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10 Key Steps For Managing School District Investments: | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 | Glossary |

6. Manage bond issuances to maximize interest earned and minimize interest paid.

The largest single sum of money that most districts will receive at one time will be the proceeds from a municipal bond issuance. Bonds are authorized by the voters and sold by the district for large projects to spread the cost over time to succeeding users of the facilities. Based upon a district’s needs and the state’s limitations on the amount of indebtedness a school district can carry (not to exceed 10 percent of assessed property valuation), the entire authorized amount does not have to be issued immediately. A district may issue in phases.

Most issues are tax exempt and in Texas are backed by the Permanent School Fund. Tens of millions of dollars are made available to pay for major construction projects when voters authorize bonds. When bonds are sold, the district is agreeing to pay interest to the buyers on a set schedule and soon after bonds are issued, the debt-service payments begin. Funds must be set aside to make payments on the debt. Depending on local ordinances and rates, districts often issue the authorized bonds as soon as the school board approves the sale of bonds, yet construction may not begin for months or years. In the meantime, the bond proceeds are invested.

Federal Income Tax Considerations
Provisions of Section 148 of the Internal Revenue Code of 1986 (from the Tax Reform Act, codified at 26 U.S.C. §148), as amended, (the "Code") states that the district’s long-term debt obligations must meet certain minimum criteria to be considered and continue to be considered "tax exempt."

This "tax exempt" status means that interest income earned by purchasers of long-term debt instruments is not subject to federal income taxes. Related U.S. Treasury Regulations under Section 148 of the Code (26 C.F.R. §1.148-2) generally provide that the determination of tax exempt status is made on or before the date such obligations are issued based on reasonable expectations about the use of the bond proceeds.

Since these issues are sold in the tax-exempt market and reinvested in the taxable market, the rates for reinvestment will normally be higher because of the nature of the markets’ relative risks.

Long-term debt that does not meet and continue to meet the minimum criteria of Section 148 of the Internal Revenue Code and the related Treasury Regulations described above are considered "arbitrage bonds" and are not considered "tax exempt." If bond proceeds are invested at a higher yield than the effective interest rate being paid on the bonds, they are said to produce arbitrage profits, and with only few exceptions, those profits must be paid back to the federal government. Under current tax laws, a district must make calculations periodically to determine any amounts that it might owe the federal government under these rules and must make actual payments of any amounts owed in five-year increments.

Obligations will become arbitrage bonds (as described above) if a district does not convey arbitrage profits to the federal government as rebate payments under Section 148(f) of the Code. The district’s obligation to calculate and make rebate payments (if any) will continue as long as there are gross proceeds allocable to that outstanding debt issues. All debt issues are separate and stand alone. Failure to remit arbitrage profits to the IRS when due can result in a penalty equal to 50 percent of the rebate amount due, plus late filing interest.

That being said, the investment should be designed to earn as much interest as allowed. If too much interest is earned, it is simply rebated to the IRS. There is no penalty or stigma involved as long as the payment is timely.

The danger is not earning the allowed interest and consequently spending money on interest for borrowed money before the money is needed.

For example, if a tax-exempt bond issue is sold at a yield of 5.5 percent and the proceeds are invested in taxable securities of 6.75 percent, arbitrage of 1.25 percent (6.75 percent – 5.5 percent) is being earned.

On the other hand, selling a bond with a yield of 5.5 percent before it is needed for construction, for example, and investing the proceeds in a savings account that only earns 3 percent interest means that the a district is losing 2.5 percent interest (5.5 percent – 3 percent). In the long run, every dollar the district has to pay in interest is a dollar that is no longer available for construction.

Small bond issues are, in some cases, exempt from the payback provisions of the law, according to section 148 of the Code. As of January 1, 1998, a district that issues less than $10 million in bonds in a calendar year to finance construction of public school facilities, is a small issuer and receives the "small issuer exemption." In other words, if a district issues less than $10 million in bonds after January 1, 1998 in a calendar year, it is exempt from having to return excess interest to the federal government.

A school district is obliged to understand the laws and regulations under which they must operate and to comply with those laws. The results of non-compliance can be damaging monetarily and politically. Consult your attorney or tax advisor for additional information or clarification on tax status of income earned from investment of bond proceeds.

Impact of Drawdown Schedule
The timely investment of bond proceeds depends on the anticipated spending plan for the funds known as the drawdown schedule. A drawdown schedule is an estimate of the dates and amounts that expenditures on a project will be paid and is normally available from contractors or architects working on the project. Drawdown schedules represent the estimated cash flow requirements and are important in determining the amount of bonds to issue and the available funds to invest. Securities can be bought to match the estimated schedule.

The following are strategies for maximizing the interest earned on bond proceeds and could hold true for all investments:

  1. Issue bonds when rates are low to reduce borrowing costs.

  2. Try to create an accurate cash flow forecast to guide the investment of the proceeds.

  3. Time the issue of bonds or portions of bonds authorized by the voters to coincide with when the money is needed and to use the small issuer exemption provisions of section 148 of the Internal Revenue Code .

  4. Invest bond money so that it earns all the allowable interest, paying back arbitrage profits if necessary, but avoiding interest losses if at all possible.

The goal when investing bond proceeds is to safely maximize the interest rate spread differential between the bond yield and the proceeds reinvestment yield within the guidelines of investment policy and specific bond covenants. This means that simply keeping bond proceeds in a bank account, money market fund or investment pool may not be the wisest decision. Investment return is often an essential part of project funding and should be taken seriously. Earning even an extra quarter point of interest can translate into significant real dollars. To illustrate, a $5 million investment with a yield of 6.25 percent will earn $12,500 more than an investment yielding 6 percent. Alternately, it may not be wise to stretch for the highest yield available and assume a high degree of risk, if excess earnings will ultimately be rebated back to the government.

Before investing any proceeds, an investor should be prepared to consider the following:

  • How much money will be invested? (Have some of the funds already been spent?)

  • How quickly are proceeds likely to be spent? (An estimated draw schedule is essential!)

  • How certain are these anticipated draws?

  • Will any arbitrage spending exceptions be met, or will the district be required to rebate excess earnings to the government?

  • What is the arbitrage yield? The arbitrage yield is a rate equal to the overall effective interest rate paid on a tax-exempt bond issue. (This will represent the benchmark rate that the district should seek to achieve.)

  • Is it possible to achieve a positive spread? (Can funds currently be invested above the arbitrage yield?)

  • What securities are authorized in the district’s investment policy and specific bond covenants? (Be especially careful to avoid investing in securities that are unauthorized!)

It is important to note that drawdown schedules are inherently uncertain, so plan for adequate liquidity. If you purchase securities, plan on leaving 10 to 20 percent in a pool or money market fund so that an unexpected draw doesn’t force a security sale at a loss.

In addition, when possible, try to gain enough yield to obtain a positive spread when you expect to be subject to IRS rebate. Positive spread is achieved when an investor earns a higher rate on securities purchased than the rate they have paid to borrow the money. For example, if a school district issues bonds at 6 percent and uses the bond proceeds to purchases securities that yield 6.50 percent, then the district has earned .50 percent positive spread.

Finally, school districts should carefully document their trade process. Keep in mind that bond counsel and financial advisors can provide a district the necessary expertise to negotiate this minefield and protect the assets of the district. Investment advisors can assist the district with the effective and efficient investment of the proceeds.

Investment of Debt Service Funds
General fund and debt service derive their revenues from taxes, however the cash outflows are very different from each other.

Debt service payments to pay off the bonds are established the day the bonds are sold. Principal and interest payments are determined for each financial year for the entire length of time till the bonds are paid off.

The district can invest its tax money that it has set aside for debt service payments to meet the principal and interest payments. For example, the district gets tax money in January of 200X. The principal and interest on bonds is due on August 15, 200X. This money can be invested to mature on the date of debt service payment in an investment for seven months (January to August) and earn interest.

Controlling Interest Cost
Controls targeting debt-related costs are very beneficial and are practical to implement. The primary objectives of debt management controls are to minimize debt-related costs and to avoid unnecessary debt-related costs. Without effective debt-management controls, the district may incur excessive interest costs and loan fees. Any degree of unnecessary or avoidable interest costs represents waste. A lower debt component of the tax rate is the primary benefit of effective debt management controls.

Interest costs may be controlled through several effective debt management techniques, which are listed below.

  • Implement a board policy to establish a debt ceiling that is related to the district's ratio of long-term debt to the amount of taxable property and/or the debt rate cap.

  • Build projections of the district’s budgetary and cash flow requirements for a three to five-year period to understand the district’s total debt requirements. These projections will facilitate study of all debt options and also help avoid excessive borrowing fees as a result of repetitive debt borrowing that could have been consolidated under a single loan.

  • Build and maintain a rainy day fund to avoid short-term borrowing.

  • Compare debt financing options and costs under all options available in the marketplace, especially when considering lease-purchase financing, which is generally viewed as an expensive option in most instances.

  • Actively monitor the economic advantages of advance refunding of long-term debt.

  • Use formal competitive procurement methods to obtain the best competitive bids or competitive proposals for financing costs.

Additional Resources:

Below is a list of additional resources you may find helpful. Information in the documents and URLs listed below are not endorsed by this agency, but only provided as resource material. For more information on these resources, consult the bibliography.

The Basics of Arbitrage Compliance
(First Southwest Asset Management)
Overview of compliance with arbitrage requirements.

The Investment of Bond Proceeds
(First Southwest Asset Management)
Considerations, strategies and bidding agents when investing bond proceeds.

State and Local Government Series Securities:
http://www.publicdebt.treas.gov/spe/spe.htm

Internal Revenue Service:
http://www.irs.gov

Bond Review Board:
http://www.brb.state.tx.us

IMPORTANT NOTICE: The information in this document is presented solely as technical assistance and as a resource available to school districts. The information does not serve as a substitute for legal advice nor replace the independent judgement of a district's governing body concerning its investments. A district should consult its attorney or other appropriate counsel such as its investment adviser to resolve questions about its investment transactions.