Why investors must wait 10 months for Arizona lottery bonds

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Arizona this week plans to lock in rates on $250.7 million of lottery revenue refunding bonds that will not be delivered for 10 months.

The forward-delivery contract is an alternative to the tax-exempt advance refundings Congress eliminated in its 2017 tax legislation.

While the forward delivery contract allows Arizona to hedge against possible rising interest rates, buyers of the bonds are also making a risky bet. The bonds pricing on Tuesday will not be delivered until Oct. 3, 2019.

“Based on recent market conditions and the demand for high credit quality bonds from investors, the state expects the sale of its Lottery Revenue Refunding Bonds will be well received in the market,” State Comptroller Clark Partridge told The Bond Buyer. “While that demand may be tempered somewhat by the delayed delivery of the refunding bonds in October of 2019, we still expect it to be strong given the credit quality of the lottery bonds and the recent upgrade of the credit by Moody’s to the Aa3 level to go along with the AA-plus rating from Standard & Poor’s.”

The serial bonds will reach final maturity in 2029.

Forward delivery bonds come with a premium designed to compensate buyers for the fact that they can’t easily sell the bonds during the forward period and have already committed funds to purchase the bonds at the future delivery, according to investment experts.

At the same time, issuers must consider any contingencies in the purchase contract that would allow the underwriter to back out on the transaction, as well as the extra documentation and complexity that comes with the deal.

The Arizona bonds will be sold only to purchasers who sign a delayed delivery contract. The state will not be a party to the contract and is not responsible for the outcome, according to the preliminary official statement.

Kurt Freund, managing director at RBC Capital Markets is financial advisor on the deal and Kim Rattigan, managing director at book-runner Citi, is lead banker on the deal. Squire Patton Boggs is bond counsel.

The Moody's upgrade “reflects steady growth of pledged lottery revenues and the state's economy, strong coverage of debt service, and the absence of future borrowing plans,” its analysts said. The outlook is stable.

Pledged revenues for fiscal year 2018 provide 5.5 times coverage of maximum annual debt service, according to Moody’s.
“At the same time, the ratings reflect the inherent susceptibility of lottery revenues to economic volatility and shifts in consumer preferences,” analysts said.

Arizona lawmakers authorized lottery bonds in the depths of a revenue crisis after the Great Recession of 2008. Arizona was one the states hardest hit by the collapse of the housing market. The state lost 11% of its jobs from 2007 to 2010, compared to 5.6% for the U.S. as a whole, according to Moody’s. Unemployment peaked at 10.4% in 2010, versus 9.6% for the U.S.

The state has no plans for additional lottery bond authorization, according to S&P Global Ratings.

“State finances have improved since the recession, in our view, reducing the likelihood of additional debt issuance authorization in the near term,” S&P analyst Ladunni Okolo wrote.

The lottery bonds precede another state issuance of $618 million of certificates of participation secured by appropriations and liens on state buildings. The COPs are rated AA-minus by S&P and Aa3 by Moody’s. Both ratings are a notch lower than the state’s issuer credit ratings of AA and Aa2 respectively.

With the upcoming sale, Arizona will have $1.8 billion of COPs outstanding, according to Moody’s.

In 2018, Arizona achieved its first structural balance on a budgetary basis in 10 years, according to S&P.

“Its financial position has shown variability with strong financial results prior to 2009 and subsequent fiscal deterioration during the Great Recession,” Okolo wrote. “While economic growth began to pick up quickly afterwards, with real gross state product returning to prerecession levels by 2013, the state's financial operations have rebounded more slowly.”

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Refunding bonds Revenue bonds Primary bond market State of Arizona Arizona
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