School systems don't usually have a lot of extra cash on hand, so when they want to make large capital expenditures like building new facilities or making major repairs, they have to borrow money. School bonds are a way for school districts to borrow money. Investors buy promissory notes like school bonds. The school district gets cash in the short term and agrees to pay the investor back over a fixed period of time.
School bonds work a lot like home loans or corporate bonds. The basic purpose is to allow the borrower to spend money right away and then pay it back over time. School districts use bonds to borrow money to pay for all sorts expensive short-term projects. Bonds are usually used to fund capital improvement projects like updating the heating system in a high school or a building a new gymnasium. For example, a school district in Alameda, California proposed a bond to upgrade existing schools and build new school buildings.
Issuing bonds is basically the same as spending public money, since the school district has to eventually pay the money back. As a result, school districts can't just issue bonds whenever they want. They have to win approval from local voters, partly by proving that funds are needed.
Once voters approve a bond measure, the school district begins selling bonds on the open market. Since school districts pay back the initial investment with interest, investors can earn profit when the district pays them back.
School bonds offer investors a big advantage over other types of bonds: they are exempt from federal taxation and sometimes state taxation. Normally, the IRS charges people a capital gains tax rate of 15 percent on income from bonds, so the exemption makes school bonds a particularly attractive investment.
Bonds have to be repaid by taxpayers with interest. The interest rate, and thus the total cost of the bond, varies according to how risky the investment is. It's no secret that the health of an economy affect interest rates. For example, a town on the verge of bankruptcy typically will have to pay very high interest rates for bonds, while a very wealthy city can qualify for very low rates.
Voting for school bond measures means voting for higher property taxes.
Citizens typically have to pay back bonds using property taxes. Voting for "yes" on a bond measure essentially means voting to increase property taxes to fund the school system. For example, the school bond measure in Alameda, California, proposed to raise property taxes by about $60 per $100,000 of assessed value. If you owned a home in the district worth $500,000, paying off the bond would require you to pay an extra $300 per year in property taxes.
Investors must be aware that bond repayment isn't guaranteed. If a city's population falls or its property tax revenue declines, the city could default on its school bonds. For example, the city of Detroit defaulted on several bonds in 2014. Defaults mean investors may get back only a small portion of the money they spent on the bonds. In some cases, they can lose their entire initial investment.