Agencies, supranationals and local government bonds
Agencies and government development banks usually carry the sovereign's rating because the government stands behind them. Supranationals are owned by several governments. Local governments issue general obligation bonds backed by their taxes and revenue bonds backed by one project, judged on debt service coverage.
Before this: Sovereign credit analysis: qualitative factors, Fixed-Income Markets for Government Issuers
On the exam
- Explain special considerations when evaluating the credit of sovereign and non-sovereign government debt issuers and issues
Explain special considerations for non-sovereign government issuers. Expect: classify a bond as general obligation or revenue; why an agency usually has the sovereign's rating; a debt service coverage ratio calculation.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
Who issues government-linked debt below the national government?
Non-sovereign government debt is issued by bodies that sit below, beside or above the national government: agencies, government banks, supranational organizations and regional and local governments. Their credit follows a simple question: what stands behind the bond?
- Agencies Use it quasi-government bodies created by law; usually the sovereign rating
- Government-sector banks and development finance institutions Use it sovereign-sponsored; often an explicit guarantee; usually the sovereign rating
- Supranationals Use it owned by member governments; often very highly rated
- Regional and local governments Use it municipal bonds in the US, local authority bonds elsewhere
- General obligation (GO) bonds Memorize backed by general taxing power; similar to sovereign analysis
- Revenue bonds Memorize backed by one project; riskier; judged on cash flow and coverage
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Agency bonds come from quasi-government bodies set up by a specific law to carry out a government mission, such as providing a public service. The law often lets the body borrow. Investors assume the government would support it in distress, either implicitly through the law that created it or explicitly through a guarantee, so the rating agencies usually give it the sovereign’s rating.
Governments also sponsor banks and development banks to serve a market or a policy goal. Like agencies, they are created or supported by the state and usually carry a similar rating, especially when a statute makes the government liable for their debts.
Supranational issuers are owned by several sovereign governments that join to pursue a common objective, such as lending to developing countries or financing regional development. Their bonds are backed by member capital and support, so their rating reflects the strength of the owners. The largest, owned by many strong governments, are among the highest-rated issuers.
| Issuer | Backing | Typical rating vs sovereign |
|---|---|---|
| Agency | implicit or explicit government support | usually equal |
| Government bank / development institution | often an explicit statutory guarantee | usually equal |
| Supranational | members’ capital and support | often very high |
| Regional or local government: GO bond | general tax revenue | equal or below |
| Regional or local government: revenue bond | revenue of one project | depends on the project |
Go deeper Why a regional government can rarely be rated above its sovereign
The usual rule is equal or below, because a regional government sits under the national legal and economic system. Strong own revenues, or protection from outside the country’s legal system, can occasionally lift a region above its sovereign, but exam questions treat this as the exception.
Go deeper Green bonds from development banks
Development banks are among the largest issuers of green bonds, with proceeds ring-fenced for climate and environmental projects. The credit risk is still the bank’s, backed by its sponsors, while the label describes how the money is used.
How are local government bonds analyzed?
Bonds of regional and local governments are called municipal bonds in the US and usually local authority bonds elsewhere. How they borrow varies by country. In some, the national government sets up a financial institution that lends to local authorities at the national rating. In others, tax revenue is shared across levels so local authorities can meet their obligations. In the US, state and local issuers are rated individually, and issue two kinds of bonds.
General obligation (GO) bonds are unsecured and backed by the issuer’s general revenues, so by its power to tax. Analysis resembles sovereign analysis: the ability to levy and collect taxes and fees, the local business climate, a diversified tax base with several major employers, prudent budgeting and sometimes implicit national support. But local governments have limited powers. They control neither monetary policy nor the national economy, and they are more exposed to a declining local industry or a shrinking population, which erodes the tax base.
Revenue bonds finance a specific project such as a toll road, bridge, sewer system, hospital or stadium. Repayment depends on one source of revenue, so they are riskier than GO bonds. The analysis is partly about the project (is it needed, how heavily will it be used, what economy supports it) and partly like a corporate bond: operating results, cash flow, liquidity and capital structure.
Some infrastructure revenue bonds also carry a government guarantee, or implicit national support, as a second line of defense. Classify them by the primary source of repayment: if the project’s revenue pays first, it is still a revenue bond. The reverse also holds: a bond that funds one project but is repaid from general taxes is a GO bond.
How does the debt service coverage ratio work?
The key measure for a revenue bond is the debt service coverage ratio . It compares the cash a project has left after running costs with the principal and interest due that year.
A higher ratio is stronger. Revenue bonds often carry a covenant requiring a minimum ratio, and a breach can trigger a default under the bond terms.
A project earns revenue of 48 million, spends 20 million to operate and owes 16 million of principal and interest a year. Its debt service coverage ratio is closest to:
(48 − 20) ÷ 16 = 1.75×
Debt service coverage ratio (times)1.75
- 48−20=÷16=coverage in times
- 48ENTER20−16÷coverage in times
ENTER enter (on the HP, puts the number on the stack)
To find the break-even revenue, set the ratio in the solver to the covenant (1.25) and solve for revenue.
Exam tip Ask what repays the bond. Taxes in general: GO. One project’s revenue: revenue bond. A government guarantee or sponsor: agency or development bank.
Go deeper Municipal bankruptcy
A sovereign cannot be forced into bankruptcy, but in some countries a local government can file for court protection from its creditors. Recoveries then depend on the type of bond, and general obligation holders may recover only part of what they are owed.
Memorize this
MemorizeWho backs the bond
| Issuer | Backing | Rating vs sovereign |
|---|---|---|
| Agency | implicit or explicit government support | usually equal |
| Government bank / development finance institution (DFI) | often an explicit statutory guarantee | usually equal |
| Supranational | members' capital and support | often very high |
| GO bond | general tax and fee revenue of that government | equal or below |
| Revenue bond | revenue of one project | depends on the project; riskier than GO |
Memory hook Ask what repays the bond: the government's taxes, one project's revenue, or a government guarantee.
Know it cold Revenue bonds are not backed by general taxes. Agencies are not rated on their own.
MemorizeDebt service coverage ratio
| Item | Rule |
|---|---|
| DSCR | (revenue − operating expenses) ÷ debt service |
| Debt service | principal + interest for the year |
| Direction | higher is stronger |
| Covenant | revenue bonds often carry a minimum DSCR |
Memory hook Subtract running costs first, then compare what is left with what is owed.
Know it cold Never use revenue before operating expenses. Revenue at the covenant limit = opex + covenant × debt service.
- Agencies Use it quasi-government bodies created by law; usually the sovereign rating
- Government-sector banks and development finance institutions Use it sovereign-sponsored; often an explicit guarantee; usually the sovereign rating
- Supranationals Use it owned by member governments; often very highly rated
- Regional and local governments Use it municipal bonds in the US, local authority bonds elsewhere
- General obligation (GO) bonds Memorize backed by general taxing power; similar to sovereign analysis
- Revenue bonds Memorize backed by one project; riskier; judged on cash flow and coverage
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Quick example
Revenue 70, operating expenses 30, debt service (principal plus interest) 25. (70 − 30) ÷ 25 = 1.60×. Higher is stronger.
- 70−30=÷25= 1.6
- 70ENTER30−25÷ 1.6
ENTER enter (on the HP, puts the number on the stack)
Quick example
Operating expenses 30, debt service 25 and a 1.40× covenant. 30 + 1.40 × 25 = 65; revenue of 70 can fall 7.1% before a breach.
- 1.4×25+30= 65
- 1.4ENTER25×30+ 65
ENTER enter (on the HP, puts the number on the stack)
How it is asked
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Classify the bond
A regional government bond is paid only from fares on a new tram line.
Revenue bond (single project). Trap: GO bond, which is backed by general taxes.
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Compute the DSCR
Revenue 35, operating expenses 12, debt service 16.
(35 − 12) ÷ 16 = 1.44×. Traps: 2.19× ignores opex; 0.70× inverts.
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Agency rating
A state-owned development bank whose debts the national government guarantees by law.
Same as the sovereign.
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How far can revenue fall?
Revenue 70, opex 30, debt service 25, covenant 1.40×.
Break-even revenue 30 + 1.4 × 25 = 65, so −7.1%. Trap: ignoring opex gives 35.
Exam traps
- Saying revenue bonds are backed by the issuer's general taxes. Only GO bonds are.
- Assuming agencies are rated on their own. The rating usually equals the sovereign's because of implicit or explicit support.
- Computing the coverage ratio on revenue before operating expenses.
- Assuming a local government can usually be rated above its sovereign. The usual rule is equal or below.
- Calling a project bond with a backup government guarantee an agency or GO bond. If the project's revenue pays first, it is a revenue bond.
Checkpoint
6 exam-style questions. About 90 seconds each.
1A regional government issues a bond whose interest and principal are paid only from fares on a new tram line. This is best described as a:
2A municipal water authority has annual revenue of EUR 36 million, operating expenses of EUR 14 million and annual debt service of EUR 15 million. Its debt service coverage ratio is closest to:
3A state-owned development bank operates under a law that makes the national government liable for its debts. Its bonds are most likely rated:
4A project has annual revenue of 60, operating expenses of 24 and debt service of 20. Its bonds carry a minimum coverage covenant of 1.50×. Revenue can fall by closest to what percentage before the covenant is breached?
5Compared with a general obligation bond from the same local government, a revenue bond is most likely:
6Which of the following is most likely a supranational issuer?
Key takeaways
- Agencies and government banks: usually the sovereign's rating.
- Supranationals: owned by several governments, often very highly rated.
- GO bonds rest on general taxes. Revenue bonds rest on one project and are judged on cash flow and DSCR.
- DSCR = (revenue − operating expenses) ÷ debt service. Higher is stronger.
Quick example
Revenue 70, operating expenses 30, debt service (principal plus interest) 25. (70 − 30) ÷ 25 = 1.60×. Higher is stronger.
- 70−30=÷25= 1.6
- 70ENTER30−25÷ 1.6
ENTER enter (on the HP, puts the number on the stack)
Quick example
Operating expenses 30, debt service 25 and a 1.40× covenant. 30 + 1.40 × 25 = 65; revenue of 70 can fall 7.1% before a breach.
- 1.4×25+30= 65
- 1.4ENTER25×30+ 65
ENTER enter (on the HP, puts the number on the stack)
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Practice exam-style questions on Credit Analysis for Government Issuers
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- Credit Analysis for Corporate Issuers Fixed Income
Questions candidates ask
What is the difference between GO and revenue bonds?
GO bonds are backed by the issuer's general taxing power. Revenue bonds are backed only by the revenue of a specific project, such as a toll road or utility.
What is a debt service coverage ratio?
Revenue after operating expenses divided by the year's debt service, which is principal plus interest. Higher means more cushion, and revenue bonds often have a minimum.
Why do agency bonds often have the same rating as the government?
Investors expect the government to stand behind them, implicitly through the law that created the agency or explicitly through a guarantee.
Can a local government be rated above its sovereign?
It is uncommon. Local governments benefit from national policy and have limited powers of their own, so the usual rule is a rating equal to or below the sovereign's.
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