The emerging university bonds market

As global educational institutions find it increasingly difficult to come by public funding, many are looking to the bond market to plug the gap

Higher education is the new frontier for the bond market, as an increasing number of universities, including the University of Oxford (pictured), issue bonds to finance debt or investment 

“Nothing short of greatness” – that is the motto of the University of Minnesota’s fundraising campaign to provide its sports programme with the state-of-the-art facilities it requires to dominate US athletics. For that purpose, the university has built the Athletes Village, a labyrinthine behemoth of concrete spanning 320,000sq ft at the university’s campus in Minneapolis. The complex, completed this January, already serves as a hub for the university’s athletes and sports teams.

The majority of US universities opt for municipal bonds, a financial vehicle traditionally preferred by US states or cities

The project cost $166m, a staggering sum even for an institution of the size of the University of Minnesota, with its more than 50,000 students and $3.2bn endowment. To bring it to life, the institution followed the example of other US higher education institutions and issued $425m of AA-rated bonds. Around a fourth of the proceeds will cover costs for the Athletes Village.

Issuing bonds is a way to finance infrastructure without taking too much risk, said Brian Burnett, Senior Vice President of Finance and Operations at the university: “The university can maintain its cash reserves for operations, while spreading the cost of a capital project over time.”

A market under construction
Higher education is the new frontier for the bond market, as an increasing number of universities issue bonds to finance debt or investment. Data held by Dealogic, a financial data provider, shows that the value of bonds issued by education providers worldwide nearly trebled from $2.2bn in 2007 to $6.4bn in 2017 (see Fig 1). Some of the biggest US universities, including Harvard, Yale, MIT, Stanford and Princeton, feature in the list of top borrowers.

In most cases, the money is spent on brick-and-mortar operations, from student residences to football stadiums and libraries: US universities spent a record $11.5bn on construction in the 2015-16 academic year. Many institutions hope to tap into the opportunities that come with globalisation; to lure international students, they invest in flashy dormitories or even campuses based abroad. Laureate Education, a multinational education provider and the top education bond issuer globally (see Fig 2), has campuses and online programmes in 23 countries and plans to expand its operations further.

The majority of US universities opt for municipal bonds, a financial vehicle traditionally preferred by US states or cities. The benefits are immense for institutions with an eye on the future rather than short-term profit, said Emily Wadhwani, an analyst at Fitch Ratings, a credit rating agency: “Municipal bonds have a lower cost of capital and wide market reach, as compared to other financing vehicles. They also allow the cost of a project to be spread over its useful life (30-40 years for most large capital projects), and also spread the resultant student fees more fairly over the life of the project. In addition, using long-term fixed-rate bonds removes the risk of increasing costs going forward.” As for investors, they pick municipal bonds for their low risk, a crucial asset in times of increasing volatility in US bond markets.

As with other institutional borrowers, universities have benefitted from an era of historically low interest rates. Most of them issue fixed-rate bonds that are immune to market volatility. “During the past 10 years or so, the interest rate environment has been relatively low, which allowed the university to lock in long-term debt at attractive rates,” said Burnett. However, some risks persist for issuers. A return to more normal interest rate levels could increase overall university borrowing costs and make it more difficult for financially strained bond issuers to service their debt. Taking a long view can save institutions from potential trouble, according to Karen Levear, Director of Treasury Operations at the University of Oregon, which issued bonds in its name for the first time in 2015 to invest in student housing: “Rising interest rates could impact the cost of future debt, but interest rates are still well below historic long-term averages, and since we issue debt for the long term, we keep a long-term view on our cost of capital.”

The double-edged debt sword
Debt can also be disastrous if a project takes a wrong turn. UC Berkeley offers a cautionary tale of what can go wrong: the Californian university borrowed $445m from the bond market in the aftermath of the financial crisis to rebuild its American football stadium. The plan overestimated the number of supporters the stadium could attract and the quality of football the university’s team could play, falling short $120m. Eventually the institution was forced to plug the financial gap with campus funds, including student fees.


Value of bonds issued by education providers worldwide in 2007


Value of bonds issued by education providers worldwide in 2017

Increasing levels of university debt can also have an impact on tuition fees, said Aman Banerji, Programme Manager of the Financialisation of Higher Education programme at the Roosevelt Institute, a US think-tank: “I worry about universities increasing the size of their debt portfolio simply to meet gaps in their operating expenses. The size of interest rate payments is another serious concern. While university administrators are likely to continue to deny that higher interest payments will drive up tuition costs, as the size of these expenses continues to grow, I worry that universities are likely to rely on students to fund the expense gap much in the way that student revenues have often helped fill revenue gaps with declining state support.”

One way to avoid such mishaps is to cast a wide net, said Levear: “We disconnect the cost of specific debt from specific projects by issuing debt for a capital pool. Then projects are funded from the pool at a blended rate. This means that all capital projects have to ‘pencil out’ at the same blended rate, [which] protects necessary projects from the risk of varying interest rates.”

The perils of extreme financialisation
Bond issuance has long been a common practice for US institutions but, according to many experts, the decline of public funding has turned it into an inevitable process for universities relying on grants to finance research. Data held by the Centre on Budget and Policy Priorities, a US think-tank, shows that public funding for the academic year 2016-17 was nearly $9bn lower than the figure in 2008, while tuition fees and student debt grew exponentially over the same period.

Leading universities are deemed credible borrowers with a global brand name, which is always an asset in bond markets

The drop in public funding has pushed universities to cosy up with the financial sector, said Banerji: “In the last couple of decades, we’ve seen a huge expansion in the nature and number of financial transactions between the financial sector and universities – interest rate swaps, letters of credit, bond agreements, hedge fund investments, and more – all of which handsomely benefit the financial sector.” The Roosevelt Institute’s report on university-linked interest rate swaps found that interest rate swaps cost 19 US institutions around $2.7bn.

Another reason why bonds have become more popular is the shifting nature of university leadership. More than one out of two members of university boards at research-intensive institutions have a background in finance, according to data from the Stanford Social Innovation Review report. Research by Charles Eaton, Assistant Professor of Sociology at UC Merced, shows that as more people with a financial background sit on university boards, financial solutions that would once seem unconventional to academics have become the norm.

Banerji told World Finance: “As universities shift to private and donor-funded sources of revenue and invest large amounts in the financial sector, they seek out experienced financiers who can guide their investments and supposedly ensure that they get the higher returns. Equally, as university boards become over-represented by those in the finance sector, they expand the type and amount of future engagement with the financial sector.”

Financialisation may also increase the gap between big and smaller institutions. Bond markets tend to favour universities that issue large chunks of bonds and penalise universities with more modest borrowing needs. Banerji said: “For small public schools, community colleges and others with lower credit ratings that must borrow at higher rates, this race is both unfair and dangerous. Smaller, less wealthy endowments appear to be investing in the types of hedge funds and alternative strategies that were once the sole purview of large public schools and wealthy private ones. The new entrants to these types of investments often generate far lower returns, along with pay management fees beyond their capacity, and put their financial model in danger through the process.”

UK universities playing along
For British universities, bonds have only recently become an option for raising funds, but demand is steadily growing. Dealogic data shows that the bond market for the UK education sector increased tenfold from £272m ($380m) in a single deal in 2007 to £2.4bn ($3.3bn) last year. As in the US, government funding for higher education has dropped by more than 30 percent since the financial crisis, pushing higher education institutions to consider alternative options.

Shifts in banking regulation have also restricted access to traditional finance options such as bank loans. Luke Reeve, a partner at EY, said: “UK universities, which have historically been relatively unleveraged and underinvested, had access to extremely cheap and long-duration bank credit prior to the financial crisis. Under Basel III rules, banks simply can’t offer long maturity debt anymore. So universities had to switch to the bond markets, where institutional investors such as pension funds and insurance companies are seeking long-dated liabilities.”


Value of UK education bond market in 2007


Value of UK education bond market in 2017

Last November, the University of Oxford entered the fray, offering investors a bond with a record maturity of 100 years – the longest in the history of university bonds and longer than any publicly issued UK government bond. The current economic climate contributed to the decision, said a spokesperson for the university: “We did consider a number of options for financing our capital investment ambitions. We concluded that a bond represented a secure and predictable way to raise money over a long time and at low interest rates, particularly the historically low rates currently available.”

For their part, institutional investors opt for university bonds for their higher returns (compared with government debt) and their safety, since the UK higher education sector is highly regulated. Leading universities are deemed credible borrowers with a global brand name – always an asset in bond markets – and can therefore afford to offer long maturities. “We see the length of the bond, along with high demand from investors and the 2.54 percent rate achieved, as testament to external confidence in Oxford as an institution and in the high quality of its teaching and research,” said Oxford’s spokesperson.

For some universities, the obligations attached to bond issuance are too onerous to meet. Last May, the University of Bristol issued debt of £525m ($735m) to finance its plan to build infrastructure, including a new library and a hi-tech campus. Around £200m ($280m) was raised through private placement of unsecured notes in a bilateral deal with Pricoa Capital Group, part of the US group Prudential Financial. Robert Kerse, Chief Financial Officer at the university, told World Finance: “We principally selected a private placement over a publicly issued bond as we did not believe that the associated obligation of maintaining a credit rating for the next 30 to 40 years would leave the best possible legacy. Additionally, we felt that a private placement offered more flexibility with repayment profiles that could be selected to best manage future refinancing risk than a single bullet repayment, as is common with public bonds.”

Recent history has shown that caution about bonds is not unfounded. In 1995, Lancaster University issued a bond at a high interest rate. More than a decade later, the credit crunch pushed the university into financial strain because of the conditions attached to the bond. The University of Greenwich issued a bond in 1998, only to withdraw it four years later after its credit rating was downgraded.

Brexit also makes it harder for UK universities to access other finance channels in Europe. Kerse said: “The university considered taking borrowings from the European Investment Bank, but considered on balance that the political risk associated with new long-term borrowings from Europe was not something that it wished to accept.”

Australian universities tap into bond markets
Australian universities are becoming competitive internationally, poaching Asian students from US and UK competitors. To accommodate them, they have to invest in infrastructure, but traditional financial channels are less accessible. Last year, the Australian Government decided to wind up its Education Investment Fund, the public body funding teaching and research, forcing universities to consider alternative financing options, such as public debt. Bond issuance has increased from just $41m in 2008 to more than $1bn in 2016, according to data by Dealogic.

A case in point is the University of Melbourne, which issued $250m in bonds in 2014 to build student housing facilities and renovate existing ones. Katerina Kapobassis, acting Chief Financial Officer at the university, said the institution picked bonds over other financial routes for their combination of long maturity and low cost: “We are borrowing money to build long-life productive infrastructure assets to service our growth, so it is sensible to match asset and liability lives and issue debt with long maturities where possible. Banks and other credit markets donít currently offer such long maturities.”

The majority of investors are “insurance companies and other similar financial institutions”, according to Kapobassis. She added: “The average duration of certain insurance policies, such as life insurance, is very long. As these institutions are investing for a long period, they find the universityís strong reputation and robust AA+ credit rating attractive.”

Other Australian universities are exploring new territories in the bond market, such as up-and-coming green bonds that finance green projects. This summer, the Australian Catholic University became the first higher education institution worldwide to issue green bonds. Scott Jenkins, Director of Finance and Chief Financial Officer at the university, said: “Universities are large, complex organisations, [so] when it comes to financing expansion, many universities have seen that balance sheets are underutilised and have the capacity to borrow. In the current environment, the cost of funding is still low, although itís moving higher.”

As in other Anglophone countries, critics allege that bond issuance makes Australian universities vulnerable to the volatile forces of financial markets. But Jenkins thinks that universities can be more entrepreneurial, without compromising their educational purpose: “Over time, administrative areas of universities have become more businesslike, while the core mission and objectives remain unchanged.”

The holy grail of credit ratings
As universities become more active in the financial markets, their credit ratings become an important metric of their success. For critics, this is the last straw in the long way towards commercialisation of higher education, as universities are forced to take more wealthy international students, increase tuition fees and borrow to invest in flashy amenities, often with little educational value. Banerji said: “Credit rating agencies, especially through their credit upgrade and downgrade factors, can play a crucial role in determining a host of decisions on campus. On the student side, credit reports often suggest colleges maintain increasing out-of-state enrolment numbers to ensure the annual growth of net tuition revenue and maintain pricing flexibility. Equally, the agencies often highlight the importance of cost containment on the spending side that can have serious implications for faculty and staff on these campuses.”

The drop in public funding has pushed universities to cosy up with the financial sector

Many academics compare the increasing importance of credit ratings in higher education with university leaders’ obsession with league tables. But Wadhwani dismissed these fears as hyperbole: “Bond ratings are very different from academic rankings, the latter being an important marketing tool internationally, but less so historically in the US. Bond rating criteria do not require any particular level of academic standards; the focus is on financial sustainability within an institution’s unique educational niche.”

For some institutions, credit rating is not worth the trouble if issuing public debt is a one-off venture. That is the case of the University of Bristol, according to Kerse: “The university is unlikely to issue further long-term debt in the foreseeable future, and a credit rating would introduce another stakeholder to the institution. We would have considered a publicly issued bond if we were in an environment where we were issuing new debt more frequently.”

On the other side of the Atlantic, most US institutions view credit ratings and the scrutiny that comes with them as a necessary evil to further their institution’s mission. Levear noted: “We view our credit rating as an asset that can be used to help the university pursue its academic and public mission.” This is a view that is becoming increasingly prevalent in higher education circles globally, as financial stability and educational excellence can go hand in hand, according to Wadhwani: “Ratings tend to correlate favourably for universities with the financial capacity to support their mission and operating needs, rather than the reverse.”