S&P - Public Finance Criteria (2007). - The Global Clearinghouse

Tax-Secured DebtIn general, projections of sales tax or special taxrevenues tend to be imprecise and depend on anumber of assumptions about such variables asthe level of future construction. AlthoughStandard & Poor’s reviews future projections ofsales tax or other pledged revenue growth, it doesnot usually use them as a major factor for a rating.Recognizing the uncertainties in forecastingprecisely when new growth will occur, Standard &Poor’s typically bases its ratings primarily on historicalrevenues generated from an existing economicbase that will cover future maximumannual debt service.Although rating criteria focuses primarily on historicalrevenues and their ability to cover futuremaximum annual debt service, pledged tax growthrates are still examined. Standard & Poor’s will nottry to determine the reasonableness of an exact economicforecast, but note when situations wheregrowth will likely continue based on historicalgrowth trends and ongoing economic conditions.Debt service coverage wholly dependent on highfuture economic growth, particularly sustainedlong-term annual growth, suggests a greater riskprofile. However, some credit may be gained forrapidly growing areas, if near-term growth assumptionsappear reasonable.Standard & Poor’s usually asks for at least fiveyears of historical tax revenues or, if a sales or specialtax is newly imposed, five-year, pro forma taxdata based on historical retail sales from jurisdictionswith overlapping sales-tax levies. Pledged taxdata that are merely estimated based on sample surveyslack historical rigor.Debt Service Coverage And RatingsA common question asked of Standard & Poor’s is,what level of debt service coverage will result in adesired rating level? The answer is that there is nofixed level of coverage that will result in a givenrating because coverage levels are only one factor inthe rating process, which also includes an assessmentof likely additional debt issuance and amunicipality’s economic vitality, diversity, and cyclicality.Higher coverage levels may somewhat offsetconcerns within the other rating factors, but eachrating must stand on its own. Higher ratings generallyenjoy higher debt service coverage; however,rating level variations typically correlate moreclosely with population levels, as a proxy for economicdiversity.Higher coverage can offset a weaker economicbase, if coverage levels can be expected to be maintained.Accordingly, issuers may choose to structurein higher coverage and legal features to raise creditquality and offset a weaker economic base. Thedegree of coverage desired will depend on thedesired rating level and the historical and expectedfluctuation in sales taxes over an economic cycle.Variable rate debt, or deals involving swaps witha variable rate should address the potential forinterest rate fluctuations and the transaction shouldshow strength during a variety of stress scenarios. Afixed asset stream, such as a sales tax, is potentiallyvulnerable to variable interest rates, unless initialcoverage is sufficient at the time the bonds areissued. One good feature about variable rate salestax debt is that periods of high interest rates arealso often coincident with periods of high inflation,potentially allowing revenues to grow to meet theincreased debt service.Legal ProtectionsAdditional parity bonds tests protect against dilutionof future debt service coverage through theissuance of additional parity debt. The strongestadditional bonds tests specify that historical revenuesmust cover future maximum annual debtservice, plus an extra debt service coverage cushion.Special tax bonds, as well as other types of fixedtax debt, typically have no ‘rate covenant’ to raisetax rates in the case of a debt service shortfall. Assuch, there may be somewhat less restraint on issuingadditional parity bonds than other types of revenuebonds, unless excess tax revenues are neededfor other essential operations, as is often the casefor sales tax revenues that flow into a municipality’sgeneral fund.Typical additional sales and income tax paritybond coverage tests range from 1.2x historicalcoverage of debt service to 3x or more, with mosttests in the 1.25x-1.5x range. Hotel and gas taxadditional parity bonds tests, as well as those fortax revenues with more cyclical revenue streamstypically range higher. Some weaker additionalbonds tests use average annual debt service coverageinstead of maximum annual debt service,although this may be offset by a higher requiredcoverage multiple. Still weaker additional bondstests may use only projected revenues. Some additionalbonds tests allow future variable rateissuance. If so, the additional bonds test coveragemultiple ideally would be sufficient to protectagainst possible future swings in interest rates. Ifthe additional bonds test coverage multiple is low,the use of prevailing short-term interest rateswhen calculating future debt service for purposesof the additional bonds test would not be asfavorable as using some extra factor anticipatinga rise in rates. A good alternative might be to useinstead prevailing long-term rates, or prevailinglong-term rates plus an extra adjustment factor,allowing a coverage margin for a potential rise ininterest rates.72 Standard & Poor’s Public Finance Criteria 2007