If you’re like me, when you think of bonds issued by a municipal government, general obligation (GO) bonds likely come to mind—those backed by the issuer’s taxing authority, often through ad valorem property taxes. However, if the term "Certificate of Participation" (COP) is included in the title, it’s a game changer.
Unlike the standard GO bond issuance, where the issuer pledges their taxing power as the security of the bond, the mechanics and security of COPs1 are different.
How Lease Certificates of Participation Work
In a lease Certificate of Participation financing, the governmental obligation is a lease2 entered into between a municipality, acting as the lessee, and a financing entity as the lessor—which can be a nonprofit or even a for-profit corporation.
A COP is used to fund a tax-exempt project or purpose functions as a tax-exempt lease-financing agreement that is sold to investors as securities. These securities share many characteristics with traditional tax-exempt bonds, such as serial or term bond structures, being callable, and being issued in $5,000 denominations.
Like standard bonds, COPs involve cash flows consisting of principal and interest payments made at regular intervals. However, the key distinction lies in their security: rather than being backed by taxes, COPs are secured by the lease agreement itself.
Also, COP financings require the involvement of an underwriter or placement agent and must comply with the disclosure requirements set by the Securities and Exchange Commission (SEC). This includes issuing an Official Statement (examples of which are included at the end of this blog).
Why COPs are a Popular Choice for Municipal Debt
Among state and municipal governments, COPs are the most popular form of appropriation-supported debt. One of the main reasons for their popularity is that, in many states, COPs are not considered a “debt” and thus do not require prior voter approval before issuance— unlike many GO bonds. This potentially shortens the path to a debt issuance.
Under the terms of a lease agreement, the municipality (lessee) is obligated to make base rental payments, which are separated into principal and interest (P&I) components.
Before the sale of the certificates is finalized, the municipality assigns a trustee through a trust agreement. The trustee is responsible for receiving the base rental payments from the municipality and distributing the P&I payments to the certificate holders.
Understanding the Mechanics of COP Financing
The mechanics of a COP financing are a little more complicated than a standard bond issuance. Here’s how it works:
- The municipality enters into a lease agreement with a financing entity.
- The municipality also establishes a trust agreement with a bank, designating it as trustee.
- The trustee, through an underwriter, sells the COPs to investors in the capital markets. Each certificate represents a fractionalized interest in the lease payments. This means investors buy a share of the lease payments rather than a bond.3
- The municipality (lessee) then makes base rental payments to the financing entity. These payments are assigned to the trustee, who then distributes them to the COP holders.
The Flow of Funds in a Certificate of Participation
Many states in the U.S., including California, Colorado, Florida, and North Carolina, issue COPs as a financing method for public projects, either as equipment, property, or facility. COPs are issued to fund public infrastructure and educational facilities such as school construction or major public works.
Below is a diagram of a basic lease Certificate of Participation flow of funds4:
Key Factors Influencing COP Credit Ratings
The credit of both the municipality and the specific project are considered when rating a COP issuance.
Key considerations include:
- Municipality Creditworthiness: The credit rating of COPs depends heavily on the creditworthiness of the lease municipality. Factors such as the municipality's financial health, revenue streams, and economic stability are crucial.5
- Lease Payment Security: COPs are secured by the lease payments made by the municipality. These payments are often subject to annual appropriation, meaning they must be approved each year by the municipality's governing body.6
- Default Risk: While COPs are generally considered safe, they do carry some risk. If the municipality fails to make lease payments, investors are left owning the leased property which may not be sufficient to repay the COP in full.
- Legal Considerations: State and federal laws impact the structuring and credit aspects of COPs. Compliance with these laws is essential to maintain the tax-exempt status and overall legality of the financing.
The Essentiality of the Project and its Impact on COP Ratings
Another important consideration in assessing the creditworthiness of a COP issuance is the perceived essentiality of the project being financed. If the credit rating agencies don’t see the project as an “essential” project, they may consider it more likely that, during economic downturns, the municipality might not appropriate the lease payments.
In such cases, the ownership of the project would transfer to the COP holders, as COPs represent shared ownership of the project. This added risk—stemming from the possibility of non-appropriation—often results in COPs carrying slightly higher yields than a standard GO bond issuance.
In Moody’s “US States and Territories Methodology” report, the rating of a COP can range from one to three notches below the municipality’s rates, depending on legal structure.
Visual Examples: Key Elements of COP Official Statements
Diagram 1. Portion of front cover of a North Carolina Certificate of Participation Official Statement
Diagram 2. Portion of Security Section of North Carolina COP OS
Diagram 3. Portion of front cover of State of Ohio COP transaction
Diagram 4. Portion of security section of State of Ohio COP OS
Understanding COPs for Smarter Financing Decisions
Certificates of Participation provide municipalities with a flexible and efficient financing tool for critical projects, offering an alternative to traditional general obligation bonds. While they come with unique considerations—such as lease payment security, project essentiality, and credit rating impacts—COPs remain a valuable option for funding public infrastructure and facilities.
By understanding the mechanics, risks, and benefits of COPs, municipal leaders and finance professionals can make informed decisions that align with their financial strategies and community needs.
[1] In this write-up, I am discussing lease COPs. There are other COPs backed securities (e.g., installment sale agreement)
[2] There are two lease participants (1) Lessee: A lessee is a person who rents land or property from a lessor. The lessee is also known as the “tenant” and must uphold specific obligations as defined in the lease agreement and by law. The lease is a legally binding document, and if the lessee violates its terms they could be evicted. (2) Lessor: A lessor is essentially someone who grants a lease to someone else. As such, a lessor is the owner of an asset that is leased under an agreement to a lessee. (Investopedia)
[3] Municipal Finance: Structuring Tax-Exempt Finance Models | CLE Webinar
[4] Source: Association for Government Leasing and Financing, An Introduction to Municipal Lease Financing: Answers to Frequently Asked Questions (municipal_lease_financing booklet.pdf)(July, 2000)
[5] National Associate of Bond Lawyers (NABL)
[6] Municipal Finance: Structuring Tax-Exempt Finance Models | CLE Webinar
Related Municipal Finance Reading
- Debt Service Calculator for Tax-Exempt Bonds
- Breaking Down the Math Behind Municipal Bonds
- Solving the Challenges of Decentralized Data in Treasury
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