With Build America Bonds at the forefront of the municipal market, Fitch Ratings is concentrating on the treatment of the federal subsidy and bond structure as two key credit considerations in its ongoing analysis of the taxable debt, according to a report being released today.
David Litvack, managing director and group credit officer of U.S. public finance at Fitch, said the agency took up the issue now because BABs are gaining in popularity among issuers looking to broaden their investor base.
To date, the BABs that Fitch has rated have all used the direct-pay option, in which the issuer elects to receive a 35% interest subsidy from the U.S. government under the American Recovery and Reinvestment Act.
Introduced into law in February, BABs have quickly gained attention from municipal issuers — especially because the federal subsidy can offer a lower capital cost than traditional tax-exempt debt.
However, the nuances have created the need for increased credit analysis, according to Fitch.
Analysts believe the two most significant credit concerns among BABs are the treatment of the federal grants by the issuer and how the bonds impact an issuer’s overall debt position and debt service coverage, as well as review of how the bond structure affects the issuer’s future financial flexibility.
For direct-pay BABs, the issuer is obligated to make the full debt service payment, not just the portion net of the expected federal subsidy. For this reason, Fitch treats the subsidy as revenue rather than as an offset to debt service, according to the report.
Bond structure is also a large focus of Fitch’s ongoing BAB analysis. Issuers have used corporate-like features, such as using optional calls with make-whole provisions, which preclude issuers from realizing interest savings should rates decline in the future — a benefit that is available on tax-exempt municipal bonds with a traditional 10-year call feature, the report notes.
In addition, to attract taxable investors, some deals have been structured with non-callable bonds with a single term or bullet maturity instead of serial maturities used in traditional tax-exempt structures.
“Fitch considers the impact of a more lumpy debt service structure — the lumps being the years with the bullet maturities — and make-whole provisions on an issuer’s financial flexibility,” Litvack said.
The corporate-like structure presents issuers with the challenge of making large bullet-maturity payments sometime in the future, he explained.
“If an issuer builds sinking fund payments into the structure, that mitigates that risk,” he said. “But if they don’t have sinking fund payments, we will ask those issuers how they expect to meet those payments when they come due.”
“We don’t want to imply that the BABs will have a negative credit impact,” Litvack said. “However, we do believe the positives may be possibly offset by the use of more corporate-like debt structures.”
While there is no limit to the amount of BABs that may be issued, the program, which began in February, will expire on Dec. 31, 2010.
Fitch believes the short duration of the program will likely limit the extent of changes to issuers’ credit profiles.
Litvack said Fitch does not expect to make any rating changes on the parity obligations of BAB issuers, either positive or negative, as a result of their issuance.
“Were the program to be extended beyond 2010, taxable debt could become a more prominent part of a municipal issuer’s capital plans,” he said.
In that case, he continued, “municipal analysts will be focusing more resources and attention to the evaluation of corporate-like structures more so than they have in the past.”
The report is the rating agency’s first independent commentary on BABs — apart from rating reports for recent deals that Fitch rated, including a California GO sale that included BABs and a $1.75 billion deal from the New Jersey Turnpike Authority.
Fitch assigns ratings to BABs based on its existing criteria for the applicable type of security being issued, such as whether it is a state obligation, or toll road bond, Litvack said.