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Special Revenue Pledges & Rating Caps: "Why So Serious?"

Triet Nguyen

August 5, 2018

The lazy, hazy days of summer notwithstanding, a couple of recent research articles, one from SNW Investment and the other from Kroll Bond Ratings, have raised a very important fundamental credit issue in the municipal market: as muni investors flock to dedicated revenue pledges in response to a perceived weakening of the traditional Full Faith and Credit General Obligation (“GO”) pledge, what should be the relationship, if any, between a credit secured by a dedicated revenue source (a “revenue carve-out” as we call it) and the related underlying GO credit? As our regular readers know, this is a topic that has been near and dear to our heart. Thus, on the ten year anniversary of “The Dark Knight”, we find ourselves asking The Joker’s infamous question: “Why So Serious?”


The timing of this renewed debate is rather interesting: this past July marked the fifth anniversary of the Detroit bankruptcy filing, which arguably paved the way for the market’s current view of the traditional full faith and credit GO pledge as merely a residual, unsecured claim, absent a statutory lien on specific revenue sources. It also comes on the heels of the controversial ruling from Judge Laura Swain in the Assured/Puerto Rico Highway Revenue Bonds case, which seems to undermine the traditional legal stay in bankruptcy for revenue bond issues (KBRA has done an excellent job sounding the alarm on this issue, by the way).


The first salvo in this debate was fired by Mark Stockwell, an analyst at SNW Investment in Seattle. In an article titled “Devolution of Value in The Dedicated Tax Sector”, Mark fretted about the Big Three rating agencies’ increasing tendency to tie the rating of the dedicated revenue pledge to that of the underlying GO pledge:


“As events associated with a jurisdiction’s fundamental credit characteristics have in some cases impacted dedicated tax debt, rating methodologies are now migrating toward closer linkages with the general obligation rating of the sponsoring municipal government, and there is an increased focus on the underlying creditworthiness of the municipal issuer as the base for the dedicated tax bond rating.”


Now, this is certainly not a new phenomenon in our market. As Mark points out, Moody’s has been applying a rating cap rule for years, however, both S&P and Fitch also appear of late to be moving toward a greater rating linkage between dedicated revenue structure and the underlying GO pledge. In SNW Investment’s opinion, this represents a “devolution” of the dedicated revenue pledge, leading to an “underweight” recommendation on the sector. As a case in point, Mark cites the recent rating convergence of the formerly AAA-rated Illinois Met Pier bonds, which are backed by a dedicated sales tax, toward the State of Illinois rating, following the last few years’ state budget fiasco.


It’s interesting to us that SNW Investment chose to highlight the Illinois Met Pier bonds, because they truly are the test case for the concept of a rating cap. In fact, most Illinois credits belong to this category, and for a couple of reasons. First, there is a significant amount of overlapping debt and taxes in Illinois due to the multitude of city and county level special tax districts, all tapping the same property tax base and the same taxpayers. Secondly, the Prairie State’s tenuous fiscal condition in recent years has had a significant negative downstream effect on local government units and exposed the dependence of such units on statewide financial conditions.


Truth be told, no red-blooded municipal analyst would ever make the naïve claim that a dedicated revenue pledge should be a free-floating obligation, completely untethered to the credit of the underlying socio-economic entity, the “base obligor”. After all, even dedicated revenues, such as sales and use tax, are derived from and supported by the same tax base as the underlying GO debt. That said, should there be a formal rating cap on special revenue credits?


A new report from the team at Kroll Bond Rating Agency (“KBRA”), with the rather feisty title “Rating Ceilings Subvert Fundamental Credit Analysis”, makes the claim that a notching approach to dedicated revenue ratings is inconsistent with sound fundamental credit analysis.


“(…) All else being equal, KBRA believes that ratings for properly structured special tax or enterprise revenue bonds are more likely to reflect the bonds’ separate credit features, and not the municipality’s corresponding general obligation credit factors, when there are good economic underpinnings and demonstrably favorable governance behaviors in the underlying municipality. Conversely, the likelihood and magnitude of rating differentiation decreases when there are weak credit fundamentals in the underlying municipality.”


As KBRA correctly points out, this debate goes straight to the core of fundamental credit analysis, although we wouldn’t necessarily dismiss the logic of the Big Three rating agencies as inconsistent with fundamental analysis. As you can imagine, there is plenty of room for debate and interpretation on an issue as complex as this.


Instead of worrying about a “devolution” of the special revenue pledge, investors should take comfort in the fact that the market’s view of any security pledge has grown much more nuanced and sophisticated as a result of what happened in Detroit and of what is still happening in Puerto Rico and Illinois. In fact, we would view this as an “evolution” of our market , not a “devolution”.


In our opinion, the key to finding an answer to this question is to adopt a more dynamic approach. “Dynamic“ means, as KBRA correctly suggests, getting rid of the “predetermined number of notches” mindset. Instead, the degree of convergence in credit rating (or credit score) between the dedicated revenue structure and the underlying GO credit should be less pronounced for highly rated obligors, say “AA” or above, and more pronounced as you go down the quality scale. In other words, highly rated obligors with ample resources to service their overall debt burden should benefit from a greater rating distinction (“more notches”) between their special revenue structure and their underlying GO credit. The State of New York, which has historically relied heavily on a myriad of special revenue structures, is a prime example of this type of obligor.


Conversely, fiscally stressed entities such as the State of Illinois or Chicago Public Schools should see fewer notches between their dedicated revenue structures, including any securitization, and their underlying GO credit.


In all fairness, one can also easily come up with a completely opposite argument, and it may go as follows: since dedicated revenue structures derive their value from their perceived stronger legal underpinnings, shouldn’t they become more valuable as the underlying GO credit deteriorates and the risk of bankruptcy rises?


I guess it all depends on how much of a cynic you are. On the one hand, if you feel that a properly set up legal structure (such as the existence of a statutory lien) will give you an edge in bankruptcy over the regular GO pledge, then the answer is “Yes”. If, on the other hand, you believe that anything can happen in bankruptcy court and any security structure can be challenged, then you would answer ”No” and the creditors of the Commonwealth of Puerto Rico would probably agree with you.


As a side note, this kind of reasoning should also apply to the ratings of so-called “moral obligation” and “annual appropriation” (“MOAA”) debt. As far as we can tell, the rating agencies continue to use a fixed number of notches approach to rating MOAA debt versus true GO debt. We can make the same argument here: as the GO credit becomes more stressed, the likelihood of a default on the moral obligation or appropriation debt should be rising exponentially and the MOAA debt should get downgraded at a much faster pace than the base GO.


In New Jersey’s case, for instance, municipal analysts have been fretting for years about appropriation debt accounting for the bulk of the State’s overall debt load. In a worst case scenario, would the composition of the debt make it easier for the State to default on its moral obligation debt? After all, that’s why these things are called “moral” and not “full faith and credit” debt. Yet, as the 38 Studio controversy in Rhode Island showed, muni investors do have the habit of wanting to have their cake and eat it too. Even though they are able to earn some extra yield buying debt subject to annual appropriation, they still want the same protection as direct debt GO debt (!). And so far they’ve mostly had their way: after flirting briefly with the notion of walking away from the 38 Studio debt, the State of Rhode Island ultimately bowed to market (and rating agency) pressure and made good on its moral obligation.


So, Mr Joker, you can see how serious (and pervasive) this issue is for our market, especially at this late stage in the credit cycle where owning the “right” security structure, if there is such a thing, may become increasing critical for future investment performance.

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