BONDS: Everything Counts in Large Amounts

By on February 21st, 2020

Gretchen Whitmer campaigned for Governor on a promise to “fix the damn roads.”  And she followed through.

Upon taking office she proposed a 45-cent increase in fuel taxes to pay for major projects to repair and replace our deteriorating road system. Unfortunately for the Governor, the same voters who elected her also returned gerrymandered Republican majorities to both houses of the state legislature. They quickly rejected her tax proposal.

So she moved to plan B: issue bonds to borrow the money. She asked the State Transportation Commission to borrow $3.5 billion. This authority to borrow had been vested in the legislature by the State Constitution, but the legislature delegated the authority to the Commission. 

The Commission, which is appointed by the Governor, approved Governor Whitmer’s proposal (even though the majority of its members had been appointed by her Republican predecessor, Rick Snyder). 

Bonds are a major component of the U.S. and world financial systems, but most people – even investors –   know little about them.

So let’s take a look.

When a corporation needs to raise a large amount of money, it has limited choices. It can either issue new shares of stock or it can borrow. Each of these alternatives comes with its own risks and benefits. Issuing stock will result in the dilution of ownership of current shareholders, and it is therefore necessary to give them some sort of reward in exchange. Borrowing, on the other hand, increases the corporation’s debt; if that debt grows too high it will result in a downgrading of the corporation’s credit rating, which in turn will increase the interest rate the corporation has to pay to borrow.

A government agency that needs to raise a large amount of money also has limited choices. It can request a large appropriation from the legislature but the legislature may say no, particularly because in order to appropriate that large increase the legislature will have to raise taxes (Michigan’s Constitution, unlike the U.S. Constitution, prohibits deficit financing). As we have seen, this was Gov. Whitmer’s first choice, which the legislature rejected.

The other option for a government agency is to borrow, and this means issuing bonds. A bond is defined as “written evidence of a borrower’s obligation to pay principal and interest at specified times and dates on money borrowed.”* Bonds are long-term obligations; if the borrowed money must be repaid within one year, it is not called a bond, but a “note”.

Michigan state agencies may create two types of bond. General obligation bonds invoke the full faith and credit of the state (they are therefore also known as “full faith and credit” bonds). A general obligation bond has the first claim on any appropriations by the legislature. If you are the holder of a general obligation bond and the state fails to make payments to you as required, you may file suit and literally attach a state building to get what you have coming.

General obligation bonds are very rarely issued, though, because of the incredibly difficult hoops the issuing agency has to pass through. First, the legislature must approve the issuance of the bonds by a 2/3 majority in each house. Then the voters have to approve by simple majority. You can see why this is not a commonly used method.

The second type of bond is called a revenue bond. This bond simply incorporates a legally guaranteed revenue stream (e.g., fuel taxes) that will be available to pay the bondholders as payments come due. ** In other words, the revenue stream is the collateral, just as your house is the collateral for your mortgage loan.

Bonds issued by local and state governments have one major advantage over their corporate cousins: The interest paid to bond holders is free of federal and state income taxes. For this reason these government bonds can be competitive in the bond market even though they pay investors a lower interest rate than corporate bonds.

The bonds which Governor Whitmer and the Transportation Commission propose to issue will be revenue bonds. The Commission estimates paying interest of 2.5% to 3.5% with a payback period of 25 years. Part of the proceeds will go to accelerating some projects already in the Commission’s 5-year plan; other parts will allow initiation of new projects that were not encompassed in the 5-year plan. 

The bond proceeds can only be used for work on “trunk line” highways, which means state and federal highways – those whose names begin with “M” (State roads), “U.S.” (federal highways) or “I” (interstates). City and county roads will not be eligible. Naturally, their advocates are not happy. They point out that the trunk line roads constitute only about 8 percent of Michigan’s road mileage. The Commission’s spokesperson responds by pointing out that it is not lane miles but traffic that matters, and the trunk line roads carry 50 percent of the state’s traffic, including industrial and commercial shipments that create jobs.

The bond proceeds will join new revenues of $1.2 billion already being phased in as a result of 2015 legislation which increased fuel taxes and redirected money from the state’s general fund (thus making those general funds unavailable for other services).

And virtually all experts are in agreement on one point: It won’t be enough.

*”Built By Bonds”, State of Michigan PPT presentation

** There is also a third type of bond which is rarely used, known as a “federal anticipation” bond. It is actually a special sub-type of revenue bond which depends on a revenue stream which the federal government is required by law to pay to the state.

Lawrence Glazer

Lawrence M. Glazer is the author of Wounded Warrior, a biography of former governor and Supreme Court justice John Swainson, and winner of theIndependent Publisher gold medal in biography. He is also a retired Ingham County Circuit Court Judge and former legal advisor to Gov. James J. Blanchard. He currently serves on the State Board of Ethics.

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