Moral Obligation Bonds ..................................................................................................
http://www.standardandpoors.com 111M
oral obligation debt differs from other debt
obligations in that there is no legal require-
ment to make debt-service payments. A moral obli-
gation pledge represents a promise by a government
obligor to seek future appropriations for debt serv-
ice payments, typically in order to make up deficits
in a reserve fund should it fall below its required
level. Usually a government official will request an
appropriation and the legislative body may grant it.
In practice, moral obligation debt is customarily
issued by the following municipal entities:
■State governments wishing to enhance the credit-
worthiness of their agencies’ revenue indebtedness;
■State bond banks that lend bond money to local
municipal subdivisions for infrastructure projects;
and
■Local units for financing projects, ranging from
downtown redevelopment, to job training, to
public housing.
Standard & Poor’s Ratings Services criteria for
moral obligation debt are strict, and all require-
ments must be met to achieve a rating based on the
obligor. Moral obligation bonds are typically rated
one full category below an issuer’s GO bond rating.
Rating Methodology
In rating any moral obligation bonds, Standard &
Poor’s expects a standard structure to be in place:
■A reserve fund, funded at maximum annual debt
service at the time of issue, either by proceeds or
other available moneys;
■Language in the resolution (local) or statutes
(state) that outlines the duty and process of mon-
itoring this fund and notifying an appropriate
official in the event the money in the reserve fund
falls below the required level. Such notification
must be made in a timely manner as to meet the
budgetary requirements of that government;
■A requirement that the appropriate budgetary
official request an appropriation to return the
reserve fund to its maximum debt-service
required level whenever there is a draw on that
fund; and
■Language that provides the appropriate body
of elected officials the option to make such
an appropriation.
In assigning a rating, Standard & Poor’s not only
will verify that this structure is in place, but will
evaluate the essentiality of the financing’s purpose
to the issuer. The legislative history will be evaluat-
ed—how important it is to ongoing operations, and
how motivated the issuer would be to live up to its
moral obligation, even if it comes under political
pressure to allocate scarce resources in other ways.
The government must also:
■Represent that it fully intends to satisfy future
moral obligation payments; and
■Provide evidence of legislation authorizing the proj-
ect or program being financed, also detailing the
requirements with respect to deficiency payments.
Most bond issues supported by a moral obliga-
tion pledge are structured to be fixed rate instru-
ments with a debt service reserve sized to maximum
annual debt service. In some instances, bonds have
been issued in a variable rate mode, which suggests
some unique credit concerns and issues. Since vari-
able rate debt payments may fluctuate over time
given changing interest rates, the appropriate sizing
of the debt service reserve is an issue.
In order for Standard & Poor’s to base the rat-
ing of such debt on the moral obligation pledge of
the government obligor, one solution is to set the
debt service reserve at the maximum allowable
interest rate or cap rate under the transaction.
Such a solution would eliminate the concern that
in a rising interest rate environment the debt serv-
ice reserve would not be sufficient to cover a full
year of debt service. Another method of resolving
this issue is to increase the times that a request to
replenish a debt service reserve that has been
drawn upon is made. This would require the abili-
ty of the government obligor’s appropriate budget-
ary official to seek interim appropriations from
the elected officials. Sufficient time must be pres-
ent for those elected officials to meet and react to
such a request. The timing of these events must be
written into the appropriate documents supporting
the bonds.
In general, moral obligation bonds are included in
an issuer’s debt ratio if the underlying non-moral
obligation security stream is not self-supporting on
its own. Similar to appropriation-backed debt, a
moral obligation bond default could result in a
downgrade of a state or local government’s GO rat-