Overall Stability in the Dedicated Tax Sector but Security Selection is Key to Finding Value and Avoiding Pitfalls

The SNWAM Investment Team maintains a stable outlook on the Dedicated Tax Bond Sector. Dedicated tax bonds are typically backed by sales or income taxes specifically dedicated to pay debt service for bonds that are typically used for infrastructure projects such as transportation facilities or systems. The tax revenues pledged for debt service may be specifically levied for debt service, or may be carved out from tax revenues and used for debt service prior to any utilization for operating expenditures in a municipality’s budget.

The Dedicated Sector outlook was the focus of the analysis for our May Muni Strategy Meeting. Our outlook is based on expectations for moderate levels of revenue growth, issuance in line with current trends, and relatively fair pricing of bonds in the sector. Our outlook also incorporates an expectation that tax revenues will continue to grow in 2017 and 2018, but that the level of growth will be lower than in prior years.

Dedicated tax bonds have historically been viewed as having very strong bondholder protections relative to other bonds backed by tax revenues, such as general obligation and appropriation debt. Investors have expectations that dedicated tax bonds will be immune from state and local government budget politics, as well as from growing liabilities such as pensions, because of the carving away of pledged revenues from state and local government budgets. Bondholder protections also include limits on leveraging revenues and covenants to protect tax revenues from cuts or diversions. We have seen a chink appear in the armor of the dedicated tax revenue pledge, which has resulted in some convergence in the credit quality between dedicated tax bonds and other tax-backed debt. Moody’s has historically capped most of its ratings of dedicated tax bonds at the level of the GO ratings of its jurisdiction. Fitch has also revised its methodology so that more of its dedicated tax bond ratings are now capped at the jurisdictional GO level.

The changes in the sector are also providing opportunities to find value there. Security selection is key to finding tactical opportunities given the wide variety of the types of revenues pledged for debt service in the sector. 

Source: SNWAM Research