In the glossary of our new book, Adventures in Muniland: A Guide to Municipal Bond Investing in the Post-Crisis Era, we define a moral obligation bond as "a bond that has, as additional backing, a nonbinding pledge from a governing body to appropriate funds to make up debt service deficiencies."
In common parlance, this translates into a somewhat tenuous promise from a state legislature to pay debt service on an outstanding bond issue. These promises are common in the municipal bond market; they are a way for states to guarantee debt to achieve a lower cost of capital -- a guarantee that will most likely never be drawn upon.
Some states rely on these guarantees to circumvent state constitutional debt limitations. The State of New Jersey is an example. During the last decade the general obligation debt on its balance sheet has stayed below $5 billion without increasing or decreasing. During the same time period, however, it issued $30 billion in debt secured by state appropriations -- a three-fold increase, from $15 billion to $45 billion. By relying on these moral obligation bonds, the state is able to avoid having to seek voter approval to issue bonds and can issue them without increasing the state's debt burden (debt as defined in the state constitution).
You're probably thinking, "Who cares? As long as the state is paying its bills, what difference does it make if the bond payments are appropriated by the legislature versus directly paid?" Our response is twofold:
1. When general obligation debt is issued, moneys to pay debt service are automatically earmarked and therefore segregated from political decision making, unlike legislatively appropriated money. We know how politics can subvert rational decision making. Take a look at Greece or Puerto Rico.
2. Bondholders lose important rights and remedies by owning bonds backed by appropriation versus direct payment of revenues a la general obligation bonds.
Consider the following case study:
On July 17th, reporter Xavira Neggers Crescioni stated in a piece published by Debtwire that the Puerto Rico legislature failed to appropriate a $93.7 million payment to a trustee on approximately $560 million in outstanding Puerto Rico Public Finance Corporation ( PFC ) debt. Crescioni states that without a special session of the Puerto Rico legislative assembly being called, the legislature will most likely also miss a $50 million payment due on August 1.
In a $437 million Puerto Rico Public Finance Corp. new issue from late 2011, the Commonwealth states the following on the bond's security features in its bond prospectus:
The Legislature of Puerto Rico is not legally bound to appropriate sufficient amounts to timely pay the principal and redemption premium, if any, and interest due on the Bonds. There is no assurance that sufficient funds will be appropriated or otherwise made available to make such payments on the Bonds.
Bondholders have no legal recourse to require the Legislature of Puerto Rico to appropriate the funds necessary to timely pay the principal of and redemption premium, if any, and interest due on the Bonds.
Each of the Appropriations Acts provides that the Commonwealth, through budgetary appropriations during a number of fiscal years specified in each Appropriation Act, will pay the principal of and interest on the Notes.
The aggregate principal and interest installments required to be paid under the Notes is sufficient to cover the aggregate principal amount of and the aggregate annual amount of interest payable on the bonds….
Neither the corporation nor the Commonwealth has ever defaulted on the payment of principal of or interest on any of its debt.
Crescioni writes that Puerto Rico Treasurer Melba Acosta stated on a conference call last week that these bonds are "a credit on which Puerto Rico would have its terms changed [i.e., restructured]." And that nonpayment "is not a covenant breach since payments are made out of appropriations… but there is no appropriation."
Puerto Rico is trying to change the rules of the game, ex-post facto, by repudiating prior promises it has made to creditors. It has attempted to do this in the past with the Debt Recovery and Reinforcement Act of 2014 and is now using loopholes with regard to Public Finance Corporation bonds. The "moral obligation" to repay these bonds has been breached. At Cumberland, when analyzing an issuer's creditworthiness, we pay close attention to the "character" of the issuing body's representatives. We do not own uninsured Puerto Rico Finance Corporation bonds, only bonds insured by Assured Guaranty and National Public Finance Guarantee. We trust that the bond insurers will make good on their promises. Puerto Rico will have to work hard to regain the trust of municipal bond investors if it wants to return to the municipal bond market any time soon.
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