Circumscribing debt issuance with written policies. (Best Practices).

The City of Virginia Beach credits its adherence to written debt policies for the city's strong financial position and credit ratings, not to mention reduced debt service costs.

In February, the GFOA Executive Board approved a new recommended practice entitled "Debt Management Policy." This replaces two 1995 recommended practices concerning debt policies: "Analyzing Debt Capacity and Establishing Debt Limits" and "Development of a Debt Policy."

GFOA's Committee on Governmental Debt Management periodically reviews all existing recommended practices to ensure that they reflect the latest debt practices and thinking. As part of the review process, the committee also considers whether it would be beneficial to combine practices that were meant to be used together. "Analyzing Debt Capacity and Establishing Debt Limits," for example, included all the essential ingredients of an effective debt policy, which were then reemphasized in "Development of a Debt Policy." The committee determined that combining the two into one new recommended practice would present a more complete picture of an effective debt policy.

"Debt management policies are written guidelines and restrictions that affect the amount and type of debt issued by a state or local government, the issuance process, and the management of a debt portfolio," the new practice states. "A debt management policy improves the quality of decisions, provides justification for the structure of debt issuance, identifies policy goals, and demonstrates a commitment to long-term financial planning, including a multi-year capital plan. Adherence to a debt management policy signals to rating agencies and the capital markets that a government is well managed and should meet its obligations in a timely manner.

Managed properly, debt can be an effective tool for furthering important government objectives. Debt financing for large capital improvements represents a practical alternative to pay-as-you-go financing that matches streams of costs and benefits over the useful life of an asset and promotes intergenerational equity. However, the burden of repayment is one that should not be taken lightly. Debt issuance must be managed in such a way that governments can continue to provide necessary and desired public services and repay all outstanding capital obligations. A debt policy establishes parameters to ensure that the overall debt program is managed within available resources.

The updated practice reaffirms GFOA's recommendation that state and local governments adopt comprehensive written debt management policies, which should be reviewed at least annually and revised as necessary. The practice also outlines the elements of an effective debt policy. A debt policy should address types of debt, debt limits (legal, policy, and financial), use of derivatives, debt structuring practices, debt issuance practices, and debt management practices.

Since the early 1990s, the City of Virginia Beach, Virginia, has had written debt policies to guide its debt management program (see Exhibit 1). The rest of this article describes how and why the city developed its debt policies and how they have positively affected the management of the city.

GROWTH FUELS BORROWING

Virginia Beach is located in the southeastern portion of the Commonwealth of Virginia. It was incorporated on January 1, 1963, the result of the merger of the smaller City of Virginia Beach and Princess Anne County. The city has grown rapidly over its 40 years. It now has an estimated population of 428,400 and covers approximately 300 square miles. The conservative charter permits the city to issue $10 million of general obligation bonds per year without a referendum (plus the principal of any debt retired in the year). As the city grew, it adhered to the charter limits on debt issuance, even though the city's infrastructure needs -- including water and sewer--could not keep pace with the growth.

As the population growth rate exceeded 10 percent and the local economy boomed during the mid-1980s, the 11-member City Council began to recognize the need for new roads, schools, and other infrastructure. To meet these needs, Virginia Beach had to look beyond the restrictive limits on general obligation debt specified in the city charter. The city held several bond referenda on general obligation issues in excess of the $10 million cap, and it established revenue bond programs for water and sewer and storm water. In addition, the city periodically issued other types of debt, such as certificates of participation for a major judicial center.

During this period, the political climate favored the issuance of new debt. Citizens approved referenda for schools, roads, and recreation centers. Although the citizenry continued to demand improvements, the city recognized the need to evaluate debt affordability and capacity. To this end, the city retained consultants (i.e., financial advisors) to evaluate debt capacity and its effect on the city's creditworthiness and access to financial markets. Benchmarks were established for debt per capita and other debt affordability measures. By the early 1990s these benchmarks had been incorporated into written policies. The benchmarks themselves have been increased only once since their original adoption.

DEBT POLICY DEVELOPMENT AND USE

Because Virginia Beach issued such a substantial amount of debt during the 1980s, the city may have been ahead of the curve in terms of its debt practices. Recognizing the need for debt policies to guide its growing capital plans, the city developed its first debt management policies with the help of its financial advisors. These policies were based on conservative projections of population growth, income, governmental expenditures, and the tax base. A proposed acceleration of capital spending for schools, transportation, economic development, and public safety was incorporated into the policies. An overriding consideration in the development of debt policies was the desire to maintain or improve the city's credit ratings.

These early policies focused on key debt ratios, such as annual debt service to general government expenditures, overall net debt to estimated full market value, overall net debt per capita, and overall net debt per capital to per capita personal income. The City Council quickly grasped the significance of these ratios and incorporated them into the city's financial management and planning policies and procedures. Other aspects of the city's debt policies have been slower to develop.

Extensive written policies have become indispensable to stakeholders desiring to understand the city's financial position. Debt limits provide a common understanding of how much debt the city can afford and why priorities must be set and choices made. The city's recent decision to build a $193.5 million convention center illustrates the utility of debt policies. Several diverse community groups came together to support this project. The need to raise the tax rate on the restaurant meal tax and the hotel tax were better understood when placed in context of the city's debt policies and credit rating goals.

Virginia Beach is currently well within its policy limits. However, over the next five to seven years, the city is expected to exceed debt per capita limits when it bonds for the new convention center. As part of its overall debt management program, city staff met with each of the rating agencies to discuss this situation and to assure them that the city's long-range plan is to bring the debt per capita ratio back within the policy limits within a reasonable period of time.

Virginia Beach's debt policies have contributed to the city's strong financial position. The debt affordability indicators are well within policy limits and the undesignated general fund balance is healthy. The city's general obligation bonds are rated AA+ by both Standard & Poor's and Fitch and Aal by Moody's. These ratings have been upgraded over the last several years, and the ratings agencies have all cited the city's strong written policies and management practices as major factors in their decisions.

Improved credit ratings have reduced the city's borrowing costs. The city's financial advisors have estimated savings of as much as $1 million for a single bond issue, based on the size of the issue and financial conditions at the time of sale. While the city's annual debt service continues to increase, debt service costs as a percentage of general government expenditures has declined over the last 10 years from 10.4 percent to 7.7 percent.

Exhibit I: City of Virginia Beach, Virginia -- Summary of Debt Management Policies

1. When practical, the city will develop, authorize, and issue revenue, special fee, or other self-supporting debt instruments instead of general obligation bonds.

2. Debt Limits:

* The total annual budgeted debt service for general government-supported debt will not exceed 12.5 percent of general government budgeted expenditures.

* The city's overall net debt will not exceed 3.5 percent of estimated full market value.

* The city's overall net debt per capita shall not exceed 6.5 percent of per capita personal income.

* The city's overall net debt per capita will not exceed $1,500 per capita.

3. The city's general obligation public improvement bond issues should be structured such that, on average, the bond life is 10 to 12 years. Generally, the city will structure each general obligation public improvement bond issue on an equal annual principal basis.

4. When the city finances capital projects by issuing bonds, it will pay back the related debt within a period not to exceed the expected useful life of the projects.

5. The city will maintain good communications regarding its financial conditions, It will regularly evaluate its adherence to its debt policies. The city will promote effective communications with bond rating agencies and others in the marketplace based on full disclosure.

6. Historically, the city has never borrowed on a short-term basis for general operating costs and does not anticipate such borrowing in the future. It is the policy of the city to maintain cash balances at a sufficient level for general operating costs (those items normally funded in the city's annual operating budget and having a useful life of less than one year). Such short-term securities may be issued in cases where the city's normal cash flow has been disrupted as a result of natural disaster or unexpected delays in the receipt of federal or state revenues.

7. Coverage for revenue bonds shall be at least 120 percent of annual total debt service.

Note: The actual debt policies are six pages long, and include definitions and other reference material. These policies are published in the city's annual capital improvement program as well as in the annual long-term debt report.

PATRICIA PHILLIPS is finance director of the City of Virginia Beach, Virginia. She also chairs the Recommended Practices Subcommittee of GFOA's Committee on Governmental Debt Management.

RICHARD DUNFORD is debt and financial services administrator for the City of Virginia Beach, Virginia