).
  • Higher-income population grew faster than the overall population.
  • Net domestic migration was greatest for residents 18-24 and residents over 60.
  • There is weakness in existing home sales.
  • Financial risks exist because of climate events, as well as the delay in the Gateway program.
  • State and federal tax-policy changes produced substantial tax revenue growth in fiscal year 2019, but some of it ($1.1 billion) is one-time.
  • A full year of collection of internet sales tax (as the result of the South Dakota v. Wayfair Supreme Court decision) is expected to yield $190 million.
  • Total amount of tax credits awarded to corporations was $371 million in fiscal 2019.
  • Total net liability of employee retirement pension and medical benefits is $222 billion; the total outstanding long-term bonded debt is $33 billion.
  • Medicaid disallowance in federal funds in the amount of almost $1 billion may be issued by the federal office of the inspector general. The amount is in dispute by the state and is currently under review, but could have a significant negative financial impact.

While not exactly light reading, the OS is one of the most comprehensive, up-to-date and readily available sources of general and specific information about New Jersey’s financial and economic condition.