2.1 Overview

Debt represents an obligation to pay a stated amount (the principal), at a given time (the maturity) with interest at a stated rate (the interest rate), where interest is the borrower’s cost of renting the principal from the lender for a period of time. This basic structure is enhanced by additional conditions. These conditions may modify or fine tune the means by which the debt will be repaid or by which the lender (i.e., debt holder or investor) will be secured against different types of risks. These conditions may also prescribe terms and conditions that the borrower undertakes to meet for the benefit of investors.

The issuer and its financing team typically make decisions about which structural elements to include iteratively, as they consider a number of different factors, beginning with the nature and scope of the project or financing objectives. Decisions are often dictated by conditions such as the financial or market position of the public agency or its authority to issue debt.

As the issuer and its financing team define the nature and scope of the project, the source of repayment, current market activity, and investor interests in more detail they begin to address preliminary questions that will help determine which structure is the best fit:

What is the source of revenue and security for repayment of the debt?
Does the project to be financed allow the agency to spread repayment over a short or long period?
Should the interest rate be fixed through that term or vary in some determined way?

A funding source is often linked to the purpose of the public agency or the project that needs to be financed. It is also linked to the statutory authority that the public agency is using to issue the debt, which may include constitutional limitations related to debt limit and revenue sources. The appropriate term and interest rate method (basic structure) of debt are affected by the useful life of the capital asset being financed and its cash flow requirements.

With respect to structural factors that address the underlying credit, including the financial operations of the issuer or the form of the debt, the public agency may ask the following:

Which structural factors are determined by or should be determined by the source of the revenues from which the debt will be repaid or by which it will be secured?
Are there project specific requirements or considerations that may affect the debt structure or investor interests?
What are the general market conventions that affect investor preferences, such as credit enhancements or provisions relating to redemptions?

The debt may be structured to mitigate bondholder risk. Investors may look at the general credit strength of the issuer, the resiliency of the source of the funds committed to debt repayment in the face of changes in financial markets (including interest rates) or in the political environment, the reliability of income streams, and the tax treatment of interest on the debt. From the investor’s perspective, a project’s essentially is often a critical factor in the assessment of its risks of nonpayment (credit risk). The more that the project is seen as supporting a critical function of the issuer, the less likely, investors believe, the issuer will default on the financing. Investors may demand additional security features or higher yields for projects that are perceived as less essential.

Other structural factors of interest to investors are the tax status of the bonds (i.e., taxable vs. tax exempt), the credit quality of the bond (credit rating), its term to maturity, the risk of redemption, and its potential for sale in the secondary market. An issuer may rely upon members of its financing team to provide advice on how to structure a debt obligation or make a recommendation on the type of debt to issue, but, ultimately, it is the issuer’s responsibility to make these decisions.

The sections below provide additional detail regarding decisions about sources of revenue and security (See Section 2.2.1) and terms and interest rates (See Section 2.2.2).