California school and community college district are often struggling with funding for their major facility upgrades, necessary infrastructure improvements, and addressing the needs of their student population. Districts regularly turn to issuing municipal debt to fund those projects. During discussions about issuing municipal bonds, you may have heard the term “capital appreciation bond.” Over a decade ago, issuing capital appreciation bonds became a hotly debated topic for California school and community college districts. What are they and why do California school and community college districts utilize them? Keygent LLC provides some insights into capital appreciation bonds and their usage.
Capital appreciation bonds are financial instruments that play a crucial role in the structure of some municipal bonds. Unlike current interest bonds that make semi-annual interest payments to investors, capital appreciation bonds defer interest payments to investors until the final maturity date of the bonds. The deferred interest compounds until the aforementioned final maturity date. By deferring interest payments, California school and community college districts gain the ability to manage their projected tax rates for future general obligation bond issuances. However, utilizing capital appreciation bonds could result in an overall higher borrowing cost for the issuing entity.
Prior to 2014, California school and community college districts had the ability to issue municipal bonds with a financing term of forty years utilizing current interest or capital appreciation bonds in any maturity. In some instances, districts had issued capital appreciation bonds that had a financing term of forty years resulting in an extremely high borrowing cost due to the compounding nature of the deferred interest. As a result, the State of California felt action was needed to ensure that the continued issuance of capital appreciation bonds would not become a burden on future taxpayers. Assembly Bill 182 went into effect on January 1, 2014, which established parameters California school and community college districts were required to adhere to when issuing capital appreciation bonds. It imposed the following restrictions:
- A maximum debt service repayment ratio of 4 to 1 (total debt service divided by the par amount) for each municipal bond issuance
- A maximum financing term of twenty-five years for capital appreciation bonds (current interest bonds remained unchanged and could have a maximum financing term of forty years)
- A maximum interest rate of 8% for capital appreciation bonds
- All capital appreciation bonds must be subject to an optional redemption after ten years
- If a California school or community district plans to utilize capital appreciation bonds, they must hold two consecutive board of trustee meetings. The first meeting is held for information purposes only and the second meeting is for approval of the municipal bond issuance
You may be wondering why would California school and community college districts still issue capital appreciation bonds despite the bad publicity in the early 2010s? “Issuing municipal bonds that utilize capital appreciation bonds can still be beneficial to California K-14 districts without creating a large tax burden for taxpayers,” explained Chet Wang of Keygent LLC. “It requires careful planning and analysis to responsibly issue municipal bonds that utilize capital appreciation bonds.”
Typically districts will consider utilizing capital appreciation bonds to help manage their projected tax rates. Most general obligation bond elections have a legal maximum tax rate or a voter-promised tax rate set within in the ballot language. There can be unforeseen circumstances, such as a decline or slow growth in assessed value, that could cause a district to be nearing its maximum allowed tax rate. This could limit a district’s ability to issue municipal bonds to meet the timing of their project needs. Since capital appreciation bonds defer interest payments, they allow a California school or community college district to issue municipal bonds while avoiding increasing taxes or minimizing the increase in taxes in certain years. This ability gives a California K-14 district the opportunity to issue its municipal bonds to meet their project needs while remaining within the maximum tax rate allowed or maintaining their voter-promised tax rate.
While there are benefits to issue capital appreciation bonds, there are some drawbacks as well. Typically, due to the lack of semi-annual interest payments, investors demand a higher interest rate when purchasing capital appreciation bonds. Generally this increases the overall borrowing cost of a municipal bond for the issuing entity. Additionally, issuing capital appreciation bonds could further compound the tax rate capacity issue for districts if assessed value conditions or interest rates remain unfavorable, which would further hinder their ability to issue future municipal bonds.
Capital appreciation bonds can be a valuable tool when issuing municipal bonds. They can help California school and community college districts navigate tricky environments and access much needed funding. However, school or community college districts must carefully weigh the pros and cons of utilizing capital appreciation bonds. With careful planning, California school and community college districts can utilize capital appreciation bonds to meet project needs and provide students with the resources they need for a brighter future, while minimizing the impact to their taxpayers.
Keygent LLC is a municipal advisor firm based in El Segundo, California that provides municipal advisory services to California school and community college districts. If you would like to learn more or speak with a municipal advisor, please visit www.keygentcorp.com.
