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Brown Spurs Rally With School Zero-Coupon Limit Law: Muni Credit

State Treasurer Bill Lockyer
Schools in the most-populous state issued $6.94 billion in such bonds from 2007 to November 2012, according to state Treasurer Bill Lockyer, who called for a crackdown. Photographer: David Paul Morris/Bloomberg

Bonds issued by California school districts that defer billions of dollars in interest payments for decades are rallying to a five-month high as Governor Jerry Brown prepares to sign a bill limiting their use.

The measure the 75-year-old Democrat is considering passed unanimously. It would cap interest on securities known as zero-coupon capital-appreciation bonds at four times the principal, and limit maturities to 25 years from the current 40. A school-finance lobbying group dropped its opposition to the bill.

The legislation was inspired by reports that the Poway Unified School District near San Diego would pay almost $1 billion to finance $105 million borrowed to improve facilities. Schools in the most-populous state issued $6.94 billion in such bonds from 2007 to November 2012, according to state Treasurer Bill Lockyer, who called for a crackdown. With curbs looming, the extra yield buyers demand on some Poway debt has shrunk to the lowest since April, data compiled by Bloomberg show.

“We have generally seen good value in CABs and it is a structure that we have and will continue to buy,” Michael Johnson, managing director at Gurtin Fixed Income Management in Solana Beach, California, said by e-mail. The debt “generally has a yield premium above what should be expected to compensate investors for the lengthy holding period to receive income.” The firm oversees $7.4 billion.

Revenue Plug

Boards overseeing California’s nearly 1,000 school districts increasingly turned to the financing mechanism after the recession that ended in 2009 reduced property-tax revenue used to build and modernize classrooms, an analysis of the bill shows. In 2009, lawmakers also eliminated a 10 percent cap on the annual growth in debt service, according to the analysis.

The result was an explosion in practices that Lockyer, a 72-year-old Democrat, termed “abusive” as districts pushed interest payments decades into the future, often with “balloon” payments due in 40 years. The securities differ from coupon-bearing bonds, which pay interest on a regular basis.

A Brown spokesman, Evan Westrup, declined to say whether the governor intends to sign the measure, noting that he rarely signals a position on pending bills. Brown has until Oct. 13 to act on the bill, according to Westrup.

Rebound Road

As the municipal market gained in September, rebounding from a four-month slide, the school bonds have done even better.

Poway securities maturing in August 2033 yielded about 5.81 percent in trading last week, or about 1.64 percentage points above benchmark debt. That spread is the smallest since at least April, when it was about 2 percentage points.

The tax-free obligations are rated Aa2 by Moody’s Investors Service, third-highest, with a negative outlook.

“They present decent value to investors,” said Eric Friedland, head of muni credit research for Schroder Investment Management North America in New York, which oversees $3 billion in munis. “There is limited downside risk because they have been trading at such a discount.”

Some districts complained the pending legislation would unfairly cripple their ability to finance new and improved schools. The California Association of School Business Officials withdrew its opposition to the measure after negotiating changes clarifying that districts could still issue current-interest bonds.

Project Obstacle

Yet Jeff Vaca, the association’s chief lobbyist in Sacramento, the state capital, said the limits on maturities and interest payments will hinder projects in districts where property values haven’t rebounded from the recession.

The 25-year limit on maturities will probably handcuff school boards looking to finance major projects without significant increases to property levies, said Jacob Manaster, the school-board president in Beverly Hills.

Leaders of the 4,600-student district near Los Angeles already have cut in half a $90 million bond issue planned for this year, he said by telephone. Voters in 2008 authorized the Beverly Hills Unified School District to borrow $334 million in the municipal market to renovate schools, with maturities as long as 40 years.

As a result of the new bill, officials are limiting maturities to 25 years and some schools won’t be reinforced against earthquakes or have classrooms enlarged to current standards, Manaster said.

Fading Facilities

“This just means more deterioration of the facilities,” he said. “It means the bonds will be less attractive to investors, which will drive up borrowing costs.”

Lockyer’s spokesman, Tom Dresslar, said he doesn’t expect the measure to chill issuance of school debt, only “the most abusive CAB deals that have inflicted the most harm on taxpayers,” he said by e-mail.

“The legislation does not hinder districts’ building programs, only their ability to unjustly shift the financing burden to future generations,” Dresslar said.

The restrictions will disproportionately affect districts in inland regions of California that have experienced rapid population growth coupled with a decline in property values, necessitating a financing mechanism that pushes costs into the future, said James Bridges, superintendent of the Jefferson School District in Tracy, California.

The district southeast of San Francisco has four schools, two of which opened since 2002.

Legislative Reach

Bridges said it’s unfair for lawmakers to remove a financing tool at the same time that state aid for modernization has evaporated. The district sold about $23 million in zero-coupon bonds in May with maturities as late as 2052.

In the most recent trades last month, the additional yield buyers demand on the bonds due in 2052 shrank to about 1.7 percentage points, from about 2.4 percentage points in May, Bloomberg data show.

“The local citizens should have the right to make that decision,” he said. “If they’re comfortable obligating themselves for 40 years, they should be able to do that. We’ve had state funding for modernization projects in the past, but not in recent years. We’re having to fund those on our own.”

Many districts have dug themselves into a hole by deferring payments for decades, said Craig Brothers, at Bel Air Investment Advisors in Los Angeles. While meeting the immediate needs for new or modernized facilities, the bonds “leave the issuer on the wrong side of the power of compounding interest,” Brothers said. The firm oversees $7 billion.

California Market

In the market for California debt, the University of California Regents are set to sell about $2.6 billion of revenue bonds next week, according to Lockyer’s website.

The sale will come as benchmark 10-year muni yields have dropped to a one-month low of 2.87 percent, compared with 2.75 percent for similar-maturity Treasuries. The ratio of the yields, a measure of relative value, is about 104 percent, compared with an average of 93 percent since 2001. The higher the figure, the cheaper munis are in comparison.

Following is a pending sale:

The Dormitory Authority of the State of New York plans to sell $183 million of debt for New York University, according to Moody’s. Proceeds will go in part toward buying a facility on Manhattan’s Lafayette Street and constructing a building for dental and nursing programs, according to Standard & Poor’s.

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