The User’s Perspective: Five Questions For Bob Reardon
Q: What information in a government’s annual financial report prepared following generally accepted accounting principles (GAAP) is of most value to you and how does that vary depending on the type of investment you are considering?
A: If you’re talking about GO [general obligation] investing, the first thing we look at is the notes to the financial statements. That’s where there’s a lot of vital information that may not necessarily show up on the face of the statements, especially related to pensions, contingent liabilities, OPEB [other postemployment benefits], and the other major issues we are concerned about.
After that, we take a look at the face of the balance sheet and income statement. The marketplace is still adapting to the notion of the government-wide statement of net assets, though some people are ahead of others in the utilization of that information.
We also look at the MD&A [management’s discussion and analysis]. That’s one place that really gives you a little more color about what’s going on and gives you an idea of the management focus and capability of the particular government you’re analyzing.
If you’re talking about revenue bonds, that tends to be more of an operating model. We’re going to look at the business market statistics and financial ratios. There’ll be an emphasis on looking at the operations, especially if you’re looking at a monopolistic-type entity within a community.
The rest of the task is looking at the balance sheet, cash flows, debt service coverage, and long-term liabilities. We’re heavily dependent on the notes relative to contingent liabilities, especially for environmental-type requirements that create large capital expenditures. That’s something we’d like to see in MD&A, a discussion of what their future capital programs are and what their five-year capital budget is projecting.
Q: How has the municipal bond market changed during your career?
A: It has changed quite a bit. . On the sell-side, a lot of the underwriting firms have changed and become much more concentrated. There are far fewer local firms that handle the smaller transactions in the marketplace. A lot of underwriting and distribution has been concentrated in the larger regional firms and the big New York houses.
On the buy-side, individuals still drive the market off and on at times, but the mutual funds have really become a force in the marketplace, which is very different from the 1980s. You’ve also seen new investors who may or may not be utilizing the tax exemption available in the market—a lot of use of leverage, a lot of managed accounts, a lot of hedge funds or proprietary pools of capital—which tend to move the market around.
The other thing is there has been an increased emphasis on the high-yield sector, especially by mutual funds. There has been increasingly less focus on the essential-service-government and utility sectors than what we had traditionally seen by those investors.
On the good side, we actually now have better financial reporting, and the disclosure is much better for state and local governments almost across the board.
Q: In what ways have annual GAAP financial reports become more useful during your career?
A: Disclosure is much better and more consistent now than it has ever been. The notes, which we rely on, are more extensive. Those that follow the standards offer much better information than they did before.
Financial statement analysis, as a result, has become a much greater proportion of what we do now, whereas at the GO level it used to be more of an economic and demographic analysis of the community.
Now we look at the financial operations, where the tax dollars are going, how services are being funded, and how governments are executing from an efficiency and effectiveness standpoint.
One problem is that some governments have made the decision not to follow GAAP standards, and that becomes increasingly more difficult to analyze.
Q: The GASB understands that financial statement users are concerned about the timeliness of financial reporting. How soon after the fiscal year end do you need to receive the financial report?
A: We’d like to see it within four months, that’s really ideal. Six months is still probably acceptable. But once you get over six months, that’s really getting to be a problem.
It becomes difficult to have confidence in the performance and management ability of those who struggle to produce financial statements until late in the year.
You’re also seeing underwriting firms beginning to back away from governments that aren’t diligently and effectively filing financial statements consistently on time.
Q: What effect, if any, does a lack of timeliness have on a government’s borrowing costs?
A: There’s lots of liquidity in the market right now and rates are extremely low. So while there is a penalty paid, I believe, by those municipalities, it’s probably not really noticeable on an overall basis, especially if they’re financing infrequently.
What you’re beginning to see is that firms, especially the larger dealers with fully developed compliance departments, will not bid in the competitive marketplace on some issuers with real problems with failure-to-file notices under the MSRB [Municipal Securities Rulemaking Board] regulations.
I think compliance efforts are beginning to have an effect on these issuers. There, you really do see a true increase in relative interest costs. Now, in absolute terms, interest rates are so low, and there’s so much money available, that they’re still able to achieve financing. However, there may be a quarter- to a half-percent penalty versus a common government within the same state.