Kroll bucks the trend on rating ceilings

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Moving against the practice of other major rating agencies, Kroll Bond Rating Agency said the use of rating ceilings on special tax and enterprise revenue bonds “subverts fundamental credit analysis and can result in inaccurate ratings.”

Karen Daly, senior managing direct at KBRA, told The Bond Buyer that even though the agency’s position on rating ceilings is articulated in its rating methodology, she felt it was necessary to release a separate report this week to add to and amplify its position when market concerns over the topic is growing.

The debate over rating ceilings — also called “piercing the GO rating” — has evolved in recent years due to defaults in Puerto Rico and Detroit, one credit analyst said.

The market’s curiosity about KBRA’s use of rating ceilings arose after “methodological revisions on the part of other rating agencies, and also by Judge [Laura] Swain’s recent decisions in Puerto Rico’s Title 3 insolvency proceedings” the agency said in the report. Such decisions have undercut market expectations concerning the treatment in bankruptcy of special tax and enterprise revenue bonds versus underlying general obligation bonds.

“We wanted to point out that we think rating ceilings really short circuit credit analysis and does a disservice in terms of looking at a credit on a unique and individual basis,” Daly said.

A rating ceiling, according to Kroll’s definition, is a limited number of notches above an underlying municipality’s GO ratings, KBRA managing director Bill Cox said in an interview on Monday.

“KBRA believes that the purported ‘logic’ of rating ceilings is faulty because it is predicated on events, such as bankruptcy filings, that are very unlikely to occur for the broad spectrum of municipal credits to which these ceilings apply,” the agency said in the report.

Due to the recent high-profile bankruptcies, special tax and enterprise revenue bonds should be looked at individually on their own merits to avoid an inaccurate rating call arrived at through notch-based policies, KBRA management said.

The report was written to address inquiries Kroll has received from market participants in recent weeks about the possibility of the agency introducing rating ceilings on special tax and enterprise revenue bonds issued by states and municipalities.

“The piece is an explanation and an articulation of a policy that is readily explained in our methodology,” Daly said. “I don’t think people who are looking for an answer to an issue necessarily turn to a methodology.

KBRA does not support the use of rules-based credit analysis or formulaic rating caps for state and municipal credits, and believes each credit requires an in-depth analysis of its legal, financial and structural merits, including a bankruptcy analysis.

KBRA believes each credit should be considered on its own merit and not on the underlying municipality’s general obligation ratings, especially when it comes to credits with positive fundamentals and credit conditions.

“In situations where an underlying state or municipality has broad economic capacity, good governance, and strong legal protections, then KBRA may rate a properly structured special tax or enterprise revenue bond based on its individual credit features, which may be higher than the issuer’s corresponding general obligation credit rating,” the report explained. “We believe that, over the life of a bond, ratings using a rating ceiling approach are likely to be underrated or otherwise inaccurate.”

While it does maintain opposition to the rating ceilings as a cap, the agency acknowledges that it does consider the underlying municipality’s GO credit ratings more closely on the downside.

“The likelihood and magnitude of rating differentiation decreases when there are weak credit fundamentals in the underlying municipality,” the report said.

“Depending on the factors in play, we would generally expect special tax or enterprise revenue bond ratings to migrate down the credit rating continuum if the general obligation credit rating of a given municipality deteriorates.”

In addition, Kroll believes it would be rare that legal structuring alone would merit higher ratings for a special tax or enterprise revenue bond: if the underlying municipality is in a markedly negative fundamental position, such as in deep distress; if it has a vulnerable economic base; and where the pledged revenues are a substantial portion of the municipality’s budget.

“We believe when a municipality is under extreme stress it’s unlikely they can carve out certain revenues — and achieve a higher rating than the underlying general obligation — especially if those revenues are a substantial portion of their budget,” Cox said in an interview Monday.

The rating agency said its credit ratings are intended to reflect both the probability of default and the severity of loss in the event of default. with greater emphasis on severity of loss at lower rating categories.

According to the report, Kroll determines a credit's ratings by examining the pledged revenue stream’s legal and practical insulation from the municipality’s budget, as well as the ability of the pledged revenues to withstand economic stresses.

“An issuer’s general obligation credit rating generally does not create a rating ceiling for special tax or enterprise revenue debt issued by a municipality with broad economic capacity, and good governance, supported by a satisfactory legal analysis and demonstrated resilience of the pledged revenues,” the report explained.

It also said it examines a credit’s legal insulation in the context of bond documents, state laws, and relevant case law, and analyzes practical insulation by determining if the municipality’s operating budget is dependent on the pledged revenue stream, by understanding the purpose for pledging the revenues, assessing management’s behavior toward investors, and examining the environment in which these behaviors and motives may change.

To test the resilience of the pledged revenue streams, KBRA develops stress scenarios, such as dramatic changes in the economy, according to the report.

“We do not believe this type of rigorous analysis can be replaced by a predetermined number of notches,” the report states. “KBRA believes that rules-based credit analysis is a disservice to the complex municipal market.”

Market participants said while they can see some justification for the use of rating ceilings, they also caution investors of the potential challenges.

“The agencies do, in fact, look at the credit on it’s own merits,” one New York municipal analyst explained on Monday. “But, they have realized that unless there is a special purpose entity, bankruptcy-remote issuer, such as Chicago and its Sales Tax Securitization Corporation, a distressed government can and will get their grubby mitts on the ‘dedicated revenue’ when push comes to shove — irrespective of the dedicated pledge,” he added.

Others say rating ceilings overall are justified, though they are not without pitfalls.

“In a general sense, rating ceilings would be appropriate given the presence of governance overlap and the fact that even in situations that have tightly constructed legal provisions, the underlying revenue stream supported by enterprise activity or a special tax will likely be closely tied to the economic cyclicality of a particular state,” Jeffrey Lipton, head of municipal research and strategy and fixed income research at Oppenheimer & Co. Inc., said Monday.
“Having said this, it is important to assess the security nature of the revenue stream, as a simple pledge would be considered weaker than a dedicated lien,” Lipton pointed out.

Daly said the Puerto Rico ruling has sparked conversations about rating ceilings in recent months.

This month, Swain, the judge in the bankruptcy proceeding authorized under Title III of the Puerto Rico Recovery, Management and Economic Stability Act, dismissed a lawsuit by investment firm Aurelius Capital Management and other investors over the territory’s default on its general obligation bonds. In doing so, she ruled that the creation by the U.S. Congress of a financial oversight board for Puerto Rico under PROMESA and the appointment of the board’s members did not violate the U.S. Constitution.

In a February ruling on Puerto Rico Highways and Transportation Authority, Convention Center District Authority, and Infrastructure Finance Authority, Judge Swain said the island’s special revenue bonds didn’t need to pay during bankruptcy. Even though the bonds may have liens on revenue, that's not the same thing as the right to receive payments during the Title III bankruptcy, she ruled.

Previously, in September 2017, Swain ruled that the island’s Highway and Transportation Authority will continue using toll revenue to maintain its system rather than pay bondholders as the agency works through bankruptcy. The ruling was viewed by some as an indication that sales-tax revenue may ultimately be used for commonwealth expenses.

Daly said she has already received positive feedback on its opposition of rating ceilings from market participants attending KBRA-led bankruptcy panels around the country.

“The feedback is the market agrees with us,” Daly said. “The market would prefer each credit be rated, analyzed, and considered on its own unique circumstances and merit.”

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Bond ratings Municipal bond ratings Credit quality General obligation bonds Bond defaults