What it means
Mechanically, a public body wants a school, a fire station or a fleet of vehicles but cannot or does not want to issue bonds. A separate entity acquires the asset, leases it to the public body, and sells certificates representing slices of the resulting lease stream to investors.
The legal distinction is the whole point of the structure. Because the payments are lease payments rather than debt service, they usually sit outside statutory debt ceilings and outside any requirement to hold a referendum, which is why the arrangement exists at all.
Investors accept a particular risk in exchange for that convenience. Most of these leases are subject to annual appropriation, meaning the governing body must vote the money through in each budget year, and non-appropriation is not a default in the ordinary sense: the lease simply ends, the asset reverts and the income stops.
That risk shows up directly in pricing. Certificates of participation normally yield more than general obligation bonds from the same issuer, because holders depend on a political decision each year and on the resale value of a specialised asset if things go wrong.
The choice of asset is therefore part of the credit analysis. A courthouse or a central administration building is very hard for a public body to walk away from, while a leisure centre is easier, and the more essential the asset the stronger the certificate.
For the public body the trade-off is cost against speed and flexibility. The structure can deliver a needed building years earlier than a referendum cycle would allow, and the price of that is a higher interest cost spread over the life of the lease.
In practice
Real-world examples.
Example
A county needs a new emergency dispatch centre and faces a two year wait for the next ballot date. It issues $18,000,000 of certificates of participation secured on a lease of the completed building, and construction starts within four months. The annual lease payment appears in the budget as an appropriation item rather than as debt service.
Example
A state university finances a $40,000,000 student services building through certificates because its bonding capacity is already committed to residence halls. Investors price the certificates about 0.5 percentage points above the university's regular bonds to reflect appropriation risk. The finance office documents that premium for its board before proceeding.
Example
A city replaces 60 refuse vehicles using a $14,000,000 equipment lease financed by certificates with a seven year term matching the vehicles' useful life. Matching the lease term to the asset life avoids the familiar trap of still paying for equipment that has already been scrapped.
Formula
Calculation
Annual lease payment = Principal instalment + (Interest Rate x Outstanding Principal)
A city finances a $10,000,000 maintenance depot with certificates of participation repaid over 10 years, with equal principal instalments of $1,000,000 a year and interest at 4% on the balance outstanding at the start of each year.
Year 1: principal of $1,000,000 plus interest of 4% x $10,000,000 = $400,000, giving a lease payment of $1,400,000.
Year 2: principal of $1,000,000 plus interest of 4% x $9,000,000 = $360,000, giving a lease payment of $1,360,000.
The interest element falls by $40,000 each year as the balance reduces. Total interest is 4% applied to the sum of the ten opening balances, which is $55,000,000, so total interest is 4% x 55,000,000 = $2,200,000.
Total lease payments across the ten years are 10,000,000 + 2,200,000 = $12,200,000 for a $10,000,000 asset. If general obligation bonds had been available at 3.4%, total interest would have been 3.4% x 55,000,000 = $1,870,000, so the flexibility of the certificate structure costs this city $330,000 over the term.Case study
Seen in the real world.
Ridgeline Valley School District is an illustrative, fictional district used here to show both sides of the structure. The district had outgrown a 60 year old middle school, had twice failed to pass a bond referendum, and had 180 pupils in temporary classrooms.
It financed a $26,000,000 replacement school with certificates of participation at an interest rate roughly 0.6 percentage points above what a general obligation bond would have cost, which in this fictional example amounted to around $2,100,000 of extra interest over 20 years. The school opened two years earlier than any realistic referendum timetable would have allowed.
Three years later a new board majority disliked the arrangement and asked whether the annual appropriation could simply be refused. Counsel explained that non-appropriation would end the lease and hand the building to the trustee, and the appropriation was duly voted through. The illustrative lesson is that appropriation risk is real for investors and usually theoretical for essential assets, which is exactly why the asset choice drives the pricing.
Watch out
Common mistakes.
- Reading certificates of participation as ordinary municipal bonds, when the payment depends on an annual appropriation vote rather than on a general promise to pay.
- Assuming the structure is cheaper because it avoids a referendum, when it almost always carries a higher interest rate than conventional debt from the same issuer.
- Financing short-lived equipment over a long lease term, which leaves the public body paying for assets it has already retired.
Questions
People also ask.
Who actually owns the asset?
A trustee or financing authority holds legal title during the lease, and ownership normally transfers to the public body once the final payment is made.
What happens if the government does not appropriate the money?
The lease terminates, the asset goes back to the trustee to be sold or re-let, and certificate holders recover what the asset is worth rather than the full amount outstanding.
Are these suitable for a cautious investor?
They can be, provided the investor understands they are buying appropriation risk on a specific asset, which is why essential-use buildings trade at tighter yields than discretionary ones.
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