Updated: Jul 22, 2018
February 22nd, 2017
As we all know, the municipal bond market is unique among all fixed-income asset classes for its wide variety of “bespoke” security structures, extreme diversity of issuers and lack of standardized financial disclosure standards. In fact, it’s been called an amalgamation of 50 separate markets (52, if you count Washington DC and Puerto Rico/US territories), each with its own legal/statutory environment: for instance, the “full faith and credit General Obligation” pledge doesn’t quite mean the same thing from one state to the next.
Back in the heydays, before the financial crisis, bond insurance was the market’s mechanism to promote some degree of commoditization across muni issues. This, of course, is no longer the case, as bond insurance’s market share has now been reduced to a paltry 5.63% in 2016 (according to the Bond Buyer) versus as much as 60% before the crash.
You would think that in the age of globalized capital markets, there’d be a movement toward more standardization and homogenization of security features, with the hope of enhancing liquidity in a market that normally only trades by appointment. But no, the opposite appears to be happening, particularly in the state and local government subsectors.
The traditional GO pledge has been undermined by the outcome of the Detroit bankruptcy, and is now under severe threat in many states of becoming subordinated to unfunded pension liabilities. Arguably, direct bank loans also threaten the senior status of the GO pledge by virtue of their inherently shorter maturity and by whatever covenants may have been imposed by the lending institution, usually without the explicit consent of current bondholders.
Faced with rising investor skepticism about the value of the traditional GO pledge, state and local governments are increasingly turning toward the dedicated revenue pledge, with a statutory lien if applicable or statutorily permitted (Note: we will discuss the concept in depth in a future issue).
Surely, revenue carve-outs are not a new phenomenon: just look at the myriad of security structures subsumed under New York State and New York City’s credits (TFA, PIT, Sales Tax etc.). However, given all the looming threats to the base GO pledge, investors appear to be flocking more and more toward dedicated revenue structures, preferably with an explicit statutory lien pledge, in the hope of bolstering their legal standing in the event of bankruptcy.
Not surprisingly, the most stressed credits in the marketplace are the ones that are latching onto the dedicated revenue concept as a means to preserve market access. Exhibit One: the latest financing from Chicago Public Schools (CPS), which elicited a vigorous debate between Fitch and Moody’s as to the real value of the dedicated revenue pledge. The State of Illinois, another moribund credit, must have gotten the same advice from its investment bankers. As part of the so-called “Grand Bargain” budget agreement currently being negotiated, the State Senate approved a measure that would allow a home rule municipality to set aside a portion of the revenues it receives from the State to a special entity such as a public corporation and use that dedicated revenue stream to secure future financings.
As such revenue carve-outs multiply, one has to wonder: what will be left to secure the basic GO pledge?