State Bonds: What Are They? How Do They Work?
September 26, 2006
by Valerie Orleans
Two years ago, John Erickson, chair and professor of finance, was interviewed about bonds and their uses. This November, Californians will be asked to approve a school bond measure benefiting schools and universities across the state, including Cal State Fullerton.
Q. What are bonds and what are they used for?
Bonds issued by states and municipalities (often called "municipal" bonds) are generally used by states to finance capital outlay projects or acquire land. With capital outlay, this could include using monies to finance construction or renovation of buildings or other infrastructure. These are usually long-term expenditures.
Q. Why do states use bonds?
Bonds generally allow the state to acquire assets or develop building programs that it could not afford on a "pay as you go" basis. Perhaps one analogy would be to look at your mortgage. When people purchase a home, they usually don't have all the money needed to finance such an acquisition. So, they take out a loan to secure a down payment. The understanding is that the loan will be repaid over the years with interest. Basically the state is doing the same thing but on a larger scale - they're taking out a loan to finance a project or series of projects.
Q. Have bonds been used to support educational goals before?
Yes, actually there is a long history of using bonds to support education. In 1962, Prop 1a authorized bonds for the expansion of the UC, CSU and California Community College systems. In Orange County, they funded the construction of UCI, Cal State Fullerton and new community college campuses.
Q. Why not just add additional taxes?
People and businesses tend to be averse to additional taxes since California is already a high-tax state, and taxes can have negative consequences. Moreover, once you institute a tax, you're frequently going to continue to pay - even if the original reasons for the tax no longer exist.
For capital investments, bonds are superior because the funds they make available are typically targeted for specific expenditures that most agree need to be made. And since the types of projects that bonds tend to fund have long-term benefits, the costs are spread out over time. Generally speaking, bonds should not be used to meet ongoing operating costs.
Q. What are the types of programs that might be considered for bonds?
Historically, some of the projects that tend to be funded with bond money include education, corrections, veterans' facilities, housing, transportation, state and local parks, natural resources and, in California, expenses related to seismic retrofitting.
Q. So, with interest, what do bonds cost?
It depends on the interest rate at the time the bond is secured. In addition, because state bonds are tax deductible under federal law, the interest on state bonds is lower than on the bonds issued by other entities with similar risk.
Q. You hear about general obligation bonds and revenue bonds. What's the difference?
Revenue bonds tend to fund specific programs or projects that will eventually bring in revenue - such as the building of toll roads, water and sewage facilities, airports, etc. The idea is that the money provided to these programs will eventually be repaid through fees and charges to the facility users. General obligation bonds are backed by taxing authority of the issuer, not by a revenue stream created by the project being financed.
Q. Are there alternatives to using bonds?
Well, the state could use a larger share of its annual general fund revenues to fund building or renovation. Of course, that also would necessitate cutbacks in other areas. If there is only so much money available at any given point, you either raise taxes, cut services and programs, or you do both. Nevertheless, whether you use bonds or general fund revenues, the taxpayer foots the bill if the bond is a general obligation bond. The taxpayer obligation is just postponed to pay over a longer period of time.
Produced by the Office of Public Affairs at California State University, Fullerton.