Late last month, Fitch Ratings downgraded $2.5 billion of Illinois’s sales-tax bonds by five steps, dropping them closer to debt backed only by the state’s promise to repay.
It may not be the last ratings cut for state and local-government bonds backed by dedicated revenue including tolls, fees or specific taxes -- a pledge that investors once assumed protected them from a government’s financial distress.
SNW Asset Management, a unit of OppenheimerFunds, said it sees less value in such bonds because of the risk of deep downgrades, said Mark Stockwell, a municipal analyst at the Seattle-based firm. He said the sector is "devolving" and becoming more closely correlated with general-obligation debt or securities repaid with money that lawmakers have to appropriate each year.
In a research note to clients last week, the company said it has shifted its recommendation on the tax-backed bonds to "underweight."
“Some of these bonds that look like they provide value may be downgraded," said Stockwell. “We could see AA or AAA rated bonds go to single A or triple B. In some cases, you could have a BBB dedicated tax bond go to a non-investment grade category."
The reassessment is coming after some recent cases made it clear that the securities aren’t necessarily immune from the impact of a government’s fiscal strains. Puerto Rico has stopped paying its sales-tax bonds to keep afloat after its bankruptcy, sidestepping the legal pledge that kept the bonds investment grade even after the territory’s rating was dropped to junk.
In 2015, S&P Global Ratings downgraded Illinois’ Metropolitan Pier & Exposition Authority’s sales-tax bonds to BBB+ from AAA after the Illinois legislature failed to appropriate the revenue needed to cover monthly debt payments amid a stalemate over the budget. The state eventually allocated the funds.
“You have these bondholder protections and you thought it was going to work, and then it didn’t," Stockwell said.
S&P is currently considering whether to change its method for rating "priority lien" bonds to tie them more closely to a municipality’s full faith and credit. The rating company currently grades about 1,300 of those securities.
Less Safety
Moody’s Investors Service already discounts the safety of the securities. It generally caps the ratings of dedicated-tax bonds at the same level as an issuer’s general-obligation bonds. The ratings can be higher only when the pledged revenue stream is legally separated from the issuer’s general finances, such as through a constitutional amendment to pledge certain revenue to the debt.