A New Form of Municipal Gambling

This past weekend I had the pleasure to visit with some old friends. Friends that date back to the 1960’s and the days of my first years in the municipal bond business. As a history major, the field of municipal finance was all new to me. My education began with a little paperback titled Money, Banking and Gold by Peter Bernstein and first published in 1965. From there, I spent many years reading books and articles about bonds and the markets.

Of all the purposes for issuing municipal bonds, school bonds are a very common purpose. In some states, like Ohio, the bonds are issued by what are called city school districts. In Ohio, these municipal bonds are general obligation bonds. General obligation bonds are paid from taxes and technically differ from revenues bonds that are paid from revenues. City school districts collect property taxes and pay the principal and interest on the district’s outstanding school bonds. In Kentucky, the set up is a little different. The bonds for schools are called school building revenue bonds. They too are paid by taxes, but because of the way they are set up legally, they are considered revenue school bonds.

For many years, school bonds were given ratings by the rating agencies and paid a net interest cost (NIC) that was the market rate for a school bond of a particular rating quality. Most school bonds probably received an A-rating, but there were some AA-rated and even a few AAA-rated school bonds years ago.

As municipal debt, school bond interest is tax free, and real attractive to fixed income investors in the higher tax brackets. Citizens of a particular state holding school bonds or other municipal bonds from their state received a double bonus as the interest is not only free of Federal income taxes, but state income taxes as well. In areas where there is a city income tax, like New York, New York city municipal bonds were triple tax free. Investors that own these bonds pay no Federal, state or city income taxes on the interest.

But somewhere along the way, this was not good enough for local school districts and their boards. Investment bankers came up with the bright idea of an option for these schools districts to potentially lower their interest costs (NIC) by using derivatives.

Derivatives are a whole new ball game and they open up the school district to lowering their NIC or if the hedge does not work, causing the school district to loss money. Several years ago, school districts like other municipal bond issuers bought bond insurance to get the AAA-rating. The AAA-rating enabled the issuer to receive a lower NIC by virtue of the fact the debt was backed by taxes or revenues, but also if something happened to the issuer's ability to pay, the insurer would pay principal and interest.

I must have been hiding in a cave the last several years because the story about hedging a school bond issue by a school board seemed to my more conservative fiscal instincts as an unnecessary risk.

I never said I was the sharpest knife in the drawer, but this idea of taking on additional risk to perhaps lower the school districts NIC seemed to me like gambling with tax payers’ money.

It took a while before investors accepted the bond insurance idea, as I remember that insured bond issues did not receive the fully advantage, in the form of lower interest costs, immediately. Bond buyers looked at the bond rating agency’s rating as the real worth of that municipal debt. In time, the bond insurance became more acceptable among portfolio managers and individual investors.

Interest rates peaked in the early 1980’s and then proceeded to decline over many years. With portfolio managers and individual investors facing ever declining rates of interest through the 1980’s and 1990’s, buyers would reach for yield, and in reaching for yield, rationalize their reasons for buying lower quality bonds, but with the bond insurance as a back up.

Now with interest rates at what I would consider historically low levels, the need for a school district to hedge their interest cost (NIC) through a side bet of buying a derivative, seems so unnecessary. Some school districts will win and save money, but I am afraid that state legislators do not fully understand the risks these schools districts are taking with their tax payers’ money. Stay tuned.