Charter schools remain somewhat of an enigma to many people, even participants in the muni bond market. This shows the importance of sufficient messaging on purpose, structure, bond security and credit considerations and I would call upon those stakeholders in this space to get the word out. This commentary is designed to offer value not only to charter school deal participants, including bond attorneys, municipal advisors and investment bankers, but to the investor audience as well.
Charter schools are not structured with a one-size-fits all model and so a clearly defined security package with appropriate legal provisions, a broad understanding of state-specific charter school support, knowledge of state demographic patterns and funding capabilities, and overall demand metrics must all be considered during the charter school financing lifecycle. Disclosure must be timely and complete and must provide investors with the necessary guidance to make informed portfolio management decisions.
To this point, we recognize the research and charter school teams at Hilltop Securities for their efforts to educate and inform the municipal bond community. Hilltop just released an update on the charter school sector, revising its outlook to unbalanced from stable, noting shifts in credit quality. Much of this decision can be tied to evolving state demographic patterns and to the overall credit profile of the host states.
The first charter school opened in Minnesota in 1992 following passage of authorizing legislation in the state the previous year. The concept quickly caught on as other states approved similar legislation providing for public school alternatives, and greater attention can now be witnessed at the federal level. Over the past 35 years, charter school innovation has met with numerous challenges that have largely dealt with the political and economic vagaries within the states, the degree of ongoing state support, the legal construct of the charter, competitive forces, management commitment and competency, and identification of adequate sites. Like not-for-profit hospitals and universities, charter schools have found borrowing in the tax-exempt market an efficient means to secure low-cost financing.
In simple terms, a charter school is a tuition-free alternative to a traditional K-12 public school, yet still receives public funding in support of operations, with state aid providing the key source of revenues. Charter schools exist independently from district oversight, yet are held to higher standards and accountability than traditional public schools. Charter school curriculum tends to be more tailor-made and innovative.
The governing charter is effectively a contract between an authorizing/sponsoring entity — such as a local school board, a state education authority or a university — with the terms of the charter outlining the school's goals, mission statement, and performance standards and measures. The charter obligates the school to adhere to specific requirements and academic standards and should there be issues of non-compliance, the charter would be at risk of non-renewal — a key credit consideration and a potentially catastrophic event for bondholders.
The author of the Hilltop report, Yaffa Ratner, head of municipal credit, points out, "California, Texas, Florida, Arizona and New York account for over 1.9 million or 50% of the 3.87 million charter school enrollment and 62% of the 2025 debt issuance." Each of these states, and all states for that matter, have varied credit profiles with different funding priorities. Not all states are created equal when it comes to developing debt structures.
While charter school debt is not a general obligation of the host state, a state's financial standing, demographic shifts and legislative support can provide a significant view into not only the demand for charter schools, but the ability and willingness of a host state to provide continued financial and authoritative support. This stands at the heart of charter school credit evaluation and I applaud Hilltop's efforts to elevate transparency and articulate evolving credit concerns. As stated in my
Yaffa cites statistics from the
Beyond state funding initiatives and priorities, I would take the analysis even further by raising federal policy uncertainty as a potential credit negative for charter schools and other muni sector cohorts. The One Big Beautiful Bill Act identifies over $1 trillion in federal healthcare program cuts, targeting Medicaid, the Affordable Care Act marketplace and Medicare. Much of the reductions are to come through lower reimbursements and decreases to enrollment given more stringent Medicaid eligibility guidelines tied largely to stricter work requirements. While certain provisions of the OBBBA took effect immediately, many of the largest cuts will be implemented over time, including Medicaid payment reductions to the states.
Charter school bond ratings run across both investment grade and speculative universes. In certain states, most charter school ratings are assigned investment-grade ratings. In these states, demographics tend to be strong, state support remains consistent with an active funding environment, risk of non-renewal is low, expenses are well-contained, and relations with the authorizing entity/sponsor are favorable without conflicts of interest.
It is very common for charter schools to be tied in with the state pension fund. About half of the states mandate participation, while others provide an opt-out provision leaving affected schools to establish their own plans. For the opt-out cohorts, these charter schools may benefit from their own flexibility and potentially avoid the trappings of unfunded state pension liabilities and theoretically heavier plan contribution payments that are set by the state. Non-portability of state pension funds can also be a roadblock for charter school employees tied to a state pension program.
Certain states demonstrate a greater commitment to traditional public schools, and proposals in some states seek to limit charter school expansion, thus diluting interest in the charter school model. Should state-level credit quality encounter material downward pressure and/or policy initiatives elevate the potential to catalyze weaker credit profiles for charter schools, I would expect more rating agency outlook shifts to negative. The default rate for charter schools greatly exceeds that of the broader muni market, with recovery rates significantly trailing the general market. Again, analytical rigor is essential moving forward, and charter school analysis certainly deserves the commitment.
