Underlying Debt

In municipal bonds, underlying debt relates to an implicit understanding that the debt of smaller governmental entities might also be backed by the creditworthiness of larger governmental entities in the jurisdiction. On their own, these smaller entities might have a difficult time raising funds if they did not have a robust financial position. However, the implicit backing of larger entities facilitates borrowing by smaller entities and allows them obtain lower interest rates on their debts. The municipal bonds would be considered the underlying debt.

This situation of smaller municipal debts being implicitly backed by larger governmental entities is quite common in practice. This occurs where smaller entities like cities and school districts offer bonds to the public to finance operations and new initiatives. If a smaller entity is unable to repay its debts, it is unlikely that the city or school district will simply be allowed to become insolvent and cease operations. Rather it is expected that the state will intervene to provide emergency funding to continue debt service and maintain essential services.