Underlying Debt

What is Underlying Debt?

Underlying debt is a term used to denote the debt obligation(s) of a smaller government entity that is guaranteed by a larger government entity in its jurisdiction. In such an instance, the larger entity considers the debt obligation issued by the smaller entity to be its underlying debt.

The concept of underlying debt is frequently referenced in relation to municipal bonds. A municipality that issues debt in the form of bonds may have the benefit of a larger government entity, such as the state or federal government, being willing to guarantee the municipality’s credit responsibilities.

Significance of Underlying Debt

Underlying debt is of primary importance to the smaller government entity that issues the debt that the larger entity considers underlying debt. These municipalities typically have smaller tax bases and therefore are seen to be less creditworthy. . The implicit backing from the larger government entity enhances the credit status of the debt and allows small entities to raise capital at lower interest rates.

Example

School districts, villages, townships, cities, and municipalities commonly need to raise money to fund capital projects, such as the construction of a new school or of a school park, infrastructure projects (e.g., highway or bridge maintenance), hospitals, public transportation, construction or renovation of public buildings, waste management, etc. Although new sources of capital funding, such as crowdfunding, are being explored, the most common means of raising money is still by issuing bonds.

The appropriate government entity, such as a city or school district, will sell bonds to investors. The entity thereby receives the money it needs for a capital project, taking on the obligation to pay back to investors the principal amount of bonds purchased, along with the stated interest rate or “coupon rate” that the bonds carry.

The issuance of municipal bonds usually involves an assumption that, should the bond issuer experience financial problems that cause it to have difficulties repaying the debt, a larger government entity, such as the state government, will step in and provide the necessary funds to pay back the bond investors.

It is highly unlikely that the smaller government entity that issued the bonds will simply default on its debt. Rather, there is an implicit assumption that the smaller government entity’s debt obligation is ultimately backed by the taxation power of the relevant larger entity.

Underlying Debt Considerations for Larger Government Entities

Although the idea that a larger government entity takes on some responsibility for the smaller entity’s debts is not necessarily a formal arrangement – rather more of an implicit assumption – it can still have a significant impact on the finances of the larger entity.

For example, Detroit and other major cities in Michigan have been in severe financial straits for many years. Because of the existence of huge amounts of underlying debt created by the cities, the state of Michigan itself has found it increasingly more difficult and more expensive to borrow money.

In other words, underlying debt can be a plus for a municipality, but it represents a risk for the larger government entity.

More Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

• Credit Risk
• Probability of Default
• Standby Letter of Credit (SBLC)
• Underlying Asset
• See all commercial lending resources