Underlying Debt
Key takeaways
- Underlying debt refers to smaller government entities’ obligations that are implicitly supported by the creditworthiness or taxing authority of a larger government in the same jurisdiction.
- It most commonly applies to general obligation municipal bonds and functions as a form of credit enhancement.
- Ratings agencies consider both the standalone profile of the smaller issuer and the potential obligation of the larger government when assigning ratings.
- Underlying debt can lower borrowing costs for smaller issuers but also creates contingent financial risk for the larger backer.
What is underlying debt?
Underlying debt describes a situation in municipal finance where the debts of smaller public entities (for example, school districts, local authorities, or special-purpose districts) are implicitly backed—formally or informally—by a larger government (such as a city, county, or state). This backing often stems from the larger entity’s taxing power, legal authority, or an expectation that it will step in to prevent default and maintain essential services.
How it works
- Smaller entities issue general obligation bonds to fund projects (schools, hospitals, roads, sanitation, etc.). Because these entities may have limited revenue bases, the market often treats their debt as implicitly supported by a larger governmental body.
- This implicit support serves as a credit enhancement, enabling the smaller issuer to borrow at lower interest rates than it could on a truly standalone basis.
- Ratings agencies evaluate the smaller issuer both on its own fundamentals and in the context of any expected support. They also include the carrying of such underlying debt when assessing the larger government’s overall creditworthiness.
Rating implications
- For the smaller issuer: implicit backing can improve perceived credit quality and lower borrowing costs.
- For the larger backer: assuming or being expected to assume responsibility for underlying debt increases its contingent liabilities. If the smaller issuer struggles to meet obligations, the larger entity’s credit rating can be pressured because rating agencies factor in the risk of having to cover those obligations.
Examples and risks
- Example: States or counties sometimes back bonds issued by cities or municipal authorities through their taxing authority, effectively creating underlying debt for the larger government.
- Historical risk: A notable example of underlying liabilities stressing a larger government is New York City’s near-insolvency in the 1970s, when municipal financial distress had broader implications for state and federal actors.
- Risk considerations:
- Contingent liabilities can strain the larger government’s finances during economic downturns.
- Political or legal limits on bailouts or transfers can complicate the assumed support.
- Investors should evaluate both the smaller issuer’s fundamentals and the larger government’s capacity and willingness to provide support.
What investors should consider
- Confirm whether a municipal obligation is a general obligation bond and whether implicit or explicit backing exists.
- Review the standalone financials and revenue sources of the smaller issuer.
- Assess the larger government’s fiscal strength, taxing authority, and track record of supporting subordinate entities.
- Understand rating agency commentary about underlying debt and any contingent liability estimates in credit reports.
Conclusion
Underlying debt is a common feature of municipal finance that helps smaller public entities access capital at lower cost, but it transfers contingent risk to larger governments. Proper assessment requires examining both issuers—the smaller borrower and the larger potential backer—to gauge credit risk and the likelihood of support in times of stress.
Further reading
- Standard & Poor’s — S&P Global Ratings definitions
- Moody’s Investors Service — rating methodology and products
- Historical summaries of municipal crises (e.g., 1970s New York City)