Pennsylvania Takes Steps to Restore Ratings of Its Credit Enhancement Program

Many states throughout the country have established state credit enhancement programs that allow local governments to issue municipal debt, primarily school district general obligation bonds, with ratings that are higher than the underlying rating of the local government. These state credit enhancement programs have increased access to and decreased the cost of borrowing for many local governments. There has also been a long-held investor acceptance of the credit enhancement programs, particularly among investors of high-grade municipal bonds.

There are a number of variations in the structure of the credit enhancement programs. Oregon and Washington, for example, have two of the strongest programs, as they guarantee the payment of debt service for school district general obligation debt, resulting in ratings equal to the highly-rated GO of each state (both Aa1/AA+/AA+). Another type of credit enhancement, the state intercept, provides that state aid to local schools will be intercepted if there is a shortfall in a school’s revenue pledged to pay debt service. While most state intercept programs are highly rated, they are typically rated lower than the state’s GO bonds because, unlike the Oregon and Washington programs, the credit enhancement does not guarantee the payment of debt service.

School bonds associated with one state intercept program, the Pennsylvania School District Enhancement Program, faced downgrades during the last fiscal year due to Pennsylvania’s budget crises. The commonwealth failed to adopt a budget for FY’16 by the time the fiscal year started on July 1, 2015. Without a budget, there was no state aid, which meant there was no revenue source to intercept, and as a result the ratings of many school district bonds throughout Pennsylvania were downgraded (when Moody’s downgraded the ratings of the enhancement program and S&P withdrew its ratings). The biggest impact from the lack of state aid was felt by holders of Philadelphia School District GO bonds, as their bonds were downgraded to non-investment grade levels.

Although the state eventually adopted a budget for FY’16 in March 2016, nine months after the start of the fiscal year, Moody’s did not reinstate the credit enhancement ratings at that time due to a lack of clarity over the funding of the program. It was not until last month that Moody’s reinstated the program to the A category. Those ratings were restored only when the commonwealth had adopted its FY’17 budget and also added a provision to the credit enhancement program that would make state funds available for the state intercept even if the commonwealth had not yet adopted a budget. S&P has not yet reinstated the ratings that it withdrew during the commonwealth’s budget crises. 

SNW continues to hold bonds that are supported by state credit enhancement programs. In light of the impacts of the Pennsylvania budget impasse on its credit enhancement program, we also continue to stress the importance of analyzing the credit characteristics as well as the resources backing state credit enhancement programs, the enhancement mechanisms of the programs, and the underlying credit of the local government issuing the bonds.

Source: Janney Montgomery Scott, Moody’s Investor Service, S&P Global Ratings