Question

The University of Kentucky Builds with Bonds

Every year, hundreds of colleges around the country build new buildings. Where do most schools get the money for these expensive projects? From long-term bonds.   

The University of Kentucky (UK) has issued “revenue” bonds to build buildings on the 23,000 student Lexington campus, and on 14 community colleges throughout the state. These bonds pledge the school’s revenues as collateral to guarantee payment of the bonds. At one time the outstanding debt on the Lexington campus buildings was $137 million. The total debt on the community college buildings equaled $121 million. The bonds generally have maturities ranging from 10 to 20 years.

Additional “guarantees” for bond purchasers are the ratings given the bonds by professional rating agencies.   Their bonds are rated “AA-“ by Standard & Poor’s Corporation, which is well above investment grade. Thee is always a very good market for the bonds.

People in Kentucky identify very closely with the university. Even though the bonds are rated “AA-” they trade at AAA (the top bond rating) because they are so easy to sell.  

One advantage for investors: the bonds’ interest revenue id exempt from federal income tax and from state tax for in-state investors. So, an issue offering 6% is the equivalent of 10% to those individuals in the top tax bracket. Many investors feel very confident in buying the bonds, because it is inconceivable to them that there would ever e a default.  

1) The University of Kentucky’s bonds are rated “AA-“ by Standard & Poor’s and A1 by Moody’s Investor Service. Why is it important to the University of Kentucky that its bonds have a high bond rating?

2) Why does the state use bonds to finance the buildings rather than taking the funds out of general revenues?

3) Explain the meaning to the tax-exempt status of the University of Kentucky bonds. What does it mean to say that “a recent issue offering 6% is the equivalent of 10% to those individuals in the top tax bracket?”

Answer 1

The Solution to the question:

1)High Bond Rating provides investor confidence to invest in these bonds and makes them sell an easy way.Investors feel that there is minimum risk of default.These ratings act as "guarantees” for bond purchasers .For University of Kentucky these bonds are source of finance.They help in financing buildings being built by them.

2)These bonds have higher maturity ranging from 10 to 20 years so they are supportive means of funding.General Revenue of the state can be used for meeting operating expenses and working capital requirements.

3)Tax Exempt status means interest from these bonds is exempt in the hands of bond holders(they are not required to pay tax on interest income of these bonds).

When it says that"a recent issue offering 6% is the equivalent of 10% to those individuals in the top tax bracket” it probably means that an issue of 10% carrying a tax rate of 40% eventually boils down to 6%{10(1-0.4)}.