SAN FRANCISCO — Citi said in a report released Monday that long-dated capital appreciation bonds issued by California school districts offer an opportunity for investors despite concerns about education funding. The zero-coupon bonds are cheap when compared to current coupon securities, the firm said.
“While zeros do come with risks, we believe they may also offer attractive opportunities for investors looking towards the long-end for locked-in yield,” Citi analyst Vikram Rai said in report Monday. “In our view, California’s fiscal challenges have no doubt contributed to the 'cheapness’ of its school district zeros.”
The report acknowledged concerns that some districts may have recently turned to selling zero-coupon bonds that don’t pay interest until maturity because of limited ability to pay debt service in tough economic times. It said despite being a more expensive form of debt compared to current interest bonds, the CABs may allow districts to “kick the can down the road.”
“Many of these deals started appearing after lower assessed property values, which has led to apprehensions that school districts may be utilizing zeros due to their inability to fund debt service,” Rai said in the report. Falling assessed property values reduce the amount of taxes districts are able to collect as has less state funding.
Citi said that CABs have considerably higher interest rate risk and tend to underperform coupon bonds when rates rise. They are also subject to higher price volatility and sometimes lack liquidity.
However, the firm said the tax-exempt zeros offer a predictable rate of return if they are held to maturity and generally require less up from capital to invest in.
Last month, the Los Angeles County treasurer Mark Saladino warned underwriters, advisers and bond attorneys to not engage school districts in bond deals that hurt taxpayers.
The treasurer’s office sent out the warning because officials began to see schools using bond proceeds to pay for cash-flow needs and using “exotic” debt structures. One of the structures cited was the use of capital appreciation bonds with 40-year maturities.
Other questionable practices include using a joint-powers authority structure to generate bond proceeds beyond the amount approved by voters. Voters must approve local general obligation bonds in California in elections that authorize special property taxes to back the debt.
The treasurer also highlighted potential tax violations that could result by using federal subsidies for taxable Build America Bonds or qualified school construction bonds for anything other than to offset debt service.
