When thinking of “credit enhancement,” most investors think of bond insurance. But there is another tool used by local governments and school districts that enables them to lower their borrowing costs and provide quality-conscious investors an added degree of security.
Known as state credit enhancements, they are widely used today. At least 21 states provide a form of credit enhancement, which enables those bonds to be sold with ratings that reflect state support, rather than the issuer’s underlying rating.
While state credit enhancements may take several forms (and some states have more than one program), the most common are “state aid intercept/withholding” programs. Recognized by all three major rating agencies, intercept programs require states to redirect state aid that is due to a city, town or school district to the bond trustee if that entity fails to set aside sufficient funds for its next debt service payment.
Depending on the level of state commitment and guaranty for the program, ratings on enhanced debt can be equal to, or just below the state’s own rating. Local government units must apply to participate in these programs and meet certain requirements specified in state law. States oversee these programs and their participants closely. Not all debt issues may qualify. Below are three examples of successful intercept programs and issuers that have used them:
Michigan
The Michigan State School Bond Loan Fund Program is an example of a strong intercept program. The city of Detroit school district has used this program to achieve an “A+” bond ratings, one notch below the state’s own “AA-” rating. If a participating school district fails to pay its debt service, the state treasurer is notified and makes the payment.
Michigan’s program is viewed as particularly strong since it is ultimately backed by the state’s pledge to use general fund revenues to make up missing participant debt service. Further, the state has pledged to issue General Obligation bonds, if needed, to ensure sufficient funds are available for the intercept.
New Jersey
The New Jersey Qualified Bond Program authorizes the state treasurer to intercept state aid due to cities, towns, or school districts and reroute those funds to the bond trustee, should the local government fail to provide sufficient funds for upcoming bond payments. Irvington Township, N.J. has successfully used this program to gain an “A1” rating from Moody’s. The enhanced rating has allowed the township broader market access than it had.
Pennsylvania
The Pennsylvania State Aid Intercept Program, which automatically applies to all school districts and community colleges, has been used extensively by the Philadelphia school district to lower its borrowing costs. The district’s “A+” bond rating reflects an intercept mechanism by which the state’s secretary of education automatically withholds state aid from the school district and forwards it to the bond trustee, to ensure timely debt service payments.
In essence, the 21 states that have enacted intercept programs are providing a low-cost financing option to their units of local government. School districts and local governments are able to borrow for capital needs at a cost far below what an unenhanced rating would allow, and quality-conscious investors are provided an added degree of security.
Investors wishing to invest in such bonds should ask their FMSbonds, Inc. representative to point them out as they become available.