BRADENTON, Fla. – As Louisiana digs deeper in cutting essential services to bridge its budget deficit, the state is turning to bond investors to help close the gap.
The cost of doing that with a general obligation bond refunding next week depends on how investors weigh this year’s rating downgrades against constitutional protections afforded the debt.
Louisiana plans to price $359.3 million of GOs next Wednesday in the first “scoop-and-toss” deal state officials can recall. The par amount of the deal depends on market conditions, according to state officials. The State Bond Commission had authorized up to $600 million.
The transaction, part of the state’s deficit reduction strategy, is expected to price with $283.94 million of tax exempt bonds and $75.35 million of taxable bonds. The offering will push bond payments into later years, while still shortening the maturity of the refunded bonds by more than a year.
The structure is designed to achieve maximum cash flow to generate $81 million in savings for budget relief, most of which will be taken in the current year.
The refunding is expected to achieve present value savings of $10.4 million or 3% of refunded par. It will depend on using $65.9 million in premiums, a practice that has been used by the state in the past and criticized by the Legislative Auditor.
The bonds are rated AA-minus with a stable outlook by Fitch Ratings, which reflects a downgrade from AA earlier this month.
Standard & Poor's maintained its AA rating on the bonds, and negative outlook.
In February, Moody's Investors Service lowered the state’s GO ratings to Aa3 from Aa2, and maintained a negative outlook. Moody’s did not rate next week’s transaction.
Even after the downgrades and ongoing budget problems, Municipal Market Analytics partner Matt Fabian said the state’s GO bonds remain among the safest available.
“Louisiana’s state GO is a classic difference between rating risk and default risk,” Fabian said. “The rating agencies have mostly ignored the structural protection given to LA’s bonds, and instead have emphasized short term economic and financial trends.
The general obligation debt is paid from the state’s bond security and redemption fund, which has first claim on most revenues flowing into the state treasury as required by the state’s constitution.
The redemption fund held $12.47 billion in revenues, providing 31 times coverage for $387.2 million in debt service in fiscal 2015, according to the state. Excess revenues are then transferred to the general fund.
“This creates an opportunity for investors, who can endure rating downgrades, to buy an extremely low default risk security at a higher yield,” Fabian said.
Michael Johnson, head of research at Gurtin Fixed Income Management LLC, said Louisiana’s protected bond redemption fund sounds great on the surface.
“In truly distressed situations, we do not believe these protections can be universally relied upon,” he said. “In distressed situations, we believe you begin to see these protections erode, as we are seeing in Puerto Rico.
“While this belief does not prevent us from purchasing high quality bonds, it does prevent us from lingering in those bonds too long as the credit quality degrades,” he added.
Louisiana has already seen spreads widen from a combination of its weakening credit, as well as blowback from headline risk associated with turmoil in Illinois and Puerto Rico, Fabian and others said.
Moody’s and S&P assigned negative outlooks to Louisiana’s debt in February 2015.
Before that, the state’s GOs tended to price about 15 to 20 basis points higher than the benchmark triple-A, according to the state’s financial advisor Renee Boicourt, with Lamont Financial Services.
After last August’s sale of $76 million in unclaimed property revenue bonds backed by the state’s backup pledge, Boicourt told the State Bond Commission that spreads had widened to about 40 basis points.
Boicourt said it was difficult to say if the wider spread was solely attributable to the negative outlook, and that it probably was more a result of broader market concerns over the fiscal troubles in Illinois and Puerto Rico.
Louisiana’s financial deficit also widened by the end of last year, as revenues in the oil-dependent state plunged along with crude prices. Dropping sale tax revenues and corporate income worsened the picture.
Gov. John Bel Edwards, a Democrat who took office Jan. 11, called a special legislative session to cure a $940 million shortfall in the current year and $2 billion deficit anticipated in 2017.
By the end of a three-week special session in March, lawmakers failed to find all of the funds to correct the state’s historic budget crisis leaving an $800 million gap in 2017.
Rating analysts criticized the state for continuing the use of one-time revenues and short-term measures to address the structural imbalance. Downgrades by Moody’s and Fitch followed.
Although S&P maintained its GO ratings, it revised the outlook to negative from stable on the state’s first- and second-lien gas and fuel tax revenue bonds while affirming its AA ratings on the debt.
“We base the outlook revision on the state's weakening general credit trends, which we believe could add some future exposure and potential pressure on this security structure given a legal flow of funds on the majority of the pledged gas tax revenue,” said S&P analyst Sussan Corson.
The structure prioritizes the payment of GO debt service before gas tax bond payments.
Even with higher protection for the GOs, many municipal investors view the security very similarly across obligors, Johnson said.
“The market is well aware of the Louisiana’s vulnerability to oil and gas production, and consequently the state’s bonds tend to trade wider than the ratings would indicate,” he said. “As such, the latest downgrades had minimal effect on market perception.
“Ultimately, the state does not appear to be close enough to distress for the headlines to impair market access, but will likely affect the interest rate on the bonds,” he added.
The pain is not over.
On Tuesday, Edwards told the House Appropriations Committee that he planned more than $750 million in new cuts to address the fiscal 2017 budget he already recommended.
The cuts will affect education, hospitals, corrections, and other state agencies.
“I wish I had better news, I don’t, but we are going to live in the real world,” he said, promising a fair and balanced approached to budgeting.
Edwards also said he wouldn’t allow the budget to be balanced through the use of one-time revenues to fund recurring needs, trust fund sweeps, and other measures that were used in the past that led to downgrades.
“We do need additional revenue because critical priorities remain painfully underfunded,” he said. He expects to call a second special session on June 7 to address avenues that will increase state revenues.
Still, the state could be penalized in terms of yield next week as the budget crisis lingers and investors remain anxious over headlines about the unsolved problems in Illinois and Puerto Rico, according to Fabian.
“Investors have been more anxious about headline risk because of worries that rising yields will affect headline credits more harshly,” Fabian said. “But that’s abating a bit as low yields look more sustainable. Louisiana’s main pricing drag will be the consideration of downgrade risk should its budget problems continue.”
JPMorgan is the book-runner for next week’s transaction. Co-managers will be Goldman Sachs, Raymond James & Associates Inc., Loop Capital Markets, and Drexel Hamilton LLC.
Foley and Judell LLP is bond counsel. Breazeale, Sachse & Wilson LLP is counsel to the underwriters.
