Extra Credit: The Lowdown on Enhancement Programs for School District Bonds

Key Points

  • Municipal bonds issued by school districts can be part of the stable foundation of a municipal bond portfolio, in our view.
  • School district bonds in some states come with extra protection from state enhancement programs that can make missed interest and principal payments.
  • The strength of the different enhancement programs varies by program.  

It's that time of year when students wind down their summer breaks and start to turn their thoughts to school. Municipal bond investors may want to follow their lead.

Bonds issued by school districts—along with other highly rated general obligation bonds from cities and states and revenue bonds backed by essential services—can serve as the stable foundation of a municipal bond portfolio. School districts in most states tend to have high credit ratings, boasting A-level ratings or better. Why? One reason is that school district bonds in most states are backed by property taxes, which can be a stable and reliable revenue source. A strong property tax pledge can help support the credit quality of school district bonds, in our view.

And bonds issued by some school districts may come with an extra layer of protection: backing from a state credit-enhancement program. In short, this just means that if a school district runs into financial trouble, the state government can step in and make principal and interest payments on the district’s behalf.

Such programs make it easier for even small districts to access bond markets to help fund construction or renovations of public schools. But not every district has this kind of backing. Generally speaking, a school district has to apply to be part of an enhancement program and then receive approval from a state oversight board. School districts can participate only in their home-state programs, and each state’s programs may differ in terms of the strength of their backing.

Below we discuss some of the risks and benefits of different state enhancement programs.

State programs can enhance the credit quality of school district bonds

Just over half the states have credit-enhancement programs for school district bonds. The financial strength of many programs is linked to the financial strength of the state sponsor, and the credit ratings of individual enhancement programs tend to be based on the rating of the state’s general obligation bond.

Enhancement programs vary by state

Ratings are the Moody’s and S&P program ratings.

Source: Moody’s and S&P. Data as of 8/18/2016. Note: For illustration only. May not include all enhancement programs. Some states may have multiple enhancement programs with different ratings. Consult the bond’s offering statement prior to investing.

However, that’s not always the case. Some enhancement programs are stronger than others and may not be closely tied, or tied at all, to the state’s GO bond rating. And for some programs a change in the state’s GO rating can also result in a change in the enhancement program’s rating, which can then affect the ratings of issuers that participate in that program. In a few states, enhancement programs are backed by large endowment funds and so don’t depend on the state’s credit quality.

Bonds backed by an enhancement program will often have two ratings: the rating of the state enhancement program, which tends to be higher, and the underlying rating of the school district, which is based on its financial health. And two sources of credit protection are better than one when it comes to state enhancement programs.

Common programs

State enhancement programs generally fall into four different program categories:

1. State guarantees

2. State appropriation pledges

3. Intercept programs

4. Permanent funds

Let’s look at each:

  1. State GO guarantees are programs in which the state promises that it will make timely interest and principal payments for a school district if it is unable to do so. In our view, this is one of the stronger kinds of enhancement programs because the state is legally obligated to use money from its general fund to help pay bondholders. School district bonds that are backed by a state guarantee are usually rated the same as the state’s other general obligation debt. A notable exception is Idaho, where school district bonds are enhanced by both a state guarantee and the backing of an endowment fund. The additional backing provides an added layer of security for bonds that are part of the program.

  2. State appropriation pledges are similar to state GO guarantees with one notable exception: Unlike a GO guarantee, a state appropriation pledge doesn’t come with a contractual guarantee. That means the sponsoring body isn’t obligated to make missed interest or principal payments on a school district’s behalf. Rather, appropriations programs generally have to be approved by the states legislature every year. That said, some states do have standing appropriation pledges, or pledges that don’t have to be approved every year.

    Although they lack a contractual guarantee, appropriation pledges are still generally strong because they are designed in a way where the risk of non-appropriation is low.

  3. Intercept programs are the most common school bond credit-enhancement programs. They work by “intercepting,” or diverting, state aid due to a school district and then sending it directly to the bond trustee to make up for missed principal or interest payments.

    Intercept programs divert funds on a pre- or post-default basis. As the names imply, pre-default intercept programs intercept funds prior to the school district defaulting. They are usually triggered when a state or an independent third party warns that a school district will miss a payment.

    Post-default intercept programs are triggered once an actual default happens. In terms of credit ratings, bonds backed by post-default intercept programs are generally rated according to the credit quality of the issuer, not the intercept program. For example, Moody’s uses a “bottom-up” rating process in which it assigns a rating to each individual school district.

    Pre-default intercept programs tend to be more secure, in our view, because they can help bondholders avoid missed interest or principal payments. With a post-default program, bondholders have to wait for the funds to be diverted before  recovering their payments. Depending on the program, this might not take too much time.

    Funding sources for pre-default programs

    The ratings of most school district bonds that participate in a pre-default intercept program are based on the rating of the intercept program. The funding mechanisms for pre-default programs fall into four categories, which vary in terms of credit strength:

    • Unlimited advance are usually the strongest types of pre-default intercept programs, in our view. Once such a program is activated, the state agrees to use all available resources to make bond payments on behalf of a school district. The ratings on these programs are generally one notch below the state’s GO rating.
       
    • Directly funded programs draw money directly from aid that would otherwise be sent to the school district. The ratings on these programs are also generally one notch below the state’s GO rating.
       
    • Limited advance programs are similar to unlimited advance programs but differ in that the state does not pledge all available resources to make up the missed interest or principal payments. That usually means the amount available for intercept is less than what would be available in an unlimited advance program, but more than a directly funded program. The ratings on these programs are also generally one notch below the state’s GO rating.
       
    • Current year programs are the most common types of pre-default intercept programs. They aren’t as strong as the other pre-default programs, in our view, because the intercept amount is limited to the aid that would be allocated to the school district in a single year only. The ratings on these programs are generally one to three notches below the state’s GO rating.
  4. Permanent fund programs are similar to municipal bond insurance. They’re essentially pools of assets authorized by a state’s constitution that are available to support school districts. Credit ratings are based on the size and availability of the funds, among other factors.

    The Texas Permanent School Fund program is one of the most widely known. This $36 billion fund exists solely to provide financial support to qualifying school districts in Texas and was originally funded by the sale of state mineral and land grants. Along with returns from the investments the fund owns, it also earns revenues from royalties from its landholdings. The fund is one of the strongest state enhancement programs, based on its ratings, and bonds that are part of the program are currently rated AAA by Moody’s and S&P.

Next steps

In our view, school district bonds—along with other highly rated general obligation bonds from cities and states and revenue bonds backed by essential services, such as a water or sewer system—can serve as the foundation of a municipal bond portfolio. In states with enhancement programs, most but not all school districts participate.

Investors interested in school district bonds can search for them using the municipal bond search feature on schwab.com. A bond’s official statement will generally have details about any enhancement-program backing. Schwab bond specialists can also help identify school district bonds that have backing from an enhancement program.

Next Steps

Talk to Us

To discuss how this article might affect your investment decisions:

-          Call Schwab anytime at 877-338-0192.
-          Talk to a Schwab Financial Consultant at your local branch.

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