Common programs
State enhancement programs generally fall into four different program categories:
1. State guarantees
2. State appropriation pledges
3. Intercept programs
4. Permanent funds
Let’s look at each:
State GO guarantees are programs in which the state promises that it will make timely interest and principal payments for a school district if it is unable to do so. In our view, this is one of the stronger kinds of enhancement programs because the state is legally obligated to use money from its general fund to help pay bondholders. School district bonds that are backed by a state guarantee are usually rated the same as the state’s other general obligation debt. A notable exception is Idaho, where school district bonds are enhanced by both a state guarantee and the backing of an endowment fund. The additional backing provides an added layer of security for bonds that are part of the program.
State appropriation pledges are similar to state GO guarantees with one notable exception: Unlike a GO guarantee, a state appropriation pledge doesn’t come with a contractual guarantee. That means the sponsoring body isn’t obligated to make missed interest or principal payments on a school district’s behalf. Rather, appropriations programs generally have to be approved by the states legislature every year. That said, some states do have standing appropriation pledges, or pledges that don’t have to be approved every year.
Although they lack a contractual guarantee, appropriation pledges are still generally strong because they are designed in a way where the risk of non-appropriation is low.
Intercept programs are the most common school bond credit-enhancement programs. They work by “intercepting,” or diverting, state aid due to a school district and then sending it directly to the bond trustee to make up for missed principal or interest payments.
Intercept programs divert funds on a pre- or post-default basis. As the names imply, pre-default intercept programs intercept funds prior to the school district defaulting. They are usually triggered when a state or an independent third party warns that a school district will miss a payment.
Post-default intercept programs are triggered once an actual default happens. In terms of credit ratings, bonds backed by post-default intercept programs are generally rated according to the credit quality of the issuer, not the intercept program. For example, Moody’s uses a “bottom-up” rating process in which it assigns a rating to each individual school district.
Pre-default intercept programs tend to be more secure, in our view, because they can help bondholders avoid missed interest or principal payments. With a post-default program, bondholders have to wait for the funds to be diverted before recovering their payments. Depending on the program, this might not take too much time.
Funding sources for pre-default programs
The ratings of most school district bonds that participate in a pre-default intercept program are based on the rating of the intercept program. The funding mechanisms for pre-default programs fall into four categories, which vary in terms of credit strength:
Unlimited advance are usually the strongest types of pre-default intercept programs, in our view. Once such a program is activated, the state agrees to use all available resources to make bond payments on behalf of a school district. The ratings on these programs are generally one notch below the state’s GO rating.
Directly funded programs draw money directly from aid that would otherwise be sent to the school district. The ratings on these programs are also generally one notch below the state’s GO rating.
Limited advance programs are similar to unlimited advance programs but differ in that the state does not pledge all available resources to make up the missed interest or principal payments. That usually means the amount available for intercept is less than what would be available in an unlimited advance program, but more than a directly funded program. The ratings on these programs are also generally one notch below the state’s GO rating.
Current year programs are the most common types of pre-default intercept programs. They aren’t as strong as the other pre-default programs, in our view, because the intercept amount is limited to the aid that would be allocated to the school district in a single year only. The ratings on these programs are generally one to three notches below the state’s GO rating.
Permanent fund programs are similar to municipal bond insurance. They’re essentially pools of assets authorized by a state’s constitution that are available to support school districts. Credit ratings are based on the size and availability of the funds, among other factors.
The Texas Permanent School Fund program is one of the most widely known. This $36 billion fund exists solely to provide financial support to qualifying school districts in Texas and was originally funded by the sale of state mineral and land grants. Along with returns from the investments the fund owns, it also earns revenues from royalties from its landholdings. The fund is one of the strongest state enhancement programs, based on its ratings, and bonds that are part of the program are currently rated AAA by Moody’s and S&P.
Next steps
In our view, school district bonds—along with other highly rated general obligation bonds from cities and states and revenue bonds backed by essential services, such as a water or sewer system—can serve as the foundation of a municipal bond portfolio. In states with enhancement programs, most but not all school districts participate.
Investors interested in school district bonds can search for them using the municipal bond search feature on schwab.com. A bond’s official statement will generally have details about any enhancement-program backing. Schwab bond specialists can also help identify school district bonds that have backing from an enhancement program.
Cooper J. Howard, CFA, is senior research analyst, fixed-income and income planning, at Charles Schwab & Co.
Rob Williams is director of income planning at the Schwab Center for Financial Research.