Rethinking Bond Repayment Ratios

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.

1. 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.
2. 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.
3. 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.

Disclosures