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Back to School with Municipal Bonds

Key Points
  • Investors looking for high credit-quality tax-advantaged income should consider school district bonds because they generally benefit from a stable and secure income streams as well as state oversight.

  • They can also benefit from state enhancement programs that help boost their credit strength.

  • We prefer bonds issued by school districts in areas with favorable economic and demographic trends.

School district bonds can offer compelling benefits. First of all, as with other municipal bonds, the interest school district bonds pay is usually exempt from federal income taxes. That can make them appealing to income-seeking investors in high tax brackets. But there’s more to the story.

School district bonds can come with solid financial pledges and may benefit from other features that could burnish their appeal among investors looking for high-credit quality assets.

We've written elsewhere about how school district bonds can benefit from credit quality-boosting state enhancement programs. These programs offer a layer of protection above and beyond the credit quality of individual bonds. So now let's take a step back and discuss how the underlying credit quality of many school district bonds may make them attractive even before credit enhancements are factored in.

Tax backing

School districts issue bonds to help fund the construction and renovation of public schools, and generally pay the bonds back using property tax revenues paid by residents in the district. The tax revenue generally cannot be mixed with the district’s other revenues, which we feel adds to the strength of the financial pledge.

However, not all school district bonds are backed by a dedicated tax pledge. Here are the three most common types of school districts bonds, which we’ve ranked in order of how we view their financial strength:

  1. Voter authorized general obligation bonds (GOs) backed by a dedicated tax pledge, as well as unlimited taxing authority. These bonds are often backed by a dedicated tax—usually a property tax—that the school district collects. Such bonds also often come with a pledge that the issuer will use all other available revenue sources, such as other taxes or state support, if the taxes specifically authorized to repay the bonds aren't sufficient.

    The residents of different school districts may also have a say on how much debt they can issue. For example, 40 states require voter authorization for school districts to issue debt above previously approved limits. Having voter support can be a positive signal about a district’s commitment to paying its bonds, we feel.

    In California, for example, school districts often issue bonds backed by a property tax dedicated specifically to debt service. Voters in a school district must agree to the tax, and the dedicated property tax cannot be mixed with the school's other revenues. If the school district doesn't have the necessary funds to pay the bonds, it typically must increase property taxes to meet the amount due. In our view, this is one of the strongest security pledges for municipal bonds.

  2. GOs backed by limited taxing authority. Like unlimited tax GOs, these bonds are backed by the general revenues of the school district, including taxes. However, the school district doesn't have the ability to increase taxes by an unlimited amount to pay the bonds back. The limit on the amount of tax increase allowed is generally described in the bond offering statement, and the bonds are clearly labeled. Although we believe this is still a strong pledge, the limit on the tax makes such bonds less secure than those backed by an unlimited tax authority.

  3. Lease revenue bonds, or Certificates of Participation (COPs). Lease revenue bonds are not secured by a school district’s tax revenues. Instead, they are usually backed by the lease revenues paid by a school district to use a property, often a building. For example, a school district may issue COPs to finance the construction of a new school. The school district then sells the building to a trustee that uses the proceeds of the bond sale to pay for the building. The school district then leases the building back from the trustee for an amount sufficient to repay the bonds.

    School districts often issue COPs if they face restrictions on the amount of debt they can incur or fail to secure voter approval to issue new debt. The lease obligation is usually not considered a form of long-term debt, and the school board must renew the lease annually. If it does not renew the lease, the trustee can repossess the property and sell it to reimburse bondholders. This rarely occurs in practice, but it's the primary source of security for bonds. In our view, COPs are among the least secure school district obligations.

One more thing to note: Bonds backed by dedicated tax revenue can often come with a high rating from a ratings agency—generally A-quality or better. Such ratings can also reflect the operational stability of the district, such as its enrollment trends and financial reserves and other factors. However, we believe the strength of the taxing authority and underlying tax base is the most important factor securing payment for voter-authorized, property-tax backed K-12 school district bonds in most states.

What about charter schools?

Charter schools, which are schools that receive public funding but operate independently of the local school district, also issue municipal bonds. From an investment standpoint, we favor public schools over charter schools. Charter schools generally do not have a pledge backed by local property taxes like public schools do. Also, public schools generally have more state oversight and have a better foothold in the local community.

Other factors to consider

The strong financial pledges that some school district bonds offer aren’t the only reason such bonds might appeal. Here are some others:

  • Defaults for school district bonds have historically been low. Since 1970, only 99 out of the thousands of municipal bonds that Moody's Investors Service rates have defaulted, and only two of those were GO bonds issued by school districts. Although some school districts may miss interest and principal payments in the future, we believe that the sector overall has strong credit characteristics that will likely limit defaults going forward.
  • The housing recovery helps property-tax backed school district bonds. Nationally, the market value of homes has risen more than 41% from the lows hit in 2012.1 Although property taxes are usually based on assessed home values rather than market values, the rise in market value nevertheless bodes well for tax revenues. That said, the increase hasn’t been uniform across all cities, as the chart below show. We prefer bonds issued by school districts in areas with stable or steadily increasing property values.

The housing market recovery has varied among cities

Source: S&P CoreLogic Case-Shiller Indices, as of 9/22/16.

  • School district finances can also benefit from state oversight. In most states, state-directed boards of education or other oversight boards monitor the financial health of K-12 school districts, which we feel can help support their credit quality. In some states, the oversight agencies can appoint a state overseer, if necessary, for districts that do not manage their finances prudently.

    In California, for example, each county has a board of education that oversees county school districts. The school districts must file a budget with the board and if the financial performance of the school district is in question, the board can provide advice on how to make corrections. If the school district’s finances severely deteriorate, the state can intervene and make financial decisions on the school district’s behalf. However, the legal powers and willingness to act vary by state. Investors should study oversight mechanisms in the states where they invest, or consider using professional managers.

What to do now

School district bonds can help bring high credit quality and variety to your muni portfolio. For an adequately diversified bond portfolio, we prefer investing in at least 10 different issuers with different credit characteristics for investors investing in individual bonds. If you prefer not to select individual bonds, consider a professionally managed solution, such as a mutual fund. Such funds will often invest in school district bonds as well as other municipal bonds.

Talk to Us

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