Overview
The bond market is an attractive source of long-term financing for charter schools, enabling schools to borrow fixed-rate debt over long, fully-amortizing terms, generally between 30 and 35 years. Moreover, the bond market allows school borrowers to finance 100% of project costs, including transaction expenses or costs of issuance. As such, schools are required to provide little or no up-front equity. Bond financing is typically secured by a first lien on the real estate collateral and revenues of the borrower

Coronavirus Side Note
At the time of this writing, the country is at the height of the coronavirus pandemic and experiencing a high degree of economic uncertainty. Thus far, uncertainty has not increased underlying market rates, but it has resulted in wider credit spreads for charter school borrowers. This risk appetite may change more significantly in 2020 with continued market uncertainty and a continued “flight-to-safety” in which investors exit higher-risk debt and equity vehicles and invest in high-quality, low-risk government instruments. It is not yet clear what the longer-term impact of COVID-19 will be for the tax-exempt market or charter school borrowers.

Tax-Exempt Basis
Charter schools have almost uniformly accessed the bond market on a tax-exempt basis, meaning that the interest on the bonds is excludable from federal income tax. In most states, including Idaho, interest from federally tax-exempt issues is also exempt from state and local taxation. Tax-exempt interest rates are usually lower than taxable rates since they produce an equivalent after-tax return to investors. However, taxable issuance may make sense in very low interest rate environments in which the spread between taxable and tax-exempt rates is particularly small or to advance refund taxexempt debt with higher interest rates (see below). For example, Voyager Academy, a North Carolina charter school, issued a 30-year taxable charter school bond in March 2020 to refinance 2012 and 2014 tax-exempt issuances with high interest rates.

Offering Method
Bonds can be offered through private placement or public offering. In a private placement, the bonds are directly placed with or purchased by a financial institution, foundation or high net-worth individual. Private placement may make financial sense for a school if it has strong institutional support from a banking or other institutional partner or if it is unable to access the public markets on an affordable basis. Private placement of charter school bonds was common earlier in the sector’s history, but as the sector has matured and investors have become more familiar with charter schools, public offering has become the norm. In a public offering, the bonds are marketed and sold competitively by a broker-dealer.
While public offering has become the norm, in certain cases it may be advantageous for a school to privately place its long-term bond offering with a supportive banking or other institutional partner.

Issuer
With the exception of charter schools in Massachusetts and Michigan, charter schools must issue tax-exempt debt through a public or quasi-public conduit issuer. The conduit issuer serves solely as an intermediary, borrowing funds from investors and relending them to the ultimate borrower, the charter school. Charter schools may choose to use an out-of-state conduit issuer for a number of reasons, including unfriendly charter policies, stringent credit requirements, cost savings, or procedural ease.

Example:
The Idaho Housing and Finance Association (IHFA) serves as the conduit for charter school bond issuances in Idaho. One example is its issuance of $7.3 million in tax-exempt bonds and $325,000 in taxable bonds in April 2020 on behalf of Compass Public Charter School.

Coupons and Yields
The coupon is the periodic interest payment the borrower pays to investors during the life of the bond. The coupon rate is the interest rate at which interest payments are calculated based on the principal amount of the bond. The interest rate used to calculate the coupon can be fixed at issuance for the life of the bond, fixed rate, or it can vary over a bond’s term, variable rate. In variable-rate bonds, the interest rate is set on certain designated dates in the future based on specific market indices, plus a predetermined spread to the index. 

The yield to investors is the rate of return on the bond. It can vary from the coupon rate if the price at which the bond is sold differs from par. When a bond is issued or resold, it can sell at a price that differs from its par value. A bond that sells at less than par is sold at a discount, and a bond that sells at more than par sells at a premium. The yield and the price of a bond are inversely related. If the bond is sold at a discount, the yield to investors is higher than the stated coupon. If the bond is sold at a premium, the yield is lower.

Pricing
A number of factors affect pricing and yields for bond issuances, including underlying market rates, credit spreads, and underlying market appetite for risk. Charter school bond offerings are priced at a spread to the triple-A Municipal Market Data Index (MMD), the interest rate the highest rated triple-A borrower would expect to pay on a tax-exempt bond priced on the same day with the same term or maturity. 
The MMD curve is similar to the Treasury yield curve—it moves with the overall economy. The MMD yield curve constitutes the underlying market rates for tax-exempt charter school bond issuances. Credit spreads to this curve vary based on individual borrower credit quality, with the extent of the variation depending on the market’s underlying appetite for risk. Given the high-yield nature of the charter school sector, this underlying market risk appetite has driven the relative share of rated and unrated issuance in differing market environments. Unrated issuance fell significantly during the Great Recession, when there was little appetite for risk in the market and spreads for higher-risk credits were at historic highs. Since that period, unrated issuance has steadily grown until recently as market appetite for risk increased, with significantly lower spreads to MMD for lower-rated or unrated credits.

Fees
In addition to the interest a charter school pays for its borrowing, charter schools must pay other expenses to execute bond transactions. These expenses include legal fees, trustee fees, issuer fees, underwriter fees, rating agency fees for rated transactions, and credit enhancement fees for enhanced transactions. The fee that has the most variance and represents a significant portion of total issuance costs is the underwriter’s discount, the fee paid to the underwriter to structure, price, and market bonds to investors. Borrowers typically fund these costs out of bond proceeds, subject to a cap of 2% of the tax-exempt issue amount (excluding the cost of credit enhancement). In cases where issuance costs exceed this cap, the borrower can issue a taxable series of bonds to fund the additional expense. While both the underwriter’s discount and overall costs of issuance have declined over the past two decades, they are still significant and can be prohibitively high for small issuances of less than $5 million. 

All-in Cost 
A school’s true cost of capital, or all-in cost, is calculated by taking interest expense, costs of issuance, and ongoing fees into account. Schools should ensure that all possible fees are disclosed when evaluating options and look beyond interest rates alone.

Schools can borrow from the bond market, but should they? 
Unlike some of the other financing sources discussed in this guide, which may place emphasis on school mission and academic performance, the bond market can be agnostic or neutral about the charter school’s service to low-income students and the quality of its academic program, to the extent it doesn’t impair repayment to investors. As a result, academically and financially weaker schools may have an easier time accessing the bond market. The question is, should they, and at what cost? Bond investors will provide capital to weaker charter school credits, but perhaps at interest rates that aren’t affordable over the long run. A school should consider the two benchmarks discussed throughout the guide: at full enrollment, debt service expense should be 15% or less and occupancy expense should be 20% or less of annual revenues. Schools should employ the toolkit’s Tab 4, Affordability and evaluation worksheet, when considering their options.

Reserve Funds
Charter school bond issues are structured with a debt service reserve fund (DSRF), which is held by the bond trustee on behalf of investors. This reserve can be tapped to pay debt service to investors should the charter school fail to do so. The DSRF generally equals maximum annual debt service for the bond offering and is funded with bond proceeds. While the DSRF increases the size and cost of the offering, it can be used by the borrower to make the final debt service payment on the bonds or be returned to the borrower at bond maturity. 

Redemption
Charter school bond issuers have the right to redeem or call bonds in whole or in part prior to maturity. Redemption makes financial sense if the bond was originally issued in a high interest rate environment, and refinancing would result in interest savings that outweigh the additional costs of issuance. There is typically a ten-year period of call protection from when a bond is first issued, during which there is a cost, or call premium, for redemption. Generally, this premium decreases according to a specified schedule until the ten-year call date, when the bonds can be called at par, or no extra cost. Prior to passage of the Tax Cuts and Jobs Act of 2017, tax-exempt bonds could also be employed in certain circumstances to “advance refund” tax-exempt issuance prior to the end of the call period. Proceeds of the new or refunding tax-exempt issuance were held in escrow (for more than 90 days) until the call date and then used to refund the higher interest rate bonds. With passage of the 2017 law, any advance refunding of tax-exempt charter school bonds after December 31, 2017 must be undertaken on a taxable basis, as in the example of Voyager Academy above.

Credit Rating
Charter schools can access the bond market on either a rated or unrated basis. In 2018, almost three-quarters of the 129 issuances were unrated, the highest percentage in two decades. The unrated share of par issuance was slightly lower, approximately two-thirds. The decision to access the capital markets on a rated or unrated basis depends in part on the pricing impact, which can vary in different market environments, as discussed above. 

Both Standard & Poor’s Global Ratings (S&P) and Moody’s Investors Service (Moody’s) provide ratings for charter schools. S&P continues to rate the great majority of transactions, 76% of the number and 80% of the par volume of all rated issuance in 2018. However, since its reentry into the sector in 2016, Moody’s share has been increasing. Fitch did not assign any ratings in 2018. A summary of the criteria employed by S&P and Moody’s in rating charter schools and their bond offerings is included in Appendix C. A former credit rating analyst also provides some tips on approaching credit rating agencies in an August 2020 publication link included in Appendix B. 

Market Size
According to EFF’s 2018 Year in Review, charter schools issued 129 distinct tax-exempt bond transactions totaling just under $3 billion during the year. This volume represented a 17% decrease compared to 2017’s $3.6 billion and a 2% increase over the total for 2016. Abnormally high volume in 2017 was driven by changes in tax law that went into effect in January 2018, including the changes to advance refunding discussed above. Tax-exempt issuances for 2018 averaged $23 million, with a lower median of $15 million, and a record-setting range from $2 million to $357 million. EFF preliminarily estimates that charter schools issued $3.5 billion in tax-exempt bonds in 2019, a projected 18% increase over 2018 volume. 

The charter school bond market is approximately $3 billion annually and growing. The median bond size is $15 million.

Refinancing Example
Liberty Charter School’s bond issuance provides an illustration of many of the concepts discussed in this section. In 2008, during the Great Recession, Liberty issued $4,005,000 in bonds, including $3,835,000 in tax-exempt Series A bonds and $170,000 in taxable Series B bonds (to finance costs of issuance above the 2% cap). Liberty issued through the Idaho Housing and Finance Association and used the proceeds to refinance short-term acquisition and construction financing for its facilities. The tax-exempt bonds were sold at par with interest rates of 5.50% and 6.00% for 2021 and 2038 maturities, respectively. The taxable bond was sold at par with a rate of 7.50% and a 2012 maturity. The bonds were callable at par beginning June 1, 2018, or ten years from issuance. The bonds had annual debt service of approximately $290,000 and an all-in cost of 6.53%.

In June 2020, Liberty issued $3,250,000 in refunding bonds through IHFA, including $3,075,000 in tax-exempt Series A bonds and $175,000 in taxable Series B bonds. The tax-exempt bonds had coupons of 4.00% but were sold at a premium. The bond maturing 2030 had a price of 106.44% and a yield of 3.23%, and the bond maturing 2038 had a price of 102.62% and a yield of 3.68%. The taxable bond was sold at par with a rate of 3.40% and a maturity date of 2022. The refunding bonds have annual debt service of approximately $255,000, a reduction of $35,000 annually from the 2008 issuance, and an all-in cost of 4.35%, more than 2% lower than the 2008 bonds. Sources and uses of funds for the 2020 bond issuance are included below. 

As can be seen, the DSRF requirement for the 2020 issuance is roughly equal to annual debt service on the new bonds. Because the 2008 bonds were being redeemed, the school was able to contribute the 2008 debt service reserve as a source for the new issuance. Because the bonds were sold at a premium, the school received additional up-front proceeds. These additional proceeds are taken into account when calculating the issue’s all-in cost. 

Related Articles in Undertsanding your Needs:

• Facility Refinancing: Preparation & Solicitation
• Assembling Your Facility Refinancing Team
• Facility Refinancing Guide to Underwriting
• Facility Refinancing: Credit Approval, Rating, and Marketing
• Facility Refinancing Guide to Closing
• Facility Refinancing Guide to State Credit Enhancement 
• Facility Refinancing Guide to Philanthropically-Enhanced Funds, Equitable Facilities Fund
• Facility Refinancing Guide to the CDFI Bond Guarantee Program
• Facility Refinancing Guide to Banks and Credit Unions
• Facility Refinancing Guide to Community Development Financial Institutions
• Facility Refinancing Guide to Philanthropically-Enhanced Funds, Facilities Investment Funds
• Facility Refinancing Guide to Replacement and Reporting 

Legal Disclaimer:

Nothing in this material should be construed as investment, financial, brokerage, or legal advice. Moreover, the facts and circumstances relating to your particular project may result in material changes in the processes, outcomes, and expenses described herein. Consult with your own professional advisors, including your financial advisors, accountants, and attorneys, before attempting to consummate any transaction described in this material.