February 24, 2020

Pennsylvania Limits Interest Accrual on Capital Debt

Robert J. Hobaugh, Jr.

Pennsylvania has limited interest that accrues on its capital debt obligations by enacting Act 43 of 2019 (the Act”) which requires principal payments to be made in equal annual maturities. This plan requires an equal amount of principal to be included in each payment over the life of an obligation. The Act removes a prior repayment option of increasing principal components of level payments to bondholders. The result of uniform principal reduction is that interest accruing on the declining principal amount requires less interest to be paid over the life of the debt. According to a Senate Appropriations Committee Fiscal Note, the Act “will result in a savings of $51.6 million to the Commonwealth in interest payments for debt service on a $1 billion, 20-year issuance at an interest rate of 4% [per annum].” Accordingly, Pennsylvanians will save money on capital debt obligations and ratings agencies could use this information to improve ratings on such obligations and thus reduce the rate of interest applicable to Commonwealth debt.

The Act amends the Capital Debt Facilities Debt Enabling Act, Act of February 9, 1999 (P.L. 1, No.1) as amended (the Capital Debt Law”). The Capital Debt Law covers Commonwealth indebtedness for capital expenditures which defer costs over the useful life of roads, bridges and other public facilities (“Capital Debt”). Capital Debt should be distinguished from debt incurred for the present cost of pensions, grants, salaries and subsidies to others (“Current Debt”). Current Debt covers items presently consumed and paid from current revenues of the Commonwealth. Capital Debt is a long-term borrowing and substitute for tax increases, although repayment comes from tax revenues, and in some cases, revenues related to financed projects and from taxpayers. Our ability to borrow for Capital Debt is closely linked to the Commonwealth’s ability to tax us. General obligation bonds (“GOs”) are repaid from pledged taxes and the Commonwealth’s ability to increase taxes helps to determine the risk rating assigned to GOs. Accordingly, the Pennsylvania Constitution and laws limit indebtedness and repayment to protect citizens of the Commonwealth so that (1) Capital Debt is not used as a disguised present tax increase and (2) our children and grandchildren are not burdened with unreasonable tax obligations.

Article VIII, Section 7 of the Pennsylvania Constitution provides that the Commonwealth may issue debt for the following purposes: (1) to suppress insurrection or provide disaster relief, (2) to assure cash flow with tax anticipation notes, (3) to refund existing debt, (4) for purposes approved by the voters in a referendum, and (5) for projects in an approved capital budget whose costs comprise Capital Debt. The Pennsylvania Constitution further limits Capital Debt in Article VII, Section 7(a) (4) and (b), as follows:

(4) Debt may be incurred without the approval of the electors for capital projects specifically itemized in a capital budget, if such debt will not cause the amount of all net debt outstanding to exceed one and three-quarters times the average of the annual tax revenues deposited in the previous five fiscal years as certified by the Auditor General. For the purposes of this subsection, debt outstanding shall not include debt incurred [for insurrection, disaster recovery or debt previously approved by voters] and [tax anticipation notes], or [refunding debt within the limits of the initial debt maturity] if the original debt would not be so considered, or debt [approved by a majority of voters in a referendum] unless the General Assembly shall so provide in the law authorizing such debt.

(b) All debt incurred for capital projects shall mature within a period not to exceed the estimated useful life of the projects as stated in the authorizing law, and when so stated shall be conclusive. All debt, except [tax anticipation debt], shall be amortized in substantial and regular amounts, the first of which shall be due prior to the expiration of a period equal to one-tenth the term of the debt.

Accordingly, Capital Debt may not exceed a maximum amount, shall be amortized within the useful life of the project and in substantial and regular amounts. Clearly, protection of Pennsylvania citizens is a policy in the Constitutional limits of Capital Debt.

The Act further protects our citizens by limiting the constitutional reference to “substantial and regular amounts.” Previously the Capital Debt Law provided that principal retirements would be substantial and regular if computed in accordance with “either a level annual debt service plan as nearly as may be or upon the equal annual maturities plan.” The Act has eliminated the ability to comply with the Constitution by using a level annual debt service plan, except as to refunding bonds. Each bond payment has a component of principal and interest. An equal annual maturities plan causes principal to be paid in equal amounts over the life of the borrowing, resulting in equal reductions in principal and declining amounts of interest accruing on that outstanding principal. An annual level debt service plan, which is no longer permitted for initial issuances of Capital Debt, provides equal regular payments with an increased component of interest in the early payments and an increased component of principal later in the payment schedule. An annual level debt service plan results in increased interest paid over the life of the borrowing. The Senate Appropriation Committee estimates that interest under an annual debt service plan would be $16 million higher in the first issuance year for a $1 billion bond than under an equal annual maturities plan.

Refunding bonds may continue to have repayments based on an annual level debt service plan. Such debt includes advance refunding bonds which issue under a lower interest rate than the initial obligation. This is an important tool for cost savings by the Commonwealth in markets with declining interest rates. The maximum capital debt amount is based on 1.75 times the annual tax revenues of the last 5 fiscal years but outstanding debt does not include refunding debt with the same maturity as the initial issuance if the initial debt was excluded from the maximum debt calculation. This prevents refunding bonds from extending the life of initial bonds but does avoid the cost savings of the Act.

The Act could help raise the debt ratings for Pennsylvania Capital Debt and thus lower the interest rate payable on any particular obligation. Nationally Recognized Statistical Rating Organizations (“NSROs”) assess an issuer’s ability to timely repay debt and assign an alphabetical rating to each issuance. The rating determines the interest rate payable on a bond because it measures risk of timely repayment. The higher the risk (lower rating), the higher the interest rate expected by investors. The higher the rating (lower risk), the lower the interest rate payable to investors. According to Arthur D.Heilman in his monograph entitled, State Debt-A Primer, (2012, last revised 2018) (“State Debt”), the Commonwealth’s rating downgrades in 2012, 2013 and 2014 were attributable to a broadened analysis of risk. “These organizations and the investment community in their analysis of risk have increased their focus on the growing, and in some cases significantly large, future costs of providing continuing and promised employee pension and other post-employment benefits and have expanded their concept of debt to include these liabilities together with those associated with a government’s bonds and other debt obligations.” State Debt, at p. 2. In addition to cumulative debt, NSROs consider the management strength of the issuer, results of financial operations, strength of financial planning and social factors. See, State Debt at p. 22. “The most recent rating change for the Commonwealth’s [GO] debt was in September 2017, when Standard and Poor’s lowered its rating of the Commonwealth to “A+” from “AA-” explaining the rating change was due to a chronic structural budget imbalance, late budget adoptions and a weakening of its liquidity position.” State Debt at p. 24. The Act positively addresses many of these risk issues such as cumulative indebtedness, management strengths and strengths of financial operation. Accordingly, Pennsylvania’s GO rating by NSROs could be enhanced by the cost savings underlying the Act.

 The Act began as HB 24, sponsored by Rep. John Lawrence (R-Chester County), and co-sponsored by Rep. Mike Turzai (R-Allegheny), Speaker of the House of Representatives. HB 24 was approved by the House on June 27, 2019 and the Senate on June 28, 2019. The Governor approved HB24 on July 2, 2019 and it became Act 43 of 2019. The Act took effect immediately and will apply to bonds, including funding bonds, issued on or after July 1, 2021. The Act is important because it will reduce the interest paid by Pennsylvanians for Commonwealth Capital Debt, and could positively affect Pennsylvania’s debt ratings thus lowering the rate of interest payable on subsequent obligations.

Robert J. Hobaugh, Jr.