Covenant flap in Connecticut may limit state's ability to refund, issue notes

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Connecticut is sifting through a controversy over a timing discrepancy between a bond covenant and a legislative amendment intended to loosen its restrictions.

Attorney General George Jepsen’s office has been asked to investigate the effect on the state’s capital spending plans of a covenant attached to a $492 million general obligation sale in June. The General Assembly passed the covenant last year, restricting state spending and borrowing in an effort to mollify bond investors after a series of downgrades.

An 11th-hour amendment lawmakers passed before the General Assembly adjourned in May to exempt refundings and short-term revenue anticipation notes from the covenant adjusted the effective date to July from May, meaning the June covenant did not reflect the change.

The covenant limits borrowing to $1.9 billion annually over five years.

The matter has prompted debate over any level of restrictions the state may encounter if it needs to issue short-term notes and triggered sniping between Gov. Dannel Malloy’s budget director, Benjamin Barnes, and state Treasurer Denise Nappier.

Barnes, who asked Jepsen’s office to investigate, wrote Nappier that the controversy “extremely distressed” him.

“If I understand the issue correctly, your office and bond counsel failed to correctly read and interpret legislation passed this year, leading to the issuance of bonds by the state that contain a covenant which, at best, is contrary to the will of the legislature, and at worst may harm the ability of future governors and legislatures to finance our capital program in a cost-effective manner,” Barnes said.

Neither Malloy nor Nappier are seeking re-election this year.

Nappier replied the next day: “I trust you concur that replacing rhetoric with collaboration is the better course of action.” She said she also welcomed Jepsen’s input.

A Jepsen representative declined comment.

“We believe our advice and the treasurer’s actions were appropriate,” said Lisa Morra, a spokeswoman for Day Pitney LLP, lead bond and disclosure counsel on the June sale.

The timing discrepancy, which Nappier called a legislative "drafting error," poses no immediate problems for the state, Nappier wrote to top lawmakers. “The $1.9 billion bonding cap, however, requires vigilance.”

The tighter bond cap, according to Nappier, makes the coordination of capital spending with bonding ability “all the more important.” While her office is responsible for financing Connecticut’s obligations, it does not control capital spending.

“The date error is likely to limit the ability of the state to reach its capital investment goals or realize savings from refundings for several years and will necessitate close management of its short-term cash flows, but would also somewhat reduce the state’s high-leverage profile,” said Marcia Van Wagner, a Moody’s vice president and senior credit officer.

According to State Sen. Scott Frantz, R-Greenwich, who co-chairs the General Assembly’s finance, revenue and bonding committee, the mistake could hamstring Connecticut should it need more flexibility in its financings.

“There may be a solution to this predicament, but it will take time for counsel to determine if it will work legally or in the marketplace,” Frantz said.

Connecticut’s Treasury has issued $239 million in refunding bonds this fiscal year, according to a spokesman. The state is analyzing a refunding component to a sale next spring.

Nappier’s office said Connecticut has another mechanism to cover temporary cash shortages that is not subject to the debt issuance cap. The state took that route in 2009, through a separate section of the general statutes that the GO issuance cap does not cover.

According to Nappier, remedial options to the timing error could include legislative or judicial action; activating an emergency clause in the bond covenant, which would require a gubernatorial declaration and a three-fifths majority vote in the General Assembly; or an expensive taxable refunding of bonds that now contain the covenant.

“Until it is resolved, we must recognize the consequences and align bond project allocations, allotments and spending with bonding capacity,” Nappier said.

The market is also scrutinizing Connecticut’s intention to issue a new instrument, credit revenue bonds, as part of an $850 million GO sale next month. A secure revenue stream from state income tax receipts would back the bonds.

Nappier has said decreasing the amount of GO bonds issued while issuing credit revenue bonds could lower state borrowing costs and while providing a “scarcity value” to the state’s outstanding GO bonds.

Bank of America Merrill Lynch called the move a credit negative for the state’s GO bondholders.

“It is very much zero-sum,” BAML said. “Should the income tax withholdings be siphoned off, it is a win for bondholders of new special tax bonds and a loss for outstanding GO [and future GO] bondholders.”

Separately, Connecticut next week intends to issue $850 million of special tax obligation bonds for transportation infrastructure. The sale will include a $100 million refunding.

Connecticut’s economy, budget strife and business climate provide a backdrop to the campaign that features open seats for governor, treasurer, and with a divided legislature. The state Senate is split 18-18 while Democrats hold an 80-71 advantage in the House of Representatives.

All four bond-rating agencies downgraded the state last fall, citing budget imbalance and high legacy costs.

Moody’s Investors Service rates Connecticut GOs A1, while S&P Global Ratings and Fitch Ratings rate them A and A-plus, respectively. Kroll Bond Ratings Agency assigns its AA-minus rating. Kroll assigns a negative outlook, the others stable.

The state recently announced a $200 million increase in its FY19 forecast for personal income tax revenue. That could help raise its rainy day fund balance to more than $2 billion.

“The balance in the fund would be the highest ever, a credit positive for a state that has experienced a stagnant economy and numerous financial challenges,” Moody’s said.

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Covenants Refunding bonds Municipal disclosure Bond counsel Denise Nappier State of Connecticut Connecticut