Many states provide programs that enhance the credit quality of debt issued by their local school districts. Typically, a local school district will issue general obligation bonds backed by the district’s property taxes. The state will also pledge resources that back the bonds if the district is not able to pay debt service with its own resources. By tapping into the credit resources of the state, the local districts have increased access to the credit markets and are able to reduce their financing costs.
There are several types of state school credit enhancement programs. Oregon and Washington are among the states that guarantee payment of school district GO bond debt service by pledging their full faith and credit to the repayment of the bonds. As a result, school district bonds in Oregon and Washington are rated at the same level as each state’s general obligation bonds (both are rated Aa1 by Moody’s and AA+ by S&P). Some states, such as Texas, have established endowment funds that pledge their assets to back school district debt. The Texas Permanent School Fund is the largest school endowment fund, and it carries the highest bond ratings, Aaa/AAA.
The third type of school credit enhancement program is a state intercept program. If the district is unable to pay debt service on its bonds, the state will divert (or “intercept”) funds intended for the support of local school district operations to pay debt service. While state intercept programs provide a credit enhancement, those programs are typically rated lower than the state guaranteed programs because the full faith and credit of the state are not pledged and the source of funds for the enhancement may vary. Pennsylvania’s State Intercept Program is rated A3 by Moody’s, three notches below its Pennsylvania GO rating, while S&P had rated the intercept A, two notches below the state GO rating. In both cases, the ratings have been lower than the GO ratings, as the funds available for the intercept program are subject to annual appropriation by the commonwealth’s legislature.
The intercept program can also be impacted by the budget process, as in Pennsylvania’s case, where the commonwealth has gone five months without a FY 2016 budget. Given uncertainty over funding for the intercept, S&P placed the intercept rating on CreditWatch in September, and Moody’s downgraded the program by a notch to A3 in November. Last week, S&P took the drastic step of withdrawing its intercept program rating, citing the long duration of the budget impasse. S&P noted that the commonwealth was able to support the program with other funds during budget delays in prior years, but the lack of “disclosure or identification of enough funds that could be used to meet debt service signals a lack of commitment…to the intercept program.”
While we believe the impact of S&P’s action in Pennsylvania on other school credit enhancement programs will be limited, this case underscores the importance of understanding the pledge and mechanics of each state enhancement program. The widespread utilization and investor acceptance of the programs should continue, as the majority of the other enhancement programs have higher credit quality and more investor protections than Pennsylvania’s State Intercept Program.
Sources: Moody’s and Standard & Poor’s