This past week, the U.S. Supreme Court declined to review an appeal of lower court decisions, which could impact the timing of debt service payments of revenue bonds during a municipal bankruptcy.
A district court ruling in 2018 opined that during Puerto Rico’s bankruptcy proceeding, payments on bonds secured by special revenues were optional, not mandatory. As the district court decision was a departure from prior court decisions, which held that the debt service payments were mandatory, investors appealed the decision. In early 2019 the U.S. Court of Appeals for the First Circuit upheld the lower court decision, prompting the appeal to the U.S. Supreme Court. While certainly unfavorable, the High Court’s decision affirms that the muni market will be operating under the new normal established by the 2018 ruling.
Subsequent to the Appeals Court decision, the rating agencies evaluated the rating links between special revenue bonds and the GO ratings of the associated government. Rating actions were taken in some cases, primarily where the special revenues bond ratings were significantly higher than the GO bonds of the affiliated issuer. Moody’s reviewed eight special revenue credits that were rated three or more notches higher than the ratings of the affiliated issuer. Following the review, four credits were downgraded. Fitch placed the ratings of six special revenue bonds on Rating Watch Negative in October 2019. Additionally, Fitch just modified its rating criteria for tax supported debt and now limits the distance between special revenue bonds and GO bonds to six notches. S&P has not made any ratings or methodology changes, stating that its criteria for evaluating priority-lien tax revenue debt, published in October 2018, already incorporates the risk that payments may be stopped on special revenue secured debt when issuers experience fiscal distress.
Given the recent responses from the rating agencies to prior court appeals, this ruling is not expected to result in significant rating downgrades. However, there are longer term implications for the municipal market and issuers of municipal bonds. Although the First Circuit Court of Appeals only includes states in New England and Puerto Rico, the ruling is expected to affect the treatment of special revenue bonds throughout the country. While the court decisions did not involve questioning the validity of the lien on special revenues, they effectively weakened the revenue pledge since the requirement to pay debt service throughout bankruptcy is no longer mandatory. In the marketplace, this perceived weaker security pledge could translate into increased borrowing costs as well as higher taxes or usage fees for the issuing municipality.
We are monitoring the ever-changing municipal landscape to determine if the quality of a bond will be impacted by a court ruling or market perception. The recent strength of the market hasn’t led to any weakness in dedicated tax structures, however, this may not be the case over a longer market cycle.
Related: The Muni Tide Keeps Rolling InSources: Moody’s, S&P, Fitch, NFMA