In a move showing that Garvees, like Build America Bonds, are subject to the risk of federal offsets, the U.S. government has reduced transportation funds backing Puerto Rico’s Garvees to make up for the Commonwealth’s failure to pay money owed to a federal agency for river projects.

The action could have wide-ranging implications for Garvee bonds, leading bond issuers and investors to re-appraise their risk, Municipal Market Advisors warned in a recent outlook.

Because of the reduced federal payments, Puerto Rico has had to tap into a reserve fund to cover debt service on the more than $100 million of Garvees, which it issued in 2004, MMA said. Federal revenues derived from gasoline taxes are used to back Garvees.

Although the federal payments expected to be made to Puerto Rico will be well in excess of annual debt service, the Commonwealth has been found to have a $214 million liability to the U.S. Army Corps of Engineers related to its completion of the Cerrilos Dam and Reservoir and the Portuguese-River and Bucana-River Projects, according to MMA.

“That liability has begun amortizing with annual payments at a 6% interest rate, creating an annual debit against Puerto Rico’s receipt of any other cash from the federal level,” MMA said. “In effect, this is a federal offset identical to what occurred with several BABs issuers in 2011 and similar to the current, sequester-related cutbacks in BAB payments now.”

Jack Schenendorf, an attorney and transportation expert at Covington and Burling LLP, said the circumstances surrounding each issuers’ Garvees are somewhat unique because it depends on their other federal grant agreements. In some cases, however, failure to live up to a grant agreement can result in the federal government withholding payment elsewhere, he said.

“I do think that if you’re in violation of grant agreements, the government can even reach across agencies,” he said.

MMA said that although the situation in Puerto Rico is likely to be resolved, it is unlikely that rating agencies have taken offset risk into account, and that the development “may (and frankly should) set in motion industry wide re-appraisals of potential risk to other Garvee issuers.”

Joseph Pezzimenti, an analyst at Standard and Poor’s, said overall debt service coverage is a much stronger factor than offset risk, although that could be a factor if an issuer was playing right on the margins of coverage.

“It’s not necessarily a material thing in terms of how we look at coverage levels, Pezzimenti said.

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