Two weeks ago in our MuniLand bullet, we discussed credit rating divergence and the potential to identify credit dislocation and buying opportunities. One sector that we highlighted as presenting an interesting opportunity was dedicated tax-backed bonds–specifically dedicated sales tax bonds. Last week, S&P downgraded sales tax bonds issued by the Metropolitan Pier and Exposition Authority of Illinois to BBB+ from AAA, which now is comparable to Moody’s existing Baa1 rating.
So why the massive and abrupt downgrade?
S&P assumed the bonds were protected from Illinois State operating pressures, and monthly revenues would be transferred to the bond trustee even in the absence of legislative appropriation. As a reminder, the State of Illinois has yet to pass a fiscal year 2016 budget because of ongoing debate between the legislature and governor. As a result, the transfer of revenues to the bond trustee cannot be made even though the money is available for debt payments. In fact, the coverage ratio on the bonds is 14x.
But if the bonds are secured by dedicated sales taxes and have ample debt service coverage, then how can there be appropriation risk? Understanding the security pledge requires a thorough review of the bond documents. The Metro Pier bonds receive sales tax revenue from a special fund at the Illinois Treasury Department. This sales tax revenue doesn’t automatically flow into the Metro Pier debt service fund. Instead, it accumulates in the special fund at the state, which then must be appropriated or have legislative action taken in order to be distributed. The security pledge for the Metro Pier bonds is not on the resources of the special IL Treasury fund, but only the appropriated revenues from the fund. So while the revenue is dedicated and the coverage on the bonds is north of 14x, the appropriation cannot take place without a budget or special legislative action.
This is called either appropriation or political risk.
While the resources are available to pay debt, there needs to be political will and there needs to be an understanding of the bonds’ security pledge. The lesson is always check the security provisions for hidden risks in the bond documents.
Source: Moody’s, S&P
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