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California Debt Limit Allocation Committee

What Are Bonds And Why Are They Used?

Definition

Government agencies sell bonds to finance a variety of projects and activities. When investors purchase bonds, they essentially lend money to the bond seller, or issuer. In this way, a bond is similar to an IOU. In return for the bond proceeds, the issuer promises to pay the investor a specified rate of interest over the life of the bond and to repay the bond when it comes due.

Municipal Bonds

Bonds issued by government agencies are called municipal bonds. The funds are used to finance projects that benefit the community such as roads, schools, bridges, sewers, parks, water treatment or low-income housing. Most bonds issued by government agencies are tax-exempt. This means bondholders do not have to pay federal income taxes and, in most cases, state income taxes on the interest they earn.

In addition to the tax-exempt status, investors benefit from the taxing authority of the government agencies. That authority strengthens the security of municipal bonds, giving investors greater assurance they will get paid on time and in full. The tax-exempt status and minimal risk of default lead investors to agree to lower interest rates relative to other forms of borrowing. As such, government agencies, and thus the taxpayers, can benefit from lower borrowing costs as compared to standard market loans or even taxable bonds.

Private Activity Bonds

Government agencies may also, in certain cases, issue tax-exempt bonds on behalf of private businesses. These bonds are known as "Qualified Private Activity Bonds" and may be issued for various purposes such as low income multi-family housing, industrial development, redevelopment projects, enterprise zones or facilities that treat water, sewage or hazardous materials. The lower borrowing costs facilitate the development of projects that may not otherwise be feasible if financed at market rates.

Unlike typical municipal bonds, the payment of principal and interest on private activity bonds is not the responsibility of the issuing government agency. Instead, it is the responsibility of the private business receiving the proceeds. By relieving government agencies of the financial obligations associated with bond debt, private activity bonds are a low-risk alternative for communities to finance projects.

The California Debt Limit Allocation Committee (CDLAC)

The 1986 Federal Tax Reform Act imposed a limit on how much private activity bonds can be issued in a state each year. The limit is determined by a stateís population, multiplied by a specified dollar amount. CDLAC was established to administer the allocation of this bond ceiling or "cap" and to make certain that the total amount of private activity bonds issued does not exceed the limits established under federal law. Through CDLACís administration, the State ensures that this limited resource is efficiently used to finance projects and programs that both provide a public benefit and contribute to the economic vitality of California.