Devolution of Value in the Dedicated Tax Sector

The SNW Investment Team has revised its recommendation for the Dedicated Tax Bond Sector to underweight from marketweight. The revision was made as the credit characteristics of bonds in the sector evolved, where potential value candidates became more highly correlated to bonds in the State General Obligation, Local General Obligation and Appropriation Sectors. Their pricing also has been trending to be less attractive. Dedicated tax bonds are typically backed by sales or income taxes specifically dedicated to pay debt service for bonds, which are often used for infrastructure projects such as transportation systems or facilities.

Dedicated tax bonds have historically been viewed as more defensive than general obligation and appropriation debt because tax revenues have been levied specifically for debt service, or have been carved out from a tax revenue base for payment of debt service prior to any utilization for operating expenditures in a municipality’s budget. The strength of the security provisions also created expectations that pledged revenues would be immune from state and local government budgeting issues (including immunity from funding of liabilities such as pensions) and political disputes. In addition, the pledged revenues of some dedicated tax bonds have been viewed as providing protection for investors if a municipality’s finances deteriorate, including Chapter 9 municipal bankruptcy scenarios.

We have seen some chink in the armor of the dedicated tax revenue pledge, which has resulted in situations where bondholder protections have not worked as intended and where the distinction between the security provisions of dedicated tax bonds and debt in the General Obligation and Appropriation sectors has been blurred. Examples include the failure of the State of Illinois to appropriate sales tax revenues, leading to a technical default of Metropolitan Pier Sales Tax Bonds in 2015, and the Commonwealth of Puerto Rico’s de facto repudiation of its COFINA sales tax bonds after marketing them through a government agency that was designed to provide bondholder protection. While the sector continues to be driven by high-grade credits with strong security provisions, those recent events have impacted the perception of dedicated tax bonds, leading to an on-going evolution of their place in our portfolios.

Furthermore, the evolution of dedicated tax bonds has had an impact on how rating agencies view bonds in the sector. 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. Moody’s has had a long-standing policy of linking dedicated tax ratings to the jurisdiction’s GO rating and has generally capped dedicated tax bonds at the level of the state or local GO rating. S&P is considering a stronger linkage to the jurisdictional rating with a modified capping of dedicated tax bonds at the associated state or local GO rating. Fitch adopted stronger linkage and modified capping for state-issued dedicated tax bonds in April after having done so for local-issued dedicated tax bonds in 2016.

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As a result of these methodology changes, we expect to see downgrades by S&P and Fitch for those dedicated tax bonds that are rated significantly higher than their jurisdiction's general obligation bonds. The evolving rating methodologies may also impact transportation agencies that issue dedicated tax bonds, such as sales tax bonds used to fund capital improvements. We expect that there could be some downgrades of those bonds as the methodology revisions begin to capture more of the operating risk of these transportation agencies.

While changes in the sector may lead to some downgrades, they may also provide opportunities to find value. Security selection will be key in finding tactical opportunities, especially given the wide variety of ways revenues are pledged for debt service in the sector.

Sources: Fitch, Moody’s, Standard & Poor’s