Underlying Debt
Type of debt obligation, including loans and other assets, that larger government entities guarantee or back the smaller ones within their jurisdiction to receive
What is Underlying Debt?
Underlying debt is a type of debt obligation, including loans and other assets, that larger government entities guarantee or back the smaller ones within their jurisdiction to receive.
In other words, when the smaller entities issue the debt obligation, the larger entities consider it the underlying debt.
Many consider this type of debt similar to municipal bonds, where a local or state government issues debt securities for the purpose of improving the community via capital expenditures.
Some things that the money from municipal bonds contributes to include highway construction, public school campus renovations, hospital renovations, power plants, and more.
This type of investment is necessary to improve things like:
- Living conditions
- Education
- Transportation
- Public roads and highways Commute
- Health
- Community Environment
Thus, underlying debt is a key component in bettering struggling neighborhoods that need financial support.
Moreover, the capital needed to improve these communities comes from investors investing in municipal bonds issued by smaller government entities.
This type of investment is often considered to be nearly risk-free as it is backed by larger entities, thus the investor will almost always get their money back.
Key Takeaways
- Underlying debt refers to debt obligations, such as loans and bonds, guaranteed or backed by larger government entities for smaller ones within their jurisdiction.
- This type of debt is similar to municipal bonds and is crucial for funding projects aimed at improving communities, including infrastructure, education, healthcare, and environmental initiatives.
- Underlying debt aims to enhance creditworthiness over time for smaller entities, enabling them to raise capital at lower interest rates and support economic development.
Understanding Underlying Debt
Underlying debt is managed by government entities through the form of municipal bonds. However, larger government entities are the ones responsible for maintaining creditworthiness should a smaller entity fail to meet its obligations.
Underlying debt can impact an entity's creditworthiness, which means how suitable an organization is in receiving financial backing or how capable someone is of paying back their loans. Delays in interest payments also make one less creditworthy.
In this case, if the smaller government entity cannot repay what it borrowed, it will have bad credit. Thus, it is the larger entities’ responsibility to manage this and maintain good creditworthiness.
In general, however, many municipalities that need this type of funding have smaller tax bases, meaning that the region may have lower average household income and other economic activity.
Given the municipality's poor financial performance, it is essential that large governments participate in paying off any obligations necessary to preserve a positive credit standing.
Still, the purpose of underlying debt is to help these municipalities become more creditworthy over time as they develop the financial resources.
It also helps small entities raise more capital that could be spent to improve economic activity at lower interest rates. This benefit makes it more feasible for struggling municipalities to pay back.
How Does Underlying Debt Work?
There are many types of entities that could use this service to raise capital and fund their projects.
Some examples of entities that turn to this type of financing include:
- School districts
- Townships
- Hospitals
- Municipalities
- Villages/cities
The projects they intend to raise capital for could be building a park for greater communal activities, establishing a more efficient waste management system to improve the quality of living, or making a more accessible public transportation system for more convenient everyday travel and commute.
It is important to note that although alternative methods to help actualize these types of projects are being explored, such as crowdfunding, bond issuing is still currently the most common approach for raising capital.
But how was the capital raised? The money comes from investors who buy bonds from local government entities like the district or city.
Once the transaction is made, the entity will use the capital raised from selling bonds to build the necessary projects. In turn, the entity must repay the investor the principal amount or the face value of the bond plus the bond's interest or coupon rate.
However, what is the incentive for investors to invest in buying these bonds?
Although it makes sense to hesitate to do so, knowing that the local government entities may lack creditworthiness, investors know that bond investments are usually close to being risk-free.
This is because the larger government entities will help repay the debt obligation if the local or smaller entity fails to do so. Sometimes, this type of assistance comes from emergency funding.
Regardless, there is still risk involved with this approach to investing. More specifically, a smaller entity could default on its debt, leading to issues regarding liquidity and return.
Despite this concern, it is often assumed that the larger entity will step in no matter how dire the situation is to ensure that all debt has been paid off.
This is also why investing in municipal bonds is often considered almost but not entirely free of risk.
Examples of Risks in Underlying Debt
Practically, it is necessary to understand that it is not always guaranteed that a larger entity will help repay the debt owed by the smaller entities.
In some cases, like Detroit, Michigan, the cities have struggled financially for years and find it increasingly difficult as it is more expensive for them to receive investments for capital expenditures. This is an example and consequence of losing creditworthiness.
New York City also had some financial backing issues in the 1970s, when it became insolvent, while Chicago, Illinois, relied on its taxing authority to help back the bonds. Both of these cases demonstrate how the cities lost the trust of the investors to help with raising capital.
This poses a risk for the larger entity, which may eventually require even greater financial support as they are now associated with having trouble with repayments.
This is because the smaller entity’s failure to repay debt consistently also lowers the creditworthiness of the larger entity, causing a negative domino effect.
However, the chances of the larger entity defaulting are extremely unlikely.
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