As federal aid ends and enrollment grows, charter schools face challenges

Growing enrollment, pent-up demand for new facilities and a drop in interest rates are a boon for the charter school sector. It also faces budget pressures, increased labor costs, and dwindling pandemic-era aid, leading to a record number of impairments.

Despite the headwinds, "the sector is due to have a strong year," said Alan Wohlstetter, founder and president of School Improvement Partnership.

As the Federal Open Market Committee this week meets and is expected to cut rates for the first time in more than four years, charter schools can expand and buy their facilities for less, providing greater opportunity for enhancing staffing and curriculum, he said.

This also means there will be more charter school bonds coming to market as families look for alternatives to traditional public schools, Wohlstetter said.

And unlike traditional K-12 public schools, which have seen a decline in enrollment since the pandemic, charter schools have seen growth , he said.

Charter schools added nearly 300,000 students from 2019-2023, a 9% increase, helped by "several states' passing legislation favorable to charter school expansion and funding," along with a more targeted curriculum focus, such as foreign language immersion, STEM or project-based learning, said Daniel J. Close, head of municipals at Nuveen, and Margot A. Kleinman, head of municipal research at Nuveen.

Enrollment remains a leading indicator for the sector's strength. "For those schools that we see stability or growth, things are going relatively well," said Emily Wadhwani, senior director and sector lead at Fitch Ratings.

"Where we start to get concerned is declines in either a competitive market or a market that competes for a shrinking number of students, and that will continue to be a very real threat, particularly in states that suffer from both the demographic strain and outmigration challenge," Wadhwani said.

Generally, states like Texas, Florida, Colorado, Arizona, New York and some areas of California are performing well in the sector. There are some outliers in those states, with some schools that face headwinds, such as depressed enrollment and static state funding, said Brian Colon, manager of Baird's National Charter School Finance Group.

Growth for charter schools in some markets, helped by favorable legislation for per-pupil funding and facilities funding and families seeking alternative education options, may translate into physical campus expansions and facilities upgrades and the associated debt along with it, said Dan Simpson, vice president and senior analyst for Moody's Public Finance Group charter school ratings team.

Charter school supply topped $4 billion and $5 billion in 2021 and 2022, respectively, proving to be "banner years" for the sector, they said.

However, volume fell in 2023 and 2023 as interest rates increased, Close and Kleinman said, noting supply could rebound this year if interest rates decline.

"Given increasing student demand for charter schools, we anticipate continued strong supply issued into the municipal market," Close and Kleinman said.

Total outstanding par for charter school credits is at $32.31 billion, as of July 1, nearly double from the pre-pandemic level of $18.73 billion in Jan. 1, 2020, and quadruple the $8.03 billion in Jan. 1, 2015, according to Municipal Market Analytics, Inc. data.

Demand for new, riskier deals in the high-yield market remained strong during the first week of September with several oversubscribed charter school issues, Birch Creek strategists said in a Sept. 7 report.

D.A. Davidson brought a $51 million Ba1-rated New York charter school deal that was 12 to 14 times oversubscribed and bumped 10 basis points to 4.90% (+135) in 30 years and a $41 million BB-rated Florida charter school deal which was 15 times oversubscribed and bumped 13 basis points to 5.10% (+151), the report said.

"Some of those investors on the buy-side tend to gravitate a little more toward the larger operations, though there are great single-site or dual-site schools that do very well in their particular geographic region," Colon said.

But even though demand for charter schools is healthy in some areas, "it may not stave off some budget pressure at charter schools [in other markets] as inflation has remained relatively stubborn and labor costs have remained pretty relatively intransitive and inflexible for some of those schools," Wadhwani said.

Further compounding the pressure faced by charter schools is the ending of the elementary and secondary school emergency relief (ESSER) program, which provided pandemic-related aid to charter schools and traditional K-12 schools over the past few years, according to a Moody's report.

"The federal support, which exceeded 10% of annual state education revenue in some states, buoyed charter school operations, off-setting pandemic-era revenue loss," the report said.

But with the program ending this month, charter schools face a period of financial challenge due to the "ESSER cliff," particularly for charter schools with high childhood poverty rates and those that used the funding for recurring budget items, the report noted.

However, a S&P report noted "budgetary transition post federal funding should be relatively smooth for schools that have been using these funds for one-time needs only, but those that have been relying on emergency money for regular and recurring expenses could face significant operating pressures in the form of a 'fiscal cliff.'"

These pressures could continue to "hamper schools with leaner management teams, less oversight, and weaker operating flexibility," the report said.

Both of these issues have contributed to the rise in impairments in charter schools. There are a record 68 distressed charter school credits, 57 of which are non-rated, said Matt Fabian, a partner at Municipal Market Analytics.

"The charter school universe has more problems than it ever had before, but it's also much larger than ever before," he said.

MMA is cautious about the sector given the number of projects in technical default, Fabian said. On average, around 40% of charter schools that have a technical default transition the payment default within a few years, he noted.

"So we have the potential for a lot of defaults in the near term," Fabian said.

Despite this, market participants are still bullish on the sector.

Moody's outlook for the sector is stable, Simpson said, noting that increased enrollment, one-off ESSER funding usage and state-passed per pupil funding rates have contributed to the health of the sector.

S&P said in a report the sector remained healthy in fiscal year 2023, "reflecting flexibility provided by federal pandemic relief funds and stable-to-increased state per-pupil revenue."

The charter school sector has benefited from American Recovery and Reinvestment Act money and robust state budgets, said John Miller, head and chief investment officer of First Eagle's High Yield Municipal Credit team.

"Broadly speaking, [charter schools] have done well, but it could get a little bit tougher going forward, because there are a handful of schools that have generated adequate debt service coverage and adequate cash on hand, in part because of federal government funding," Miller said. "And that's not going to be repeated."

States continue to support K-12 education, "with fully funded education funding formulas, higher per-pupil funding, contributions to capital projects and support for increased teacher pay," said a Fitch report.

Several states, the report noted, shift education funding to private schools, often from public schools, through vouchers or "school choice" programs.

"The scope and cost of these programs continue to increase, with several states expanding the programs to include all students, rather than using a need-based approach for low-income households or students with disabilities," the report said.

Wohlstetter noted, "Education funding is strong to the degree that tax revenues are strong."

With charter schools, the funding follows the student, so "providing that schools are growing, their revenue will grow," he said.