A spike in Oregon school districts’ reliance on capital appreciation bonds to fund expansion is stirring a debate among debt analysts.
Since early 2017, Oregon school districts have floated the greatest par value of tax-exempt CABs at almost 50% of the $1.1 billion total in primary market issuance for schools, according to an April 2 report from Municipal Market Analytics.
Speculative borrowing structures such as CABs can strain credit quality if property value growth assumptions do not materialize, wrote Lisa Washburn, an MMA managing director and the report’s author. S&P Global Ratings analysts, however, said they've seen no reason to change their ratings on the districts.
“In terms of structure, we haven’t seen cases in Oregon where the CAB structure has been a significant challenge to the credit,” said Chris Morgan, an S&P Global Ratings analyst.
The debt instrument can be dangerous if risky structures are employed, but they also give schools the opportunity to secure funding when new buildings are needed, and interest rates are low, rather than approaching voters with a doomed-to-fail tax hike, according to market participants.
Capital appreciation bonds achieved notoriety in 2012 following reports that Poway Unified School District in San Diego had issued $105 million without a call option, agreeing to repay investors $1 billion. Poway would not make interest payments the first 20 years in exchange for higher payments as it paid off the debt and interest in the last 20 years through the 40-year maturity.
A review found that many California school districts had issued deferred interest bonds with high repayment ratios that lacked call options. Legislation was adopted that restricted the debt-to-payment ratios, required call options and restricted maturities.
CABs pay a compounded interest rate and principal upon maturity, rather than annual principal and interest payments common to current interest bonds.
Nine Oregon school districts have issued a combined $554.2 million in deferred interest bonds in just over a year, according to MMA. The remaining volume was split between California, Texas, Illinois and Pennsylvania.
The heavy use of the CABs warrants investor concern, Washburn said.
“Oregon doesn’t have the most school districts doing them, but it does have the greatest dollar amount issued since the beginning of 2017 and Oregon is not a huge bond issuer,” Washburn said.
The amounts of the zero coupon bonds issued in Oregon were also substantially higher. The nine bonds had an average par of $60 million, compared with par of just a few million issued by the other states, Washburn said.
“Oregon had nine districts issue 10 deals since January 2017 – and that accounted for half the dollar amount of CABS issued in the school district sector in all 50 states,” she said.
Sherwood School District in the Portland metro area and Clackamas County School District No. 12 issued CABs with the highest amounts. Clackamas issued $140.3 million in zero coupon bonds in a $322.7 million sale in January 2017 that included $182.4 million in current interest bonds. Sherwood issued a total of $163.8 million in CABs in two separate sales during the first two months of 2018.
MMA considers the decision to issue the deferred interest bonds a red flag, because they can signal underlying fiscal woes and/or excessive risk taking by management, Washburn wrote.
Sherwood School District holds Aa1 rating from Moody’s Investor Service and AA-plus from S&P.
“We saw MMA’s commentary – and it is of note when you see a grouping of credit structures you haven’t seen in the past,” said Geoff Buswick, an S&P Global Ratings analyst. “But of the nine school districts mentioned, we haven’t seen them introducing risk so great that we are changing the ratings.”
S&P is agnostic when it comes to the use of capital appreciation bonds.
“We don’t take a side as to whether it is the right or wrong avenue,” Buswick said.
The ratings agency considers whether the school districts are issuing more long term risk and gauges what that means about the school district’s ability to pay, Buswick said.
“When we see them we pay attention, but it is not something that changes our view in any material way just because they are there,” he said.
If a school district is issuing them regularly, it can show there are current year deficits, though "it's contextual," Buswick said.
It makes a difference if the school district is using them to deal with budget stress, as opposed to issuing the bonds as part of a meaningful strategy, he said.
Since the Oregon school districts issue general obligation bonds that are paid for with a dedicated property tax, there typically isn’t a risk to operations or likelihood the bonds won’t be repaid, Morgan said.
“In the extreme, it could mean liquidity implications,” Morgan said.
The Oregon CAB structures are a more expensive form of debt than current interest bonds, but are also less dodgy than some of the notable California school district CABs, Washburn said.
Unlike the Poway bonds, MMA wrote, the Oregon bonds tend to be structured with serial maturities, and the latest maturity is within 20 to25 years. The Oregon bonds also contain an optional redemption feature that allows the issuer to redeem the bonds after 10 years at accreted value.
The fact the Poway bonds — and many of the more notorious California CABs — lacked a call option made refinancing difficult.
“These are better versions of CABs, but still CABs all the same,” Washburn said.
Oregon’s restrictions on bond campaigns and its fiscal conservatism has resulted in the issuance of capital appreciation bonds, according to market participants.
The state has had a 50% failure rate on school district bond elections at least since the mid-1990s, according to a Northwest region financial adviser.
The ballot measures are required to include the maximum term and par amount of the bond. In addition, school districts commonly include what levy rate will result from the bond measure. The amount of a tax increase voters are willing to approve limits the ability to issue enough current interest bonds to cover new building construction and modernization needs.
The school districts conduct polling to arrive at what levy amount voters will approve. They want to borrow as much as they can within the maturity limit approved by voters, while minimizing tax increases.
Piper Jaffray was the lead underwriter on all nine of the school district bond sales involving CABs that were cited in the MMA report. The broker-dealer also holds the top spot in Oregon, with $2.1 billion in 35 issues in 2017, according to Thomson Reuters data. Citi trails with roughly half that figure.
“The debt service structures were designed to allow the school districts to maintain a level or targeted tax levy over time and used low ratios of total debt service to amount borrowed,” said Pamela Steensland, a Piper Jaffray spokeswoman.
“We believe these issues were an appropriate approach to funding their projects and managing the levy impact to taxpayers,” Steensland said.
School districts, particularly those in the Portland metropolitan area, have experienced substantial enrollment growth.
Enrollment at Sherwood School District’s seven schools either exceeded capacity or were near capacity, according to a Jan. 27, 2016, report posted on the school’s website. Four of the schools had portable classrooms, and the high school had 1,619 students enrolled in a school with room for 1,550.
Three market segments account for nearly 60% of the $245 billion of outstanding capital appreciation bonds – tobacco, sales/special tax and school districts, Washburn wrote. Puerto Rico’s COFINA bonds comprise the largest portion of the sales/special tax bonds.
School districts accounted for nearly $55 billion of CABS outstanding, which Washburn considered unusual, because they are using debt structures that are more complex and costly than other municipal governments like cities and states.
“I wouldn’t ever say that CABs are a good idea,” though there can be offsetting circumstances, Washburn said.
For instance, if the CABs comprise a small portion of the school district’s debt and the district is in a growing area, she said.
She added that in any situation, issuance of CABs amounts to kicking the can down the road, and that school districts are better off raising taxes to pay for projects than pushing payment into the future.