September 2012
Are California School District GO Bonds
Misunderstood?
By Ty Schoback, Senior Analyst, Tax-Exempt Fixed Income Research
California local governments have increasingly found themselves the subject of unfavorable press, with cities and school
districts being the focus. We offered some perspective on cities facing fiscal distress in our Stockton: Omen or Outlier and
California Tremors white papers and thought it would be helpful to explore school districts given the sizable cuts to
education at the state level since the onset of the recession.
The most fundamental question of any municipal bond is its security pledge and how that pledge is paid. In the case of
California School District general obligation (GO) bonds, debt service is repaid from a voter-approved, unlimited,
dedicated, debt service property tax levy. This levy is collected by the County Treasurer, not the school district, and is
distributed directly to the bond trustee — a lockbox flow of funds structure. The County Treasurer is required to levy an
amount sufficient to meet debt service without limit as to rate or amount. Despite our confidence that school GO bonds
will be paid, we also consider relative value since market prices are closely correlated with rating agency ratings. While
school district fiscal health is important to consider, we do not believe budget stress will ultimately affect GO bond
repayment, due to the flow of funds structure. As a result, reports indicating California school GO bond repayment is at
risk, if state aid cuts continue, may be misguided.
It may be tempting to favor California school GO bonds over state GO debt since the California state constitution requires
appropriation of education funds to local school districts first and state GO debt service appropriation second. However,
we believe this approach is flawed because California school GO bonds are paid from a district’s local tax base, not state
aid. California school district GO bonds are a separate security from the State.
Fiscal Distress, Insolvency and State Takeover
The state has reduced and deferred aid to school districts almost every year since 2008 according to Education Data
Partnership. In the early years of the recession, schools received federal stimulus money that could be allocated through
Fiscal Year 2012. The intent of the stimulus money was to compensate districts for state aid cuts until the state could
afford to increase education funding again. In Fiscal Year 2013, California schools have no remaining stimulus funds to
spend and the outlook for state aid funding continues to look dismal. As a result, the fiscal health of districts statewide
has declined. In August 2012, Inglewood Unified School District (USD) was the first district to require a state takeover
post-housing bust. Although many districts are making the tough budget decisions to maintain adequate fiscal health, we
suspect there will be more school districts in need of state takeover.
Every school district budget is submitted to their respective County Office of Education (COE) for review, which then
assigns a Positive, Qualified or Negative Certification. The media often focuses on districts whose budgets have been
assigned a Qualified or Negative Certification. While this is something we watch we give little weight to the certifications,
since they are often used for political purposes or negotiating tactics and are not always the most accurate measure of a
district’s true fiscal health. We conduct our own credit analysis of school districts to determine the risk of a state takeover
for districts in fiscal distress. Of the eight state takeovers since 1991, six districts had a Positive Certification from their
respective COE.
In the event a school district is facing too many headwinds and is likely to become insolvent, it is the responsibility of the
local state representative to submit legislation for an emergency state loan. The legislation must be passed by the state
legislature and signed by the Governor before a district receives any money. Once an emergency state loan is
authorized, the superintendent of the school is fired, the school board is stripped of all authority and a state trustee takes
Are California School District GO Bonds Misunderstood?
over the district. The state trustee’s only mandate is to make sure the district remains solvent and is able to pay back any
state emergency loan. The process of preparing and moving a state emergency loan request through the legislature
typically takes four to six months.
The moment the state takes control of a school district, the district becomes a fundamentally stronger credit. With a stateappointed trustee, who reports to the State Board of Education, in control, the element of local political pressure is
removed. The loss of local control implicit in a state takeover provides strong incentive for local school boards to
overcome their status quo tendencies and to implement politically difficult fiscal decisions. The State Trustee remains at
the district until the state emergency loan is repaid, typically 20 years.
Chapter 9 Bankruptcy
While a number of California school districts have been taken over by the state in the past two decades, only one has
officially filed for Chapter 9 bankruptcy protection. In 1991, Richmond USD (now known as West Contra Costa USD) was
facing insolvency and submitted a Chapter 9 bankruptcy filing. The judge deemed the school district a ward of the state,
citing its reliance on state aid for operating revenues and threw out the bankruptcy filing. Soon after, the state legislature
passed a measure approving an emergency loan and state takeover of West Contra Costa USD. During this process,
West Contra Costa USD Certificates of Participation (COPs) went into default, although they were ultimately paid back in
full. The district’s GO bonds were not impacted. West Contra Costa USD paid off its state emergency loan and emerged
from state oversight in May 2012. Standard & Poor’s rates the district A+ Stable*.
Security Selection Remains Important
While the most highly rated school districts should continue to be preferred by many investors, we believe there may be
attractive investment opportunities in lower rated credits if bonds are purchased at prices that appropriately reflect the
risks. There are very few California school district credits that we believe should be avoided or sold at any level given the
state support mechanisms and lock-box debt service payment structures that are in place.
Are California School District GO Bonds Misunderstood?
The views expressed are as of the date given, may change as market or other conditions change, and may differ
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* Standard and Poor's rates the creditworthiness of corporate bonds, with 15 categories ranging from AAA (highest)
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