Keeping You Informed: State School District Enhancement Programs
Michael S. Sroda, Sr. Fixed Income Research AnalystDownload (PDF) article
Municipal bonds and school district funding
Municipal bonds play a significant role in the funding of school districts. They allow a school district to borrow principal up front with the promise of repayment, including interest, at a later date. Without this form of borrowing, many school districts would be hard pressed to find the funding needed for capital projects such as improving infrastructure. State school district enhancement programs help to provide a way to make all of this possible.
Approximately half of all U.S. states currently maintain an enhancement program with ratings. These programs are useful to both the issuer and the bondholder for various reasons. Districts benefit from the lower borrowing costs associated with the higher rating while bondholders benefit from the additional layer of protection provided. As an investor in this type of security, it is important to know the background of how these programs operate. While these programs may differ in ratings and nuances (see chart on page 2), the credit quality of any given program is determined by the following components:
Revenue Sufficiency - Determines whether, if invoked, the program/state can provide sufficient monies to make up the shortfall in the debt service payment. A state's current financial condition is an important factor of this component.
Timing - Determines when the program is "triggered" to come into effect. Programs that are triggered pre-default rather than post-default are preferred to ensure there are no interruptions in the bondholder receiving an on-time payment.
Program Mechanics - These are the detailed processes of how the state goes about distributing the monies to the district if the program is invoked. Program mechanics differ greatly from program to program and from state to state.
While the nuances of the program mechanics are specific to each state's school district enhancement program, each program can be generally grouped into one of four main structure types. Certain structures provide a higher level security than others, but all are intended to provide assurance that, in the event of a missed debt service payment, the bondholder will be made whole.
Districts benefit from the lower borrowing costs associated with the higher rating while bondholders benefit from the additional layer of protection provided.
Certain structures provide a higher level of security than others, but all are intended to provide assurance that in the event of a missed debt service payment, the bondholder will be made whole.
Without these types of programs and the credit enhancements they provide, districts would find it much more difficult to access the market, with bondholders being more reluctant to invest in these districts' bonds.
Below we break out the various structures:
Intercept - If a debt service payment is expected to be missed, the district will notify the state of the shortfall. The state will then "intercept" future state aid the district was intended to receive and forward it to the district as directed by the program mechanics. Programs vary, with some states only allowing the current year allocation of state aid to be intercepted while other states allow unlimited future allocations to be intercepted. These types of programs are typically rated below the state's general obligation rating.
State Guaranty - Full faith and credit taxing power is pledged in the event of a potential missed debt service payment. The state typically transfers monies from its general fund to make the payment. This type of program is rated on par with the state's general obligation rating and is viewed as the strongest of the four structure types.
Permanent Fund - An independent fund is established from which the district would draw in the event of a potential missed debt service payment. The strength of the program is determined by how leveraged the fund stands, the current assets of the fund, and how the fund is managed. Ratings are independent of state ratings.
Appropriation/Direct Pay - The state pledges to appropriate monies to the district in the event of a potential missed debt service payment from either their general fund or another specified annual appropriation. Ratings vary based on program mechanics.
|State||Structure Type||State Rating||Program Rating||Timing|
*Combination of Permanent Fund & Guaranty
Without these types of programs and the credit enhancements they provide, districts would find it much more difficult to access the market with bondholders being more reluctant to invest in these districts' bonds. Understanding the credit components as well as the different types of program structures are important to consider when investing in bonds backed by a state school district enhancement program.