California school and community college districts primarily issue municipal bonds to finance the construction and modernization of their school facilities. However, what if a district does not have the ability to issue municipal bonds due to lack of remaining voter-approved authorization or other limitations? How can they access much needed funding for their necessary projects and infrastructure improvements? Certificates of participation are a financing tool that can be a solution for districts in this situation. Chet Wang of Keygent LLC, a municipal advisory firm, agreed to discuss certificates of participation with us and described the benefits and risks of utilizing them.
What is a certificate of participation? A certificate of participation, also referred to as a COP, is a financial instrument used by municipalities, including California school and community college districts, to raise funds for capital projects in lieu of issuing municipal bonds. It involves a lease agreement between the issuing district and a financing entity, allowing a school or community college district to use the proceeds from a COP issuance to fund infrastructure improvements. In turn, the district will lease a school site to the financing entity, and the lease payments made by the district becomes the source of repayment for the debt issuance.
Unlike general obligation bonds, certificates of participation do not require voter approval which can sometimes take months when pursuing a bond authorization. Many districts are also unable to pass bonds due to tax sentiment among voters in their districts. Chet Wang of Keygent LLC noted, “The flexibility to issue a COP without voter approval expedites the financing process, allowing California school and community college districts to receive funding sooner for pressing facility or infrastructure needs.” While the absence of voter approval streamlines the funding process, it is essential to note that COPs do not carry the same level of security as municipal bonds, making them subject to different considerations when issuing them. COPs also require county oversight before issuance.
As previously mentioned, lease payments made by a California school or community college district are the source of repayment for COPs, unlike municipal bonds which are typically repaid by ad valorem taxes levied by their respective county. The lease payments come directly from a district’s budget, making it a liability to their General Fund, or operating funds. Chet Wang explained, “When issuing certificates of participation, a district should work with their municipal advisor to determine the principal amount and structure of the COPs to ensure that the district would be able to make payments on the COPs without endangering the financial health of the district.” Economic downturns, budget constraints, or unforeseen financial challenges may create issues with a district’s ability to repay a COP, placing an unnecessary strain on the financial stability of a district.
As a result of the difference in repayment sources, credit rating agencies generally view COPs as a riskier investment than municipal bonds. COPs typically will have a lower rating than municipal bonds from the same issuer. Due to lower credit ratings, investors will typically demand higher interest rates to compensate for the perceived additional risk resulting in an overall higher borrowing cost for certificates of participation when compared to municipal bonds with similar financing terms and structures.
In some instances, a California school and community college district may consider issuing a COP ahead of an upcoming bond election with the plan to repay the certificates of participation with a future municipal bond issuance from the bond election, if it is passed. This strategy allows districts to receive funding for much needed projects ahead of voter approval while minimizing the long-term General Fund liability. However, the passage of a bond election is never guaranteed and it is imperative that districts issue and structure COPs in a manner where they will be able to continue to fulfill their obligation if they are unable to refund the COP with a municipal bond as planned.
The issuance of certificates of participation by school and community college districts can be a strategic financial approach to addressing critical facility or infrastructure needs. The flexibility offered by COPs enables districts to swiftly respond to sudden demands. However, it is important to acknowledge the risks associated with issuing a COP such as source of repayment, which can impact the financial stability of the issuing district. As school and community college districts navigate the complex landscape of funding capital projects, the strategic and careful use of COPs can be leveraged to improve educational facilities and infrastructure and, ultimately, the quality of education provided to their students.
Keygent LLC is a municipal advisory services firm located in El Segundo, California. If you would like to learn more about financing options for California school and community college districts, please visit www.keygentcorp.com.