Frequently Asked Questions About Bond Financing (2025)

February 2007

Our office recently issued Implementing the 2006 Bond Package(we also released avideo summary of that report), aimed at helping the Legislature in overseeing the spending of the $43 billion in bond funds just approved by the voters. This report is intended to complement the report on the 2006 bond package. It answers basic questions about the state’s use of bonds to finance its infrastructure.

What Exactly Is Bond Financing?

Bond financing is a type of long-term borrowing that state and local governments frequently use to raise money, primarily for long-lived infrastructure assets. They obtain this money by selling bonds to investors. In exchange, they promise to repay this money, with interest, according to specified schedules. The interest the state has to pay investors on the bonds it issues for public infrastructure is exempt from their federal and state income taxes, which makes the state’s interest cost on the bonds less than it otherwise would be.

Why Are Bonds Used?

As noted above, the state often uses bonds to finance its major capital outlay projects such as educational facilities, prisons, parks, water projects, and office buildings. This is done mainly because these facilities provide services over many years, their large dollar costs can be difficult to pay for all at once, and different generations of taxpayers benefit from the facilities. The latter fact offers a rationale for spreading the costs of infrastructure over time, as bond repayments allow you to do. In contrast, funds to operate facilities or deliver services to the public are paid out of current revenues.

What Types of Bonds Does the State Sell?

The state traditionally has sold two main types of bonds. These are:

General Fund-Supported Bonds. These are paid off from the state’s General Fund, which is largely supported by tax revenues. These bonds take two forms:

  • The majority are general obligation (GO) bonds. These must be approved by the voters and their repayment is guaranteed by the state’s general taxing power. Most of these are directly paid for by the General Fund, although there are some that are paid off from designated revenue streams like mortgage or water contract payments and for which the General Fund only provides back-up security. In addition, the state recently issued GO bonds to help finance its budget deficit. Although their debt service is paid for by an earmarked one-quarter cent local sales tax, the General Fund ends up paying this amount through its increased share of Proposition98 educational funding.

Figure 1

Comparisons Between State General Obligation (GO) Bonds and Lease-Revenue Bonds

Feature or Characteristic

General Obligation Bonds

Lease-Revenue Bonds

Legislative authorization needed for program

2/3 vote in each house

Majority vote in each house

Voter approval required?

Yes—majority vote of the electorate

No

Pledged security to bondholders

Full faith and credit of the state (its taxing power)

Annual debt-service appropriations, plus available bond reserve funds

Interest rate on bonds

Lowest possible

Recently has been averaging roughly 0.2percentage point above GO bond rate

Underwriting process

Usually competitive bidding, but negotiated sales allowed if cheaper

Some competitive bidding, but most sales to date have been negotiated

Need for reserve fund to effectively market bonds?

No

Yes

Need to purchase property and liability insurance?

No

Yes

Amount of bonds required

Based on project costs, plus small amount (less than 1percent) for issuance costs

Bond volume upsized, typically by roughly 15percent over project costs, to cover underwriting fees, debt-service during construction period, other issuance costs, and reserve fund

Type of amortization schedule currently used

Typically level total payment (principal and interest) over 30years

Typically level total payment (principal and interest) over 25 years

Real cost of bond financing

Lowest possible (typically about $1.20 to $1.30 per $1 of capital costs

Typically 10percent to 15percent above GO bond cost, depending on circumstances

Traditional Revenue Bonds. These also finance capital infrastructure projects, but are not supported by the General Fund. Rather, they are paid off from a designated revenue stream-usually generated by the projects they finance-such as bridge tolls, parking garage fees, or water contract payments. These bonds normally do not require voter approval.

Doesn’t Using Bonds Cost More?

Funding infrastructure using bonds is definitely more costly than direct appropriations due to the interest that has to be paid. This extra cost depends primarily on the interest rate and the time period over which the bonds have to be repaid. For example, the most recent GO bonds sold for an interest rate of about 4.4percent and will be paid off over a 30-year period. Figure2 shows that under these assumptions, the total cost of a bond will be about $180million for each $100million borrowed-$100million for repaying the amount borrowed and $80million for interest. However, because the repayment is spread over the entire 30-year period, the cost after adjusting for inflation is considerably less-about $1.2million for each $1million borrowed.

Frequently Asked Questions About Bond Financing (1)

So, Given This Extra Cost, Why Use Bonds?

It makes sense to pay the extra cost of using bonds when this expense is outweighed by the benefits of having projects in place sooner than otherwise would be possible. This criterion is often met in the case of capital outlays, given the large costs of infrastructure projects, the many years over which they provide services, and the substantial increases in taxes or other charges that would be needed to pay for them up front. Proposals to use more bonds, however, do raise a number of other key questions as we discuss below.

How Much DoWe Already Owe?

Figure3 shows that as of January 1, 2007, the state had $37.7billion of GO bond debt outstanding. (“Outstanding” debt is the total amount of bonds that have been sold less any that have been paid off.) Almost two-thirds of this debt is in K-12 education. In addition to the $37.7billion in GO bond debt, the state has nearly $8billion outstanding in lease-revenue bond debt and $9.6billion in deficit-financing bond debt.

Figure3

Summary of California General Obligation Bonds By Program Area and Type

As of January 1, 2007 (In Billions)

Outstanding Debt

Unissued Bonds

Pre-November 2006 Authorizations

November 2006 Authorizations

Total Authorizations

Corrections

$1.0

a

Health

0.1

$0.7

$0.7

Higher Education

5.0

3.2

$3.1

6.3

Housing

2.1

2.9

5.0

K-12 Education

23.2

8.6

7.3

16.0

Local Governmentb

0.1

0.2

0.2

Resources and Flood Control

4.9

6.8

9.5

16.3

State Administration

0.2

0.2

0.2

Stem Cells

3.0

3.0

Transportation

3.2

0.4

19.9

20.3

Total, General Obligation Bonds

$37.7

$25.2

$42.7

$67.9

Source: California State Treasurer

a $10million in unissued bonds.

b Includes bonds for reading and literacy improvement and library construction.

Detail may not add due to rounding.

How Many Bonds Have Not Been Sold?

Figure3 also shows that the state has not yet sold $25.2billion of GO bonds authorized prior to November 2006. About 70 percent of this amount, however, is already committed to specific projects, largely to education. In addition, the voters just approved $42.7billion in new bonds last November.

Why Are There So Many Unissued Bonds?

There are several reasons why the state typically has a large amount of authorized, but-as-yet unsold bonds:

  • One reason is that when voters are periodically asked to approve bonds, the volume authorized is often expected to last for a number of years.

  • A second reason is that there often is a time lag between when bonds are authorized and funds are needed for their projects. This can be because the projects involved have not yet been started, or those in progress have not yet reached construction. This, in turn, depends largely on such factors as how long it takes to acquire any necessary property, prepare any required environmental documents, develop project plans and working drawings, agree to contracts, make arrangements for actual construction to begin, and make progress on the projects themselves.

  • A third factor reflects the fact that short-term loans are typically made to bond programs (using commercial paper or the state’s Pooled Money Investment Account) to bridge the gap between when programs need funds and when the state sells the bonds.

Once it is time to sell bonds, they are marketed by the State Treasurer, generally through a competitive-bid auction process. This is where the bidder (often a consortium of financial firms) offering the lowest interest rate gets to purchase the bonds, generally for resale to the investment community. Typically, GO bonds from several different programs will be bundled together in a single sale.

What Does Our Debt Cost Us Each Year?

In our recently released report Implementing the 2006 Bond Package(January 2007), we estimated that General Fund debt payments for already authorized GO and lease-revenue bonds for infrastructure-related purposes will total about $4.7billion in 2007-08, rising to a peak of $7.5billion in 2014-15. (These numbers would increase further if bonds proposed by the Governor for future years are approved and sold. Figure4 summarizes the Governor’s proposal.) If the annual costs of the deficit-financing bonds are included, total debt-service costs will be about $7.8billion in 2007-08 and $8.3billion in 2008-09.

Figure 4

Governor’s Proposed Bond Package—by Bond Type

(In Billions)

General Obligation

2008 Ballot

2010 Ballot

Lease Revenue

Revenue

Total

K-12 Education

$6.5

$5.1

$11.6

Higher Education

7.2

4.3

$0.1

11.6

Corrections

9.5

9.5

Flood control/ water supply

4.0

$2.0

6.0

Courts

2.0

2.0

Other

0.3

2.3

2.6

Totals

$20.0

$9.4

$11.9

$2.0

$43.3

How Much More Debt Can We Afford?

There is no accepted “rule” for how much debt is “too much” or how many bonds the state can “afford.” Rather, this depends on policy choices about how much of our revenues to devote to the funding of infrastructure versus other state spending priorities, and also what level of taxes and user charges is appropriate for the funding of infrastructure. In addition, it depends on the state’s ability to sell its bonds at reasonable interest rates in the financial marketplace.

What About the State’s Low Bond Ratings-Aren’t They a Problem?

California’s credit ratings currently are scored as A+, A1, and A+, respectively, by the nation’s three major rating agencies-Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings. (State ratings typically range from a low of “BBB” up to the best rating of “AAA.”) Although these all are investment-grade ratings and reflect recent improvement, they remain nearly the lowest of all states rated by these agencies. The state’s current low ratings are principally related to factors other than the amount of debt outstanding-most notably, the continued imbalance between state revenues and expenditures and the ongoing structural deficit this implies. (Figure5, shows the history of the state’s credit ratings by the three agencies. California was last rated a AAA state in the early 1990s.) It would appear that the main adverse implication of the low ratings thus far has been the additional interest premium the state has had to pay on its new bond issues compared to what AAA-rated states pay. In recent years, this premium has been somewhat over 0.2percentage points. Put another way, for every $1billion in new debt sold, the added interest cost to the state is roughly $1.5million annually over the life of the bonds.

Figure 5

History of California's General Obligation Bond Credit Ratings

Standard & Poor's

Moody's Investors Service

Fitch

Date

Rating

Date

Rating

Date

Rating

May-06

A+

May-06

A1

June-06

A+

August-04

A

July-05

A2

July-05

A

July-03

BBB

May-04

A3

September-04

A-

December-02

A

December-03

Baa1

December-03

BBB

April-01

A+

August-03

A3

December-02

A

September-00

AA

February-03

A2

February-00

AA

August-99

AA-

November-01

A1

October-97

AA-

July-96

A+

May-01

Aa3

February-96

A+

July-94

A

September-00

Aa2

July-94

A

July-92

A+

October-98

Aa3

September-92

AA

December-91

AA

July-94

A1

February-92

AA+

July-86

AAA

July-92

Aa

July-86

AAA

February-85

AA+

February-92

Aa1

October-82

AA

January-83

AA

October-89

Aaa

Prior to 1982

A

January-80

AA+

April-80

Aa

May-68

AAA

September-72

Aaa

November-40

Aa

January-38

A

Isn’t the State’s Debt-Service Ratio a Good Guideline?

Some parties in the investment community look to the debt-service ratio (that is, the DSR, or ratio of annual debt-service costs to yearly revenues) as a general guideline regarding the state’s debt burden. Figure6 shows that California’s DSR increased in the early 1990s and peaked at somewhat over 5percent in the middle of the decade. It currently stands at 4.3percent.

Frequently Asked Questions About Bond Financing (2)

Other indicators of debt capacity or affordability that sometimes have been used are the ratio of state debt outstanding to statewide personal income, and per-capita debt outstanding. California also appears to be in an acceptable range using these measures. This conclusion is similar to that for the DSR indicator noted above.

In terms of how California’s debt levels compare to other parts of the country, the California State Treasurer described them as consistent with those of other large states in his 2006 Debt Affordability Report. The report also indicates that while the state’s ratios of tax-supported debt to personal income and debt per capita rank well above the medians for the ten most populous states, several states are above California, and California’s position partly reflects its deficit-related borrowing as opposed to the use of bonds for capital projects.

Does This Mean AffordabilityIs Not a Major Issue?

Even if the state is able to market additional debt at reasonable interest rates, it still needs to be able to make room in its budget to pay the added debt service. This is because for any given level of state revenues, each new dollar of debt service comes at the expense of a dollar that could be allocated to another program area, whether this be education, health, social services, or tax relief. Thus, the “affordability” of more bonds has to be considered not just in terms of their initial marketability, but also whether their debt service can be accommodated both on a near- and long-term cumulative basis within the state’s budget, given other spending priorities. This is a particularly important consideration, given that the costs of using bonds are largely delayed, and each $1billion of new bonds sold at 5percent interest adds close to $65million annually for as long as 30 years to state debt-service costs.

What Will the 2006 Bond PackageMean for the DSR?

Figure6 also shows that the state’s DSR would increase from its current level as bonds authorized in the 2006 package are sold. We estimate that the DSR would peak at 5.6percent in 2010-11. At that time, the 2006 bond package will be adding about 1.2percent to the DSR.

What Will the Governor’s New Bond Proposals Mean?

Including the new GO and lease-revenue bonds proposed by the Governor, the DSR would peak at 6.1percent in 2014-15. At that time, the new bond proposal would add another 1.2percent to the DSR. To put this into perspective, this additional debt service is roughly equivalent to total state spending proposed for the In-Home Supportive Services program in 2007-08.

So What’s the Bottom Line?

It certainly is possible that the state’s DSR could rise to a level that might lead to some investor concerns, higher interest costs, and possibly some challenges in marketing the bonds. This might occur even if the state’s bond ratings held constant or improved, due to the need to attract a sufficient number of new bond investors to absorb the added debt. Under these conditions, it would be particularly important that the state mitigate the situation by being committed to a well-thought-out, multiyear capital infrastructure plan capable of convincing investors that the plan made financial sense, would be effectively carried out, and would eventually pay dividends in terms of benefiting California’s economy. Thus, it is critical that the state have an effective capital outlay game plan and implementation process in order to accommodate a substantial amount of new bond debt without adverse financial consequences.

Acknowledgments

This report was prepared by David Vasché and reviewed byRobert Ingenito, with the assistance of many others in the office. The Legislative Analyst's Office (LAO) is a nonpartisan office which provides fiscal and policy information and advice to the Legislature.

LAO Publications

To request publications call (916) 445-4656. This report and others, as well as an E-mail subscription service, are available on the LAO's Internet site at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814.

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Frequently Asked Questions About Bond Financing (2025)

FAQs

What are some questions about bonds? ›

Your 10 most-asked bond questions, answered
  • Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
  • Why should I hold bonds in my portfolio? ...
  • What's the outlook for bonds for 2024? ...
  • How can I invest in a bond fund?
Feb 7, 2024

What are some key questions to consider before investing in a bond? ›

key takeaways
  • Before investing in a bond, know two things about risk: Your own degree of tolerance for it, and the degree inherent in the instrument (via its rating).
  • Consider a bond's maturity date, and whether the issuer can call it back in before it matures.
  • Is the bond's interest rate a fixed or a floating one?

What is a disadvantage of bond financing? ›

A disadvantage of financing through bonds is the issuing company will pay periodic interest and its par value at maturity, so it is required to accumulate funds to pay these obligations, unlike equity financing, which pays dividends when the firm has enough funds.

What are some of the factors you should consider when buying a bond? ›

ASSESSING RISKS

That may mean you sacrifice the potential for higher returns in favor of a safer investment. There are a number of key variables that comprise the risk profile of a bond: its price, interest rate, yield, maturity, redemption features, default history, credit ratings and tax status.

How does bond financing work? ›

Bond financing is a type of long-term borrowing that state and local governments frequently use to raise money, primarily for long-lived infrastructure assets. They obtain this money by selling bonds to investors. In exchange, they promise to repay this money, with interest, according to specified schedules.

Why don't people invest in bonds? ›

Bonds pay a fixed rate of interest over time, and so cannot keep up with inflation. A constant is incapable of keeping pace with an increasing variable. At a minimum, you need your money to appreciate more than the rate of inflation, and a fixed-income portfolio simply cannot do that for you. Don't buy bonds.

What are the three major risks when investing in bonds? ›

  • Credit Risk — The risk that a bond's issuer will go into default before a bond reaches maturity.
  • Market Risk — The risk that a bond's value will fluctuate with changing market conditions.
  • Interest Rate Risk — The risk that a bond's price will fall with rising interest rates.

What is the biggest risk in bond investing? ›

The biggest risk for bonds is typically considered to be interest rate risk, also known as market risk or price risk. Interest rate risk refers to the potential for the value of a bond to fluctuate in response to changes in prevailing interest rates in the market.

What is a primary concern for investors when it comes to bonds? ›

one key risk to a bondholder is that the company may fail to make timely payments of interest or principal. If that happens, the company will default on its bonds. this “default risk” makes the creditworthiness of the company—that is, its ability to pay its debt obligations on time—an important concern to bondholders.

What are the pros and cons of bond financing? ›

Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and various term structures. However, bonds are subject to interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.

What are the pros and cons of bond funds? ›

Pros and cons of bond funds
ProsCons
Bond funds are typically easier to buy and sell than individual bonds.Less predictable future market value.
Monthly income.No control over capital gains and cost basis.
Low minimum investment.
Automatically reinvest interest payments.
1 more row

What is the ROI of a bond? ›

It is the ratio of interest you receive compared with what you paid for the bond. For example, if you receive payments of $50 per year on a bond for which you paid $1,000 for the yield would be 5%. When you purchase a bond directly from the issuer, the yield and the interest rate are the same.

How much is a $100 savings bond worth after 30 years? ›

How to get the most value from your savings bonds
Face ValuePurchase Amount30-Year Value (Purchased May 1990)
$50 Bond$100$207.36
$100 Bond$200$414.72
$500 Bond$400$1,036.80
$1,000 Bond$800$2,073.60

What type of bond is best? ›

U.S. government and agency bonds and securities carry the "full faith and credit" guarantee of the U.S. government and are considered one of the safest investments. What that means: regardless of war, inflation or the state of the economy, the U.S. government pays back its bondholders.

What is the best treasury bond to buy now? ›

  • Vanguard Total World Bond ETF (BNDW)
  • Vanguard Core-Plus Bond ETF (VPLS)
  • DoubleLine Commercial Real Estate ETF (DCRE)
  • Global X 1-3 Month T-Bill ETF (CLIP)
  • SPDR Portfolio Corporate Bond ETF (SPBO)
  • JPMorgan Ultra-Short Income ETF (JPST)
  • iShares 7-10 Year Treasury Bond ETF (IEF)
  • iShares 10-20 Year Treasury Bond ETF (TLH)
Apr 8, 2024

What is a question for chemical bonds? ›

When does the breaking of chemical bonds release energy? Why are there so many different kinds of forces in chemistry? Why don't objects fuse to my finger when I touch them?

What is interesting about bonds? ›

Bonds have historically been more conservative and less volatile than stocks, but there are still risks. For instance, there is a credit risk that the bond issuer will default. There is also interest rate risk, where bond prices can fall if interest rates increase.

Why are bonds so important? ›

The Bottom Line. Bonds can contribute an element of stability to almost any diversified portfolio – they are a safe and conservative investment. They provide a predictable stream of income when stocks perform poorly, and they are a great savings vehicle for when you don't want to put your money at risk.

Which bonds are hardest to break? ›

Intramolecular covalent bonds are the hardest to break and are very stable, being about 98% stronger than intermolecular bonds. The covalent and intermolecular bonds discussed above result in numerous structures and functions of biochemical systems.

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