California School District Bonds: Navigating Credit Risks and Identifying Undervalued Opportunities

The surge in child sex abuse lawsuits against California school districts, fueled by the 2020 passage of AB 218—which temporarily eliminated statutes of limitations—has created a complex landscape for municipal bond investors. While systemic legal liabilities have destabilized district finances, the resulting demand for judgment obligation bonds presents a compelling opportunity for risk-aware investors. This article dissects the credit risks and identifies undervalued bonds in this high-stakes sector.

The Credit Risk Landscape

California school districts face unprecedented financial strain as abuse settlements and jury awards exceed $3 billion. Key risks include:
1. Legal Liabilities: Districts like Carpinteria Unified, with a $42 million annual budget, face multi-million-dollar settlements that could force insolvency. Smaller districts, such as Montecito Union Elementary, risk state takeover due to payouts exceeding their budgets.
2. Insurance Gaps: Many districts' historical insurers no longer exist, leaving them to bear costs directly. The Schools Excess Liability Fund (SELF), which insures over 500 districts, faces a 700% premium spike and $300–400 million in supplemental assessments.
3. Ongoing Litigation: Lawsuits may persist beyond current estimates, as claims dating to the 1940s continue to surface. Trial attorneys, some taking up to 40% of settlements, further drain district resources.

The Case for Opportunity

Despite these risks, judgment obligation bonds issued to fund settlements offer attractive yields, particularly for investors with a long-term horizon. Key factors driving undervalued potential:
1. Legislative Safeguards: SB 577 permits districts to issue bonds without voter approval and extends repayment terms to 30 years. This flexibility reduces default risks by smoothing cash flow demands.
2. Insurance Backstops: Bonds tied to districts with SELF coverage or other insurance mechanisms benefit from a layer of protection. For example, Los Angeles Unified's $303 million bond issue (5.6% interest) is partially backed by SELF.
3. Yield Advantage: California school bonds currently offer yields 1–2% higher than comparable municipal bonds, reflecting their perceived risk but also their undervalued status.

Investment Strategy: How to Navigate

To capitalize on this sector, investors should:
1. Prioritize Larger Districts: Focus on issuers like Los Angeles Unified, which have broader revenue streams and access to state-backed programs. Avoid smaller districts with budgets under $100 million.
2. Verify Insurance Coverage: Seek bonds explicitly tied to SELF or other insurance funds. Districts relying solely on reserves or unsecured bonds face higher default risks.
3. Monitor Legislative Progress: Track SB 577's implementation, including proposed state compensation funds or caps on attorney fees. Positive developments could stabilize yields.

Risks to Consider

• Unresolved Litigation: New lawsuits could strain even well-funded districts.
• Insurance Sustainability: SELF's ability to cover future claims remains uncertain.
• Economic Downturn: A recession could reduce property tax revenues, a primary funding source for schools.

Conclusion

California school district bonds are a high-risk, high-reward proposition. While systemic legal liabilities and financial strain pose significant challenges, the legislative and structural safeguards in place—coupled with elevated yields—create a compelling entry point for investors willing to navigate the risks. Focus on insured bonds from large districts, and remain vigilant about legislative and fiscal developments. For the cautious contrarian, this sector offers a rare chance to profit from a market dislocation driven by societal reckoning.

Invest with eyes wide open, but do not overlook the asymmetric opportunities here.