We have covered some pretty obscure alternative investments including peer-to-peer loans, small business accounts receivable and consumer debt. Our quest for uncorrelated returns continues with a look at investing in a most unlikely place, the classroom- charter school classrooms to be exact.
What is a Charter School?
Charter schools are public schools that operate independently from their local school districts and receive both public and private funding. As our nation’s public education system is strained, there is increasing demand for alternative educational options, especially in poorly-performing school districts. Charter schools developed from meager beginnings in the early ‘90s, often finding school space in church basements or vacant strip mall spaces.1
The flexibility of charter school curriculum is attractive to many, especially amid inflexible Common Core standards. They aren’t required to comply with all the same standards as public schools, but they must follow the curriculum spelled out in their charter. There are charter schools specializing in the performing arts, business education and STEM (Science, Technology, Engineering and Math).2
Sound appealing? It is to many. There were 2.6 million students enrolled in charter schools at the end of 2014.3 And competition to get into charter schools can be fierce.
According to an article from Business Insider, there were 400,000 children on waiting lists for charter schools in 2012.4 That number has reportedly grown to one million as of 2015.5
Given the limited capacity, charter schools often use a lottery system for acceptance. A major reason for the growth is investor capital.
Like public schools, charter schools are funded on a per-student basis from local governments (via tax revenues) but financial support also comes from grants, private donations and investor capital. Without this private funding, charter schools would be in serious financial distress considering they are funded at just 61% of their public school peers.6
Charter School Bonds
Consequently, charter schools began issuing bonds to meet these funding challenges. Total charter school bond issuance reached $10 billion at the end of 2014, rising steadily since the first tax-exempt bond issue in 1998.7 The schools issuing the debt pay somewhere between 6-7% as borrowing costs (the cost of issuance plus underwriters discount).8
The growth in charter school bond deals has also been a growing area of profitability for the investment banks that underwrite the deals.
But like all investments, there are benefits and risks to consider with charter school bonds. Here’s a look at a few of each:
Benefits of Charter School Bonds
Individual investors are responding well to charter school bonds since they’re classified as municipal securities (essential services). As such, the interest income is exempt from federal and possibly state and local taxes, depending on where the investors live. These tax-advantaged bonds are an especially attractive proposition for investors in high tax brackets.
Further, the above average returns these bonds offer, on a tax equivalent basis, are desirable in today’s low-interest rate environment. The historical spread above comparable AAA municipal market data index (MMD) is 233 basis points, or 2.3%.9
You may already own some charter school bonds and not even know it. If you own a fixed income fund with a name like High Yield Municipal Bond Fund or Enhanced Municipal Bond Fund, there is a good chance it owns plenty of charter school bonds. Many of these are also offered widely in 401(k) retirement plans. Public pension funds may even own charter school debt.
David Brain, former president of EPR Properties, a Real Estate Investment Trust (REIT) that owns a number of charter school properties, calls charter schools ‘recession resistant’, given they are not tied to the more cyclical property taxes like public schools (this remains to be seen since ultimately the states pay some of the charter schools rent).10
There is increased political pressure on states to fund alternative education. Some states (including Arizona, Colorado and Utah) fund charter schools directly to bond trustees.11 Texas also made headlines when it decided to backstop certain charter school debt.12 As such, charter school bonds from these states may offer added financial security. If a charter school is in a well-funded state, it is a real benefit to the credit rating of the school. Charter school debt may be further secured by a first mortgage on the real estate assets.
Higher Default Rates
But with every investment comes risks.
A 2015 Bond Study revealed that the number of defaulted charter school bond offerings, 41, had risen from the 22 released as of the 2012 Bond Study.13 The 41 defaults represent 5% of the 881 charter school bond transactions in three years between the studies.14
If you are going to invest in charter school debt, you should really do your homework on the particular bond issue since default rates vary drastically between credit quality. For example, the default rates on investment grade issues was just 1.2% but jumped to 6% with non-investment grade (junk status) issues and 8.1% on unrated issues.15 This 6% default rate is considerably higher than the 3.8% default rate on high yield corporate (junk) bonds we saw at the end of Q1 2016, according to S&P Global.16
Academic quality was cited as the most fundamental metric in charter school credit analysis. Almost ¾ of the total defaulted issues were linked with “subpar academics”. An analysis of the defaults revealed that they were primarily stand-alone schools, not associated with larger charter school networks.17 These schools are at higher risk of having their charter revoked.
Despite the aforementioned security, charter school debt is considered one of the riskier types of municipal debt. In fact, they are considered the 7th riskiest of the 33 subsectors of municipal bond debt according to Municipal Market Advisors.18 They are perceived to be riskier than traditional public school debt because charter school’s primary funding is per-student payments from the state, not supported by local property taxes.19 As such, the risks for a charter school is more academics and reputational since the funding comes from the number of students who enroll voluntarily, a potentially fickle prospect.
Be wary of charter school debt located in fiscally unsound areas. Some geographic areas such as the Northeast and Midwest already have serious financial strains because of shrinking tax basis and population outflow.20 In 2013, Moody’s downgraded Philadelphia’s public school system partly citing the emergence of charter schools.21
A disproportionate amount of failed charter schools were located in the state of Michigan. Many charter schools popped up in Detroit as an alternative to their poor public school system. But since charter schools siphon some public funds away from public schools, it can make areas with existing poor finances worsen for both types of schools. This is part of the “negative feedback loop” of charter schools, according to Moody’s analyst Michael D’Arcy, who was part of a team that downgraded Detroit Public Schools.22 In other words, you might want to focus on charter school bonds in states with deeper coffers.