“The future, according to some scientists, will be exactly like the past,
only far more expensive.”

~ John Sladek

BOND RATINGS FOR THE CHICAGO PUBLIC SCHOOLS

I don’t even know where to start with the Chicago Public Schools (CPS). Long ago in a galaxy far, far away I studied business at Rice University. I worked as a corporate and municipal bonds analyst afterwards. I understand bonds. CPS wants to issue (more)bonds to fund future district expenses.

Understanding how bonds work will help explain the CPS problem. A bond is basically a loan. The idea is that investors loan CPS $875 million so the district can meet its many obligations. In return, investors expect to get back the money they lent along with additional interest, extra money they receive for for giving up the use of their money for awhile. CPS promises to pay interest payments for the length of the loan. How much and how often interest is paid will depend on the bond, but interest will have to be high. CPS will end up paying a great deal of interest to get investors to fund its school system. When a bond reaches a pre-set “maturity” date, the principal, or amount of the original loan, will be repaid.

A bond is not like a stock. You don’t own part of the company when you buy a bond. Stocks represent slivers of corporate ownership. Bonds are simply loans. When government entities issue bonds, these are called municipal bonds or “munis.” Interest on munis offers some tax advantages and munis are frequently favored because they are safe. People who invest in U.S. government bonds expect to get their money back when the bonds mature, for example..

One important consideration when investing in bonds will be the interest rate associated with the bond. Safer bonds offer less interest. A search on safest municipal bonds turned up two interesting examples at http://www.municipalbonds.com/risk-management/the-top-10-safest-municipal-bonds/:

Williamson County Texas Unlimited Road Tax Road Bonds Series 2007 (969887UH9): These Texan AAA-rated, insured, general obligation bonds are backed by unlimited taxation with a 4.75% interest rate and long-term February 15, 2032 maturity date.

City of Arlington Texas Water and Wastewater System Revenue Bond Series 2007 (0484KEW1): These Texan AAA-rated, insured, general obligation bonds are backed by limited taxation with a 5% interest rate and short-term June 1, 2017 maturity date.

A variety of factors are considered when deciding on the quality of a bond. For the two bonds above, factors that jumped out at me were the unlimited taxation backing the Williamson County road bonds and the 2017 maturity date of the Arlington water bonds. More access to tax revenues helps ensure I will get my interest and principal back from Williamson County. A near maturity date doesn’t allow much time for economic changes that might interfere with Arlington’s ability to pay back what it owes.

Fortunately for investors, a few U.S. firms such as Standard & Poor’s, Moody’s, and Fitch rate bonds as their business. That “AAA” rating translates to “extremely safe investment.” Highly-rated, municipal bonds are considered one of the safest places to park money when investing, although these bonds have betrayed investors. Washington nuclear plant investors recovered only 40% of their money from one historic highly-rated, municipal bond disaster. Cities, counties and other municipal entities can and have gone bankrupt. When that happens, investors may not get all of their principal back, much less interest payments.

Which brings us back to CPS and bond ratings. The chart above shows a slide down to junk bond status.  Junk bonds are bonds that carry a rating of ‘BB’ or lower by Standard & Poor’s, or ‘Ba’ or below by Moody’s. We call these bonds junk bonds because they carry a higher default risk than so-called investment grade bonds. Default translates to “Oops! We can’t afford to pay you back.”

As the odds of default for a bond go up, interest has to go up in order to get people to buy the bonds. The greater the risk, the more money CPS must pay people to buy its bonds. Why? That junk bond status tells us that the rating agencies believe a real chance exists that, at some point, CPS will be unable to pay back interest and/or principal owed to investors. For investors to take a chance on the CPS bonds, they have to expect to receive high interest payments while they wait to (hopefully) get their principal back. Risk will also affect the amount of money investors can get if they want to sell their bonds after purchase, but that’s another issue, one that also pushes CPS to offer higher interest.

The following is taken from an article by the Chicago News Tribune’s Heather Gillers and Juan Perez:

 Chicago Public Schools held off on a planned $875 million borrowing deal Wednesday as investors take a hard look at whether to bet on the cash-strapped district’s bonds.