California Dirt, the Good Land of Tax Allocation Bonds

California tax allocation bonds (TABs) secured by tax increment revenues have had a renaissance since the dissolution of California redevelopment agencies ended the use of tax increment financing for California cities in 2011. Tax increment revenues used to repay TABs had been based on growth in property tax values above a base valuation amount determined in areas established as redevelopment projects (tax increment districts). California redevelopment agencies were dissolved by the California legislature as a way to divert more tax revenues to schools and reduce the State’s school funding liability. Except for the payment of outstanding bonds and specified liabilities, the former tax increment revenues now flow to the overlapping municipal jurisdictions (county, city, schools and special districts).

Tax increments that would have been generated are still calculated to determine revenues available to repay outstanding debt. Revenues still flow to TAB bondholders who have also benefitted from the termination of tax increment financing because the lien on revenues has been closed and revenues used for redevelopment activities have also become available to pay debt service. Concurrently, property values in many areas around the state have recovered and assessed values have increased. The redevelopment legislation also authorized successor agencies to the respective redevelopment agencies (usually the city) to issue bonds to refund outstanding debt and lower debt service costs. As a result of these events, coverage levels, a key determinant of the credit quality of TABs, have improved significantly. In many cases, TABs rated by Standard & Poor’s that had been rated in the A- to BBB+ range have seen upgrades to the AA- to A+ range. Until recently, most issuers had not requested Moody’s ratings, but with the continued improvement in credit metrics, Moody’s has updated their TABs rating methodology and is upgrading TABs they had deemed to be less than investment grade back to investment grade ratings.

The biggest risk factor for bonds secured by tax increment revenues is a decline in taxable values of properties within the district(s) due to real estate market fluctuations or other events. As there are no other revenue sources pledged for debt service, and no mechanisms to offset valuation declines, tax increment pledges are particularly sensitive to real estate cycles or events that would cause a decline in values. To offset that risk, we look for TABs with high and increasing coverage levels, a fully funded debt service reserve, and a tax base that is relatively immune from volatility in its assessed values. A large tax base, with low taxpayer concentration, and seasoned development that has an embedded cushion under California property tax procedures are factors that can lower the risk of valuation volatility.  

Sources: SNWAM Research, S&P Ratings and Moody’s