There is often much misunderstanding and controversy surrounding the issuance of facility bonds by local school districts, and completely ignored is a real cost added on to taxpayers by rating agencies who either don’t understand, or choose to ignore, how they work.
As background, if a school district issues local general obligation bonds (which must be placed on the ballot by the school board and then approved by local voters), these bonds are funded by an additional tax levy on property owners; this tax pays the interest and principal costs of these bonds over their life. Typically, this is an “ad valorem” tax, meaning the tax levied to pay debt service in any given year is based on real estate values (generally annual debt service divided by assessed values in that year). Each property owner pays an equal percentage tax tacked onto their annual property tax bills. So, effectively the bond debt service is collateralized by the property tax stream from the property owners. This is in contrast to a standard municipal bond where the issuing agency (the one receiving the proceeds) is the same as the one servicing the bond debt.
Like any financial instrument, the cost (interest in the case of bonds) is determined by the market. While investors generally conduct internal credit analysis, the bond market still relies on rating agencies, such as Standard & Poor’s (S&P) and Moody’s, to assign a rating to each bond issuance. For S&P, these ratings go from AAA all the way to D, with gradations along the way (AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, etc.). The lower the rating, the higher the interest cost, on the theory that a lower rated bond has a higher likelihood of default and therefore must compensate investors with a higher return to accept that higher risk. For all bond issuers, public and private, getting a strong bond rating is key to keeping costs down.
When a school district issues general obligation bonds, it also goes to an agency like S&P to get a rating. As it does for other issuers, S&P rates the creditworthiness of the issuer on four key factors — the health of the local economy (which includes the tax base), the finances of the district, the management of the district, and the indebtedness of the district. The problem, however, is that three of these four criteria actually have nothing to do with the credit worthiness of the bonds. As school bond debt service is paid by property owners (unlike standard municipal bonds), the financial health of the district isn’t relevant at all. Even if our school district ceased to exist tomorrow, all of our bonds issued would still be paid off with no risk of default because the debt service isn’t coming from the district — it’s coming from property owners! The only possible scenario where these bonds could default would be if every property owner in the district declared bankruptcy, and did it simultaneously! Because even if the town were hit with a severe recession or if a substantial number of citizens moved away, the burden of debt service would just shift to the remaining taxpayers (who would then each pay a higher percentage ad valorem tax rate). In practice, the only conceivable — albeit farfetched — scenario to have a bond default would be some natural disaster where overnight our town literally ceased to exist!
It may be too easy to assume that this ignorance by the rating agencies is just laziness, but I would suggest this standardized approach is rather simply self-serving — the rating agencies generate business by doing this “research” on each local district when in reality no such research is necessary, because any objective analysis would conclude that all school bonds of this sort must be AAA rated almost by definition. This “rating deflation” costs taxpayers and districts real money — districts get reduced bonding capacity (given tax rate limits, a district can issue less bonds) and/or taxpayers pay more interest for no reason. For example, in a 2014 General Obligation Bond issuance, the San Carlos School District was rated AA-, which is considered fairly strong by current methods. But even that three-step distance from a AAA rating meant a difference of 0.35%, so for every $100 million in bonds outstanding, the taxpayers were burdened with an extra $350,000 per year (and of course, much more for districts with lower ratings).
Some bond attorneys argue that S&P has concerns about a theoretical situation where a district goes bankrupt and then looks to “sweep” money from the dedicated debt service account for general fund purposes. As this has never actually happened and is even against the law in this state, it’s a better assumption that keeping the status quo is just in the rating agencies’ self-interest. What incentive do they have to change a system so as to minimize or eliminate their “value-add”? Perhaps there are two conclusions here: (1) school bonds are probably one of the best debt instruments an investor can make given the relatively higher interest rate with no higher risk, and (2) in the absence of the rating agencies doing the right thing, maybe a state policy change can mitigate this long-standing, monopolistic power that is surreptitiously issuing an additional tax on most of our citizens.