This content was originally published by Keygent Managing Member, Chet Wang.
Within the past few years, the concept of the repayment ratio (or debt ratio) has gained traction as a metric for assessing a bond financing’s cost-effectiveness. The repayment ratio is equal to a financing’s total debt service divided by its principal amount. So if a $1 million financing had total interest payments of $3 million over the financing term, the repayment ratio would be 4 to 1 (($1 million in principal plus $3 million in interest) divided by $1 million in principal).
California Education General Obligation Bonds Have a 4 to 1 Repayment Ratio Limit
California legislation (Assembly Bill 182, effective since 2014) implemented a repayment ratio cap of 4 to 1 for all school district and community college district general obligation bond financings.
In the current, historically low interest rate environment, this cap has largely been a formality that has not stymied education financings. This may change if interest rates rise significantly.
The Bond Repayment Ratio is a One-Size-Fits-All Metric
The repayment ratio cap ignores the unique circumstances of each district’s financing plan and applies a one-size-fits-all approach to every bond financing. Specifically, my issues are: (1) it’s based on nominal dollars, (2) it ignores the credit quality of issuers, and (3) it ignores bond market conditions.
- In nominal dollars, a 40-year financing should be more expensive than a 25-year financing. But a dollar today is not the same as a dollar tomorrow. The repayment ratio does not account for the time value of money. A payment 40 years from now should be worth less than a payment 25 years from now, and both should be worth less than a payment today.
- Districts with higher credit ratings should get lower borrowing costs than districts with lower credit ratings. In a higher interest rate environment where a AAA-rated district issues a financing with a permissible 4 to 1 repayment ratio, a BBB-rated district with the exact same financing structure would likely have an impermissible repayment ratio due to their higher interest cost.
- In the current, low interest rate environment, a financing may have a repayment ratio of 2 to 1. If the interest rate environment reaches double digits (as it did in the 1980s), then what was a cost-effective financing structure in a low interest rate environment may become impermissible in a high interest rate environment (and even more so for lower-rated districts).
The repayment ratio cap may have to be revisited in a higher interest rate environment, especially if lower-rated districts are prevented from issuing financings that higher-rated districts can issue.