What Is a Sub-Sovereign Obligation (SSO)?
A sub-sovereign obligation is a form of debt obligation issued by hierarchical tiers below the ultimate governing body of a nation, country, or territory. This form of debt comes from bond issues made by states, provinces, cities, or towns in order to fund municipal and local projects.
A sub-sovereign obligation is also referred to as a municipal debt obligation.
Understanding Sub-Sovereign Obligation (SSO)
A sub-sovereign obligation is a form of debt obligation commonly created by municipalities in order to meet funding requirements. Investors or the higher government authority of a country may purchase municipal bonds issued by these sub-sovereign entities. The issuers are obligated to pay interest periodically on the bonds until the securities mature, at which point the principal amount of investment is repaid.
Sub-sovereign obligations are issued to raise capital to finance a project that would add value to a region or community after completion. Interest payment on the obligation can be funded from the revenue that will be generated from the project or from the revenue account of the municipal issuer. Issuing bodies are responsible for their own debt issues, which can carry significant risk depending on the financial health of the municipality. Rating agencies evaluate the risk of default of each issuer and rate the bonds accordingly. However, given that these bonds are backed by a small governmental body, the risk of default is lower than that of corporate bonds. For this reason, municipal bonds are typically issued with lower yields than corporate bonds.
While some sub-sovereign debt obligations are taxable, others are not. A tax-exempt bond is issued to fund a project that directly impacts the community positively. Interest earned on these bonds is not subject to tax at the federal level. An investor has an added tax-exemption benefit at the state or local level if they reside in the state of issue. Sub-sovereign obligations are taxable if the project for which proceeds of the bond finances has no obvious public benefits. Most taxable sub-sovereign obligations are issued to finance the shortfalls of state and local pension funds. Other situations in which taxable sub-sovereign debt may be issued include financing local sports facilities, financing investor-led housing, or refinancing debt. Build America Bonds (BABs) are an example of taxable bonds; they were created under the American Recovery and Reinvestment Act (ARRA) of 2009 and, although taxable, have special tax credits and federal subsidies for the bond issuer and holder.
Investors who purchase debt issued by a sub-sovereign body are exposed to call risk. The municipal debt obligations are callable, which means that an issuer that hopes to refinance its outstanding debt with a lower interest rate, seeks a more favorable payment schedule, or wants a better debt covenant can redeem the bonds prior to maturity. Once a bond is retired from the market on a call date, the bondholder stops receiving interest payments. A debtholder faced with the risk that his or her bond could be called, also faces reinvestment risk. In an economy with declining interest rates, an issuer may seize the opportunity to buy back its existing bonds and reissue the bonds at a lower interest rate. By buying its bonds back, investors may have no choice but to reinvest their proceeds into similar debt offerings with lower interest payments.