CHICAGO — Moody's Investors Service says a recent default by an Indiana school district highlights the importance of underlying credit analysis when bonds are enhanced with a post-default school intercept program.
The School Town of Munster, Ind. missed two bond payments in January due in part to thin cash flow. The district quickly cured the default by borrowing from a local bank, but some market participants said the default shows the importance of closely examining both underlying credit fundamentals and the mechanics of a state intercept program - particularly whether it's a post- or pre-default intercept.
In a comment in its weekly outlook on March 6, Moody's said the default underscores the "bottom-up" rating approach the firm takes on post-default intercept programs, like the one in Indiana.
"Unlike pre-default intercepts, a post-default intercept generally cures deficiencies only after a default has already taken place, meaning it does not necessarily reduce the probability of default," Moody's analyst Dan Seymour said in the comment. "Therefore, for post-default-enhanced credits, the probability of default is primarily based on the underlying credit quality, and the enhanced rating starts with an analysis of the underlying obligor."
Moody's does not rate the Munster school district, but Seymour says if it did, the rating "almost certainly not have been high enough to warrant a high investment grade enhanced rating."
Standard & Poor's, the only agency that does rate the bonds, placed its BBB rating on credit watch negative two weeks after the default.
Moody's said it bases its ratings on bonds covered by pre-default intercept programs more on the state itself than the underlying credit.
The traditional "notch differentials" that Moody's relies on to rate both pre- and post-default intercept program-covered bonds could change once a credit sinks into lower rating levels, Seymour said.
"For lower speculative grade underlying credits, we may decide to alter the notch differentials between the underlying and enhanced ratings, depending on the default and recovery dynamics," he said. "Post-default enhanced ratings generally move up or down in lockstep with the underlying rating at the investment grade level. If an issuer's public underlying rating falls into low speculative grade, this relationship could change."
