2.2.2.1 Long-Term, Fixed-Rate Debt
Most municipal debt is issued as long term, fixed-rate debt.3 Long term debt is typically structured so that issuers can spread the cost of the project over time. Principal is generally payable over 25 or 30 years, although bonds maturing over longer periods have been issued. Long term, fixed rate bonds are generally sold in denominations of $5,000 or integral multiples thereof and contain provisions allowing the issuer to redeem the bonds before maturity (see Section 2.3.1, Redemption or Prepayment).
Long term, fixed rate bonds generally pay interest twice per year and the issuer is required to make either twice yearly or annual principal payments. Debt service payments are scheduled to provide payment of all principal and interest on the bond issue over the term of the issue. If the amount of debt service (principal and interest) payable is to be relatively the same each year (level debt service), the amount of interest payable each year will decline, and the amount of principal payable will increase. If the amount of principal paid each year is the same (level principal), debt service will decline over time. If revenues are subject to significant uncertainty, all principal can be scheduled to mature at a later date with revenues required to be applied to pay principal (through the redemption of bonds) when available.
Long term, fixed rate bond issues typically include both serial bonds and term bonds. The principal of a serial bond is payable on a specific date. Serial bonds generally mature in a “series,” with a separate bond maturing on each consecutive annual or twice yearly principal payment date. Purchasers of bonds that mature during the first 10 to 15 years after the issuance date, which tend to be retail investors, usually value having a specific date on which the principal will be paid.
A term bond is a bond on which principal is payable by redemption through “mandatory sinking fund payments” on consecutive principal payment dates leading up to and including the term bond’s maturity date. The principal amounts of term bonds of a particular maturity to be redeemed are selected by lot. The investors in bonds maturing 15, 20, or 30 years after the issuance date, which tend to be institutional investors, purchase bonds in large pieces that are more easily resold when the institutions need cash (i.e., they are more liquid). As a result, the secondary market demand for long dated term bonds more than offsets any benefit from a specific date of principal payment. A bond issue that includes a range of maturities spread across the yield curve appeals to investors with varied needs and thus tends to result in a lower overall interest cost than selling a long term, fixed rate bond issue as a single bond maturity.
With a long term, fixed rate bond issue, the issuer pays a fixed rate of interest on a particular bond for the life of the bond. The market value of a particular fixed rate bond, however, changes over time, depending on a variety of factors, including the credit of the issuer or its credit provider, the likelihood that the bond will be redeemed before maturity, income tax rates, and the tax law treatment of municipal debt. The most significant factors affecting the value of a fixed rate bond, however, are the rate of interest payable on the bond and the time remaining to the bond’s maturity or, if the bond is likely to be redeemed early, to the first date on which the bond can be redeemed. If market interest rates fall, the value of a fixed rate bond generally rises and if market interest rates rise, the value of a fixed rate bond generally falls. Bonds not maturing or expected to be redeemed for many years may fluctuate significantly in value.
PAR, DISCOUNT, AND PREMIUM BONDS – When a fixed rate bond is initially offered, it may be sold at par (a price equal to 100% of its principal amount), at a discount (a price lower than its principal amount) or at a premium (a price higher than its principal amount). The expected yield to the investor on par bonds matches the interest coupon (i.e., the stated rate), the expected yield on a discount bond is higher than the interest coupon and the expected yield on a premium bond is lower than the interest coupon. The expected yield on premium bonds is generally calculated with reference to the date on which the bond can first be redeemed instead of or as well as with respect to its maturity date (such bonds are referred to as “yield to call bonds”).
CAPITAL APPRECIATION BONDS – Capital appreciation bonds (CABs) are long term, fixed rate bonds on which the interest is compounded on each interest payment date rather than paid to bondholders. CABs are, from an economic standpoint, the equivalent of bonds with a 0% interest rate sold at a deep discount. They are sometimes referred to as zero coupon bonds for this reason. All interest is paid when the principal on the bond is paid at maturity or prepaid. Because they have an established reinvestment rate (compounded interest is in essence reinvested at the yield on the bond), CABs fluctuate in value more than conventional bonds of the same maturity. Moreover, because interest and principal on CABs are only paid at maturity, the amount of debt service due in any particular year is more easily manipulated and public agencies can use CABs to defer the payment of debt service