Understanding Bonds 101
Wednesday, March 15, 2006
It's not the best conversation starter:
We checked with someone who has much more than a clue - Dr. Steven Frates, a Senior Fellow at the Rose Institute of State and Local Government at Clermont-McKenna College:
Frates: "the simple answer is a bond is a promise to pay."
Seems simple enough. A government - in our case, California, sells bonds to investors in order to get money for projects sooner rather than later. The state then has to re-pay that money - with interest and usually over a pretty long period, 20 to 30 years.
Where the state comes up with the funds to make good on its promise depends on the type of bond and there are two worth mentioning. With a general-fund supported bond, the money comes from - you guessed it - the state's general fund, basically our tax dollars. But Frates says sometimes that's not a solid enough promise for investors - or state officials - that's where the other type - a revenue bond - comes in:
Frates: "the investment bankers who take the bonds and give the money to the government, they want to be sure that there is a dedicated revenue stream that will pay off those bonds."
Some examples: tolls that pay for roads or bridges, or water user-fees. But either way, there's interest. And analysts agree, it costs more to use bonds, especially the general fund type, says David Vashay, Director of Economics and Taxation at the Legislative Analyst's Office.
Vashay: "You do get to pay them off with future dollars, which due to inflation are a little less valuable, so if you adjust for inflation, bonds of that nature typically cost about 25-30% more than just directly appropriating that money."
So, at this point, you might be thinking, if California has to pay back the money borrowed, along with all that interest, why use bonds? Think of it less as credit card debt and more like a mortgage, says Vashay
Vashay: "It's much like buying a house. You might not like to pay your mortgage and your interest, but you know, it might be the only way to have your house, so you're really sort of choosing between, like a teeter-totter almost. On the one hand you've got the interest to pay, on the other, you've got the project in place sooner than otherwise."
That's why he says governments should limit such bond spending to things like highways, bridges, schools, ports, commonly called infrastructure, things that'll still be around in 30 years when they're finally paid off. And then, of course, there's the issue of debt, says the Rose Institute's Frates.
Frates: "The downside of course is one wants to be judicious and prudent about going into debt, the more debt you go into, the more you have to pay it off, and as you pay off that debt, the annual payments come out of operating funds."
And debt is something to be concerned about, says David Hitchcock, with credit rating provider Standard and Poor's. Just as each of us worries about good credit in order to get a better interest rate on a home, or a car, California's credit affects the rate it will pay on bonds. Hitchcock says debt is hurting California's credit rating, which is the lowest of any state.
Hitchcock: "Just for comparison, most states now have record surpluses, because the economy is so strong, so it's troubling that the state still has a deficit, even at the economic high water mark."
All this talk about bonds has shaken and stirred lawmakers up and any major proposal will require a two-thirds vote of the legislature, as well as voter approval. So even if these bonds aren't as entertaining as the Hollywood hero, you'll probably want to at least form an opinion on them.
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