Last week, the Chicago Sales Tax Securitization Corporation (the “Corporation”) issued bonds backed by City of Chicago sales tax revenues. The city had sold these revenues to the Corporation, who in turn pledged them to pay debt service. The securitization of the sales tax revenues provides higher credit quality and stronger bondholder protections than the City of Chicago’s General Obligation bonds, and likewise if the city had issued sales tax bonds itself. The Corporation bonds are rated AA- by both Standard & Poor’s and Fitch, while Moody’s does not rate the bonds.
Historically, bonds backed by a dedicated source of tax revenues (such as a sales tax, income tax or other tax revenues) have provided an opportunity for state and local governments to issue bonds (commonly known as dedicated tax bonds) as an alternative to that government’s general obligation bonds. In many cases, the dedicated tax bonds provided higher ratings than the state or local government’s G.O. bonds because of high coverage levels, insulation from budget stress and growing pension liabilities, and bondholder protections that constrained leverage. Recently, investors have begun to question the insulation of dedicated tax bonds from the credit quality of associated state and local governments, particularly following the Puerto Rico bankruptcy and other cases where revenues pledged for debt service on the dedicated tax bonds turned out to be less protected than investors had expected.
The securitization of a stream of dedicated taxes addresses some of the credit insulation issues seen in prior dedicated tax bonds. In the Chicago sales tax securitization, the City of Chicago sold its rights to the pledged sales taxes to the Corporation, which is a bankruptcy-remote organization created by the State of Illinois. The key is that there is a true sale of the sales taxes to the Corporation, creating a separation of the pledged sales taxes from the city. The sale was absolute once executed, and the City and the Corporation irrevocably directed the State of Illinois to collect the pledged taxes and transmit them directly to the bond trustee. As a result, the city has no control over the revenue stream, insulating pledged revenues from a potential diversion for the city’s budget and pension liabilities. State statutes authorizing the securitization also created a statutory lien on the revenues, and a covenant that the state would not impair the flow of pledged revenues.
The Chicago securitization is not a new concept. New York City Transitional Finance Authority (TFA) bonds provide an example of a long-established securitization structure where TFA provides insulation from the bankruptcy and operating risk of New York City. The securitization was facilitated by the New York State Legislature, which created TFA as a separate and distinct entity from New York City, and the city has transferred its rights to pledged revenues to TFA as a separate, independent entity. Both New York City and New York State have covenanted not to interfere with the allocation of pledged revenues to TFA. Moody’s, S&P and Fitch all rate the TFA bonds at their highest rating level, AAA (Aaa by Moody’s).
While the securitization of pledged revenues provides more insulation for bondholders from the fiscal stress of an associated government, the linkage to the associated government is not completely severed. As such, investors of securitization bonds must still review the credit quality of the associated jurisdiction. For example, we would expect that any further deterioration of the City of Chicago’s credit quality could impact the value of the Corporations’ Sales Tax Securitization Bonds, even if the overall credit quality of these bonds remained stable. While the City of Chicago, as is the case with other Illinois cities, is not authorized to file bankruptcy, it continues to struggle to balance its operating budgets and growing retirement liabilities. Its GO bond ratings include a non-investment grade Ba1 rating from Moody’s and BBB+ and BBB- ratings, respectively, from S&P and Fitch. Based on our analysis of the Corporation bonds, we expect that the they would still be rated in the A rating category if S&P and/or Fitch were to downgrade the city’s GO bonds into the non-investment grade BB rating category. Furthermore, we expect that the bondholder protections of the securitization would not be impacted, and debt service would still be paid on a timely basis under a downside credit scenario for the City of Chicago.
Sources: Standard & Poor’s, Fitch, Invesco Fixed Income