This is another in a series of posts that dive deep into some of the more complex nuances of municipal finance. In addition to bonds, municipalities may issue Certificates of Participation, commonly referred to as COPs. Although these may look and smell like a bond, they are not, and investors need to be aware of the differences in these instruments. This post will attempt to explain some of the features of COPs and what to watch out for when purchasing these investments.
How do you get a firetruck?
Sometimes a municipality may want or need equipment like a fire truck, construction equipment, or even a new phone system. If the municipality does not have the cash on hand for a fire truck purchase, that municipality often must issue bonds through a voter referendum. The bond issuance process is long and the outcome, especially in an anti-tax environment, is never guaranteed. So, instead of issuing bonds to gain access to equipment, a municipality may lease the equipment.
Certificate of Participation
A Certificate of Participation (COP) might be issued to lease the equipment needed. The owner of the COP (the “bond” holder if you will) owns a fractional interest in the lease payments the government entity is making to the trustee who receives the lease payments from the government. With a General Obligation bond, the government entity is on the hook for bond repayment. With a COP, the government entity is most often able to get out of the lease if it wants. The lease payments are most often subject to annual appropriation, meaning if the government doesn’t want to continue the lease, it simply won’t appropriate the money to the lease payment due. And yes, the government will lose the fire truck, construction equipment, phone system, etc. that it was leasing, but it can simply walk away.
Anyone want a used phone system?
What happens to the COP holder if the annual appropriation isn’t made? As was mentioned earlier, the capital equipment is often taken back and sold to help make the COP holder whole. If the capital equipment is something fungible like a rail car or a fire truck, it often holds great value. However, if the capital equipment involved in the lease is a phone system, the value is next to nothing. After all, how much is a fully wired and installed phone system worth to a buyer in the secondary market? Again, next to nothing.
Early redemption
If the annual appropriation is not made, the COPs are immediately callable at par. An investor who paid $106 just a couple days before the cancellation of the annual appropriation might get only $100 for his COPs. If the equipment happens to be a phone system or other quickly depreciating asset, watch out! You’ll most likely get nothing close to $100.
Some positives
COPs will carry higher yields than similarly structured high grade bonds because of this risk. If a COP is available at par or a discount, is for fungible equipment, and carries a good rating and has good cash flow, it can be an attractive instrument for those needing fixed income in their portfolio. The more it strays from these guidelines, the riskier it becomes and the more yield the buyer should demand.
Questions? Comments? Reach out to us. We have extensive knowledge and experience with bonds and would welcome your thoughts.
