CHICAGO -- A debate is raging in Michigan's public finance community over the increased use by school districts of capital appreciation bonds, which push debt service payments into future years, allow school officials to sidestep unpopular tax increases, and often are backed by the state's full faith and credit.
At last month's Michigan Treasurer's conference, Deputy State Treasurer Nick Khouri posed the question during one session as to whether the bonds were an "appropriate tool" for school districts or "a gimmick to delay interest and principal payments out to the future."
According to Louis Schimmel Jr., director of the Municipal Advisory Council of Michigan and a speaker at the session, opponents of this type of financing are concerned that while voters are being told the zero coupon bonds will not increase their taxes, the districts' taxpayers will end up paying three to four times the interest cost on a normal bond issue.
The principal and interest payments on capital appreciation bonds are deferred until maturity, with the intention of not increasing the property tax millage. The expectation is that future growth in assessed valuation will pay off the bonds when the debt service payments are due.
This means the principal and interest cost on the $256 million of capital appreciation bonds sold by school districts since the late 1980s, when their use was approved by the state, will total more than $1 billion at maturity, according to the advisory council.
The debate over the use of capital appreciation bonds focuses not only on their cost, but also on why all of these issues were sold in negotiated deals and charges that the political influence of certain public finance people has resulted in two firms -- Kemper Capital Markets and A.G. Edwards & Sons -- serving as senior manager on all the deals.
Concerns for the creditworthiness of the state also have been voiced, because 90% of a school district's annual debt service needs are paid through loans from the state's school bond loan fund, if the district's needs exceed the amount a seven-mill levy will produce.
While the money eventually would have to be repaid to the state by the districts, critics of capital appreciation bonds say the proliferation of the zero coupon bonds has increased the total amount of debt service the state is guaranteeing under its loan program to $4.4 billion as of Dec. 31, 1990, from $3.2 billion at the end of 1988.
"We've got a ticking time bomb [with these bonds]" said one public finance official.
No one is worried about the school district's ability to pay debt service on the bonds. Because they have an unlimited-tax backing from the school districts, and are sometimes insured or "qualified" to tap into the state's school bond loan fund, industry officials in the state said there were numerous safety nets in place to ensure payment.
Proponents of the bonds argue that the structure allows school districts to balance their increasing capital needs with a tax-wary public, which must, under state law, vote on any unlimited-tax bond issue.
James Doyle, the superintendent of the Huron Valley School District, said it was evident to school officials earlier this year that putting a millage increase on the ballot to support a $48.6 million bond issue for two new school buildings would fail.
In fact, he pointed out that while voters on Feb. 11 approved the district's issue, which included $20.5 million of capital appreciation bonds and no millage increase, they turned down a proposed bond issue for a neighboring school district that asked for a three-mill increase in the tax levy to support its issue.
"We did it to meet our needs without putting the tax burden on our community," he explained.
Other school officials said that, given today's transient population, the delayed payment on the bonds helps spread the cost of capital projects to the people who will be using the facilities.
"There are pluses and minuses to it, like you are going to pay more interest in the end," said Ray Johnson, assistant superintendent of finance for the West Ottawa Public Schools. "But if you have a fast-growing district like [ours], you've got to put the kids someplace and you have to say what is the taxpayer's threshold in terms of millage."
Richard Allen, a senior vice president at Kemper Capital Markets' Lansing office, said all the capital appreciation bond issues he has worked on involve districts in areas that are growing in terms of their state equalized valuation, which enables them to use future, "conservative estimates" of growth to offset a millage increase.
He pointed out that sometimes school districts incorporate the bonds into their proposed issues to avoid a significant millage increase after a regular current interest issue with the corresponding millage increase is defeated at the polls.
But even some proponents agree there is room for abuse in these kind of bond issues.
"I think the utilization of capital appreciation bonds is beneficial to the districts," said Don Elliot, a vice president at A.G. Edwards & Sons' Lansing office. "But the districts must be cautious. We emphasize to them to use conservative estimates on their state equalized valuation because if [the estimates] are off, the alternative is to have to raise millage."
There are other problems as well. In a CreditWeek comment last December, Standard & Poor's Corp. raised questions about the creditworthiness of issuers of these kinds of bonds, pointing out that "as interest continues to accrue, the use of zero coupon bonds understate the true debt burden being assumed and could leave a district and its taxpayers vulnerable to unpredictable economic and financial conditions with potential negative rating implications."
In fact, the agency cited the increase in debt burden from the use of zero coupon bonds as a factor in its November downgrade of West Ottawa School District's rating to BBB-plus from A-minus. Even the Government Accounting Standards Board, the entity that sets the rules for financial reporting by governments, is voicing some concern.
Robert Buckham, a project manager with GASB, said that while the GASB board was not opposed to non-sinking-fund zero coupon bonds like those being used in Michigan, some board members were interested in recommending that municipalities recognize principal and interest as an expense in their financial statements as debt service payments on the bonds accrete each year.
"As these things snowball to final maturity, there ought to be some recognition of debt service," Mr. Buckham said. Paul Devine, vice president and manager of the Great Lakes Region at Moody's Investors Service, said the way the bonds are structured to push payments "way out" was "troubling."
"The whole concept of a rating is the willingness and ability of people to repay debt," he said, adding that if voters support the bond issues only because no tax increase is promised, they speak "volumes" about their willingness to pay off the debt if higher taxes are, in fact, needed.
The fact that payments on zero coupon bonds is delayed could affect future borrowing, some observers said. Mr. Devine said he did not think the structure of capital appreciation bonds takes into account additional borrowing because bond payments delayed into the future could eat up any flexibility for more bond issuance under the issuer's millage rate.
But Paul Stauder, a first vice president at Stauder, Barch & Associates, a financial adviser to several Michigan school districts, said the bonds have not been used long enough to assess the impact on future borrowings.
"What we try to do with [the districts] is get them to consider their long-term needs," he said.
As for the competitive versus negotiated debate, Mr. Schimmel said he cannot understand "why such garden variety vanilla-type ice cream issues are all negotiated.
"Many of us in the investment business don't think that the size of these issues is so horrendous they have to be negotiated," he stated. "I think we ought to bring some of these on a competitive basis and [the issuers] might just be surprised at what the interest rates are compared to a negotiated basis."
But Mr. Allen disagreed, saying the issues he has been managing for school districts always included current interest bonds along with the zero coupons in deals that could include an "extremely complicated" mix of serial and term bonds spread over 25 to 30 years. He acknowledged that the interest rate on zeros is 15 to 20 basis points higher than on current interest bonds, but pointed out the higher rate simply reflects market conditions and the fact that the bonds are callable.
For the state, the biggest concern is that people in the school districts understand the risk they may be taking by issuing the bonds, according to State Treasurer Doug Roberts. He pointed out that with a new law that freezes 1992 property assessments at the 1991 level and the possibility that voters will approve in November 1992 a constitutional amendment limiting future residential property assessment increases to 5% or the rate of inflation, whichever is lower, the districts may be faced with automatic millage increases to meet debt service.
This, he said, could happen despite the fact the public was sold the bond issues on the basis that there would be enough future assessment growth to eliminate the need for tax increases.
"The bonds are protected, I'm not worried about that," Mr. Roberts said, referring to the majority of zero coupon school district issues that are qualified by the state, insured, or both. "I'm more concerned about the public being misled. It deals with an issue that anyone in government should be sensitive to, that is cynicism in a government that promises to carry out a policy and doesn't do it."
Mr. Roberts said the state's role through its school bond loan fund as a guarantor of debt service above a certain millage was not a concern. He pointed out that Michigan's overall debt "is relatively low compared to other states" and that the amount of debt in the loan fund "is very small." The state has about $133 million in outstanding loans taken out by school districts.
Mr. Allen pointed out that since 1988, when the Michigan Legislature loosened up the bond rules for local governments in the state, the zero coupons have been used not only by school districts, but by cities, counties, and state agencies as well. He said he and others working at Prescott, Ball & Turbin at that time were instrumental in getting the legislation passed that approved the zero coupon bonds, and subsequent firms he has joined, including Tucker Anthony Inc. and A.G. Edwards, where he was employed before moving to Kemper last August, have been at the forefront of zero coupon bond issuance in the state.
Mr. Allen dismissed charges of political influence on his part and that of Phil Runkel, a former state superintendent of schools and a former employee of A.G. Edwards who also left to join Kemper last summer, calling it criticism by competitors who have not made in-roads into this part of the municipal market as well as a misunderstanding of how the zero coupon bonds work.
"We consider our public finance team to be innovative," he said. "There are few firms that are leaders in this area, and firms without public finance departments might be more critical."
Mr. Allen added that Kemper supports the practice of issuing zero coupon bonds. "Our position is that every financing tool ought to be available to local government officials, and they should be able to make an informed choice," Mr. Allen said. "And the marketplace should be the final arbiter of their decision."
