Our office recently issued Implementing the 2006 Bond Package (we also released a video 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 Proposition 98 educational funding.

The second type is lease-revenue bonds, which are authorized by the Legislature. These are paid off from lease payments (primarily financed by the General Fund) by state agencies using the facilities they finance. (Historically, most of these bonds have been used to finance higher education facilities, prisons, and state office building.) These bonds do not require voter approval and are not guaranteed. As a result, they have somewhat higher interest costs than GO bonds. Figure 1 compares key features of lease-revenue and GO bonds.