What Is a Certificate of Participation?

Certificates of Participation (COPs) are financial instruments used by governmental entities across the United States. They provide a method for state and local governments to finance public projects and acquire assets. Functioning as a lease-financing arrangement, COPs allow public agencies to secure funding for various initiatives. This approach offers a distinct mechanism for governments to address their capital needs. The following sections will provide a comprehensive understanding of how Certificates of Participation operate within the financial landscape.

Understanding Certificates of Participation

A Certificate of Participation (COP) represents an investor’s share in the lease payments made by a governmental entity for the use of a specific asset or facility. These instruments are tax-exempt lease-financing agreements sold to investors as securities. Unlike traditional general obligation bonds, which are backed by the issuer’s taxing authority, COPs are secured by the lease agreement itself.

Several parties are involved in a COP financing arrangement. The governmental entity, such as a municipality or school district, acts as the lessee, utilizing the asset. A financing entity, often a non-profit corporation or public authority, functions as the lessor, acquiring the asset and entering into a lease agreement with the government. A trustee, typically a bank, is appointed to manage the flow of funds. Investors, who purchase the COPs, receive payments facilitated by this trustee.

COPs allow governmental entities to finance projects without issuing traditional general obligation bonds. This method can circumvent debt limits or voter approval requirements that might apply to general obligation debt in some jurisdictions. COPs serve as an alternative financing tool tied to specific lease revenues rather than a direct pledge of the government’s full taxing power.

The Structure and Mechanics of Certificates of Participation

The structure of Certificates of Participation begins with a lease agreement between the governmental entity and a special purpose financing entity. This entity acquires or constructs the asset for the government’s use. The governmental entity, as the lessee, commits to making regular lease payments to this financing entity.

The financing entity then assigns its right to receive these lease payments to a trustee, typically a bank, through a trust agreement. The trustee issues the Certificates of Participation to investors in the capital markets. Each certificate represents a fractionalized interest in the stream of lease payments the government is obligated to make.

A key characteristic of COP financing is “appropriation risk.” The governmental entity’s obligation to make lease payments is subject to annual appropriation by its legislative body, such as a city council or state legislature. This means future legislative bodies are not legally required to continue appropriating funds for these payments. If a legislative body fails to appropriate funds, the governmental entity may lose its right to use the leased asset, and investors’ recourse is generally limited to the leased property itself.

The government makes lease payments directly to the designated trustee. The trustee distributes these principal and interest payments to the individual COP holders on a pro-rata basis. This pass-through mechanism ensures investors receive their share of the lease revenues as collected.

Common Uses and Applications

Certificates of Participation are used by state and local governmental entities to finance a range of public projects and acquisitions. These instruments provide flexibility for funding various capital needs, particularly when traditional general obligation bonds are not a suitable option.

Common applications include the construction or renovation of public buildings such as schools, administrative offices, courthouses, and police or fire stations. Governments also utilize COPs for acquiring equipment, such as vehicles, technology systems, or heavy machinery for public works.

Infrastructure improvements, such as water and wastewater facilities, parking structures, and land acquisition, are also frequently financed through COPs.

COPs are often chosen because, in many jurisdictions, they are not considered direct “debt” of the municipality. This allows governments to bypass constitutional or statutory debt limits that might restrict general obligation bonds. COPs typically do not require direct voter approval, which can streamline the financing process and make it more efficient.

Investment Considerations for Certificates of Participation

For investors, Certificates of Participation offer specific characteristics. A primary attraction is the tax-exempt status of the interest income generated by COPs. Generally, interest earned on COPs is exempt from federal income tax, and often from state and local taxes for residents within the issuing state. This tax advantage can enhance the after-tax yield for certain investors.

Investors considering COPs should understand appropriation risk. The government’s obligation to make lease payments is contingent upon annual appropriation by its legislative body. While government entities have a strong incentive to make these payments to avoid disrupting essential services or damaging their credit reputation, the absence of a direct, long-term debt pledge means COPs are viewed as having a slightly higher risk profile than general obligation bonds. This increased risk can result in COPs carrying slightly higher yields compared to general obligation bonds from the same issuer.

Despite appropriation risk, COPs are considered a stable investment due to the governmental nature of the issuers. These instruments are commonly issued in denominations similar to traditional tax-exempt bonds, often in $5,000 increments. The credit rating of COPs can vary, with rating agencies typically assigning them a rating one or two notches below the municipality’s general obligation bond rating, reflecting the annual appropriation contingency.