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Why capital appreciation bonds aren't as bad as they sound

A playground for kindergarten students under construction. It's being build in part with capital appreciation bonds.
A playground for kindergarten students under construction. It's being build in part with capital appreciation bonds.
Maya Sugarman/KPCC

Capital Appreciation Bonds. CABs for short. They're getting a very, very bad name and have invited some very, very bad press over the past few months. My KPCC colleague Vanessa Romo is the latest reporter to take a dive into these financial instruments, which school districts in California and other states have been using to borrow money.

Why the bad name? In exchange for making no payments on principal or interest for, in some cases, decades, school districts trying to build facilities borrow tens of millions today and can end up paying six times that when the bill comes due, well into the future, after the interest has "accreted," in the lingo of finance.

The cost of present-day, voter-approved borrowing is passed on to a completely different generation of taxpaying voters.

School districts do this when property taxes aren't adequate to fund projects and when raising taxes is politically unpalatable. 

This practice —  California’s State Treasurer Bill Lockyer described it to KPCC's Romo as " imprudent, unreasonable and irresponsible" — has drawn the ire of numerous financial observers.

The Financial Times' Gillian Tett calls CABs "a dangerous cocktail of innovation and debt."

"[A] costly and risky form of financing that has saddled [school districts] with staggering debt," said the L.A. Times.

"[P]erfectly exemplifies the parasitic, ponzi and entirely unsustainably criminal carcass of an economy," said the Liberty Blitzkrieg blog.

"Get thee behind me, CABs!" you might hear everyone in California shouting at this point.

But as with many things, the rage that the dramatic headlines provokes is only responding...well, to the headlines. Paying $6 for every $1 borrowed to build classrooms and playgrounds sounds appalling. But as Romo reported, CABs are often part of an overall financing package with aggregate terms that are far less dramatic.

And then there's the argument that CABs are justified, given the length of time that the assets they'll help pay to build will be around for many, many years.

Shawn O'Leary, an analyst at Nuveen Asset Management, issued a breakdown of CABs back in August that focused on the role that "intergenerational equity" plays in choosing this type of debt:

As the district contemplates how to finance the construction of significant new capital investment in a short time frame, they are forced to consider what is the most equitable way to finance assets with expected lives of 50 or more years. In other words, should today’s residents pay for the entire cost over the next 15 or 20 years, or should future generations of residents that will also benefit from the facilities share some of the burden? The former strategy may be less expensive to the district as a singular entity but more expensive to today’s residents. By comparison, the latter strategy is more expensive to the district as a singular entity but may well be the more affordable option for residents that don’t intend to live in the community for 40 years or would rather maintain lower taxes over time. This is a tough public policy call and not all bond issuers make the same choices when faced with such a dilemma.

O'Leary deconstructs this in terms of the Poway Unified School District in San Diego; it issued $105 million in CABs that will cost the district $981.5 million at maturity in 2051. He argues that if Poway residents were to pay off the 2051 bill today, the tab would represent only 0.9 percent of the district's median income (Poway is affluent, and O'Leary does note that CABs can make sense for high-income areas). 

That's a payoff today. One assumes that Poway median incomes will be substantially higher in 40 years.

Then there's inflation. Even with those big payoffs in the distant future, inflation will do its inevitable work, reducing the cost of the debt over time. Even at a $1-to-$6 ratio, that $6 is calculated based on 2012 dollars, not 2051 dollars.

I checked with my pal Cate Long, who writes the MuniLand blog for Reuters and covers municipal debt better than anyone. I was curious about whether CABs could be inflation adjusted, as she said she'd never heard of an inflation-adjusted CAB, but she pointed out that an enterprising investment banker could engineer one.

I was also curious about whether a school district could at some point during the life of the CAB refinance the debt. In some cases, the answer is yes. Issuers may also pay off the bonds early. In the Poway case, however, neither of those options is available. 

The real issue here is of course is that, in a post-Prop 13 world, school districts have to get creative with their borrowing, given that they haven't been able to rely on steadily advancing property tax rates to fund education in the state since the 1970s. They can't wait around for the economy to improve enough to bolster property tax revenues that'll generate money for new facilities. So a building needed today may be worth, in some measure, paying a lot more for it in the distant future.

Or more accurately, making future generations who will use the facilties perhaps justifiably bear the cost.

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