I am not an expert on Municipal Bonds, so if an expert reads this, and has corrections for me, please leave corrections in the comments.
In general, I am a conservative guy who avoids situations with a lot of debt. I am also an actuary and a financial analyst who has a lot of experience with long dated assets. I know how illiquid they can be, and how violent the price moves can be when they happen.
Most of the discussion here stems from this article: Where Borrowing $105 Million Will Cost $1 Billion: Poway Schools.
There are a few other notable writers who have picked up on this:
- Herb Greenberg: Are California Munis Paying Loan Shark Rates?
- Mike Shedlock: Ponzi Financing in Poway California Based on Massively Rising Property Values
But unlike them, I want to give you more data, and less opinion. For a start, here is the dense prospectus, should you want to review it.
As an aside, I looked at buying a house in Poway back in 1989, when I was considering a job in San Diego with the soon-to-be gone First Capital Holdings. Poway was what I could afford in such an expensive area.
Financial crises always come at the wrong time. In 2007, the Poway School District borrowed money to fix up the physical plant of the schools. They financed it short-term, then in early 2009 issued the “A” notes, financing much of the project, encumbering tax revenues out to 2032, and allowed the rest to float via General Obligation Anticipation Notes. The “A” series were also capital appreciation bonds, which means they are zero coupon bonds, and the interest comes from buying the bonds at a discount to the face value, and receiving the face value at maturity. The time period was shorter then the “B” notes, so they were cheaper, and hence less odious.
Given that they had already encumbered tax revenues all the way out to 2032, and had a large amount of debt that they needed to refinance, they needed to issue more permanent debt. They were already at their maximum level of what they could expect given assumed growth in the property tax base, so what could they do if they wanted to issue more general obligation debt without raising the tax rate?
After getting the assent of the voters in February 2008, to extend tax rates for an estimated additional 11 to 14 years, they issued the “A” notes, and then in 2011, the “B” notes. The “B” notes picked up where the “A” notes left off. They would make payments from 2033 through 2051.
Now, anyone who has worked with long duration fixed income (there aren’t many of us) know a few things:
- It’s illiquid because there aren’t that many that can fund it for so long. It becomes the province of strong balance sheets and speculators.
- It’s rare for people to give up current income for capital appreciation over the long haul. Most people need income over the next 20-30 years.
- Slight changes in the interest rate can make a lot of difference to the value of the debt.
- When you issue very-long-dated credit-sensitive notes, expect to pay a high yield. Poway SD is rated Aa2/AA-. That’s a high rating, but when you say you will pay nothing for 20 years, that injects a lot of uncertainty/risk into the likelihood of payment.
After all, what will the courts be like 20 years from now? What will the nation be like? What will we default on or inflate away? I know that present rules make it difficult for any entity to not repay General Obligation debt, but 20 years from now, things could be different.
The “B” notes, capital appreciatin bonds, that they offered in 2011 refinanced prior debts, and left $21 million to be used as they wished, which raised the hackles of the California Attorney General, though nothing came of that. Letter from the Attorney General Article on the topic — Second article on the topic
Take a look at the sources an uses of funds:
ESTIMATED SOURCES AND USES OF FUNDS
The proceeds of the Series B Bonds are expected to be applied as follows:
Sources of Funds
Principal Amount of Series B Bonds $105,000,149.70
Original Issue Premium 21,360,189.45
Total Sources $126,360,339.15
Uses of Funds
Deposit relating to partial payment of
Lease Revenue Bonds(1) $98,707,473.55
Deposit for full payment of 2010 Notes 26,270,000.00
Costs of Issuance(2) 569,114.44
Underwriter’s Discount 813,751.16
Total Uses $126,360,339.15
(1) Includes $98,327,473.55 for partial payment of the Lease Revenue Bonds and $380,000 for payment of costs associated with refinancing the Lease Revenue Bonds.
(2) Includes, among other things, the fees and expenses of Bond Counsel, the fees and expenses of Disclosure Counsel, the fees and expenses of District Counsel, the fees and expenses of the Paying Agent, the fees and expenses of School District consultants, rating fees, the cost of printing the preliminary and final Official Statements and other costs associated with issuing, selling and delivering the Series B Bonds, as well as costs associated with refinancing the 2010 Notes.
I would note that the premium was entirely applied to the reduction of existing debts. They may not be debts of the same class, and that makes me wonder.
Now capital appreciation notes are politically controversial. Here is a White paper from the LA Treasurer, and here is an article about it. It’s not that different than what you have heard already. Borrowing using long zero coupon notes is expensive.
Let me show you the cash flow table for the “A” and “B” bonds.
The “B” bonds kick in after the “A” bonds give out, which means that if future politicians want to do capital improvement projects in the Poway school district, they will have to wait a while, until debt gets paid down. The present has stripped flexibility from the future. Who should be surprised, this is the USA.
Now one should argue over whether the expenditures reflect the life of the bonds. Poway SD says that structures have a 45 year lifespan, and this fits inside that.
But maybe there was a cheaper way to fund this. Rather than using Capital Appreciation Bonds, maybe a mortgage-style note could have done it, even over 40 years, and at a much cheaper rate. Even accepting the premium boosted the combined yield of the “B” notes from around 6.9% to 7.6%.
As it is the deal bets on the appreciation of real estate:
Right now, the district receives about $11 million a year from homeowners towards paying off its bonds.
So, to be able to afford its debt payments 20 years from now, the total assessed value of property within the taxed area would have to quadruple.
That’s about 7%/year, which is not impossible if inflation comes. It is still a difficult target to manage against.
Personally, I think it would be cheaper to do with out the improvements, or add user fees, or raise taxes. The benefits are going to those living there in the short run, taxes should be similar.
Finally, I would like to note that the “B” bonds appreciated dramatically from their issue prices. You can see it here: data for the “B” series. My view is that it was a period of falling interest rates, but that the rate on the Poway “B” note fell more. Whoever bought and held has made a lot of money, and at the expense of Poway SD taxpayers, who will have to pay more, because of the lame way that the district borrowed.
That said, if you think your area is in better shape, spend some time digging into the numbers, and prove it.
PS — Who would buy a bond like this? P&C insurers with long tail liabilities, like asbestos and environmental. But Buffett is cutting down on his munis.