Fitch Ratings believes a small number of special tax bonds with slim debt service coverage could see a noticeable narrowing of margins with the potential reduction in the direct subsidy payments that issuers receive from the U.S. government on Build America Bonds (BABs).
The Office of Management and Budget's report on budget cuts under sequestration projected a 7.6% reduction in the subsidy. Unless Congress and the President make changes to the sequestration cuts, the reductions will become effective on Jan. 2.
The majority of special tax bonds maintain sound coverage, yielding plenty of cushion to weather the subsidy reduction. However, the reduction could contribute to a decline in credit quality if the bonds were issued with debt service coverage ratios (DSCRs) below 1.5 times (x) and pledged revenue, thus coverage, subsequently declined.
Because Fitch has acknowledged from the start of the BABs program the potential for reduction or revocation of the subsidy, its analysis incorporates the possible scenario of a cut in or loss of subsidy by calculating coverage with and without that support. Fitch's approach to BABs was first addressed in a special report, "Build America Bonds Broaden Municipal Market - Credit Considerations," published on April 27, 2010. In the report, Fitch explains that it considers the subsidy as an addition to pledged revenue. Fitch is concerned when debt service coverage net of the tax subsidy payment provides little or no cushion, and the rating of an issuer's parity debt (including BABs) reflects this.
As anticipated in Fitch's analysis, BAB issuers should be able to shoulder the reduction in the subsidy. Notably, certain higher education, water and sewer, and public power entities have some ability to raise rates, depending on their particular operating environment, thereby increasing revenues to cover debt service. If the subsidy is cut on Jan. 2, Fitch would expect issuers to manage their current budgets to absorb the pressure, show a small tightening in their DSCRs, and in the next fiscal year, modify their budgets to accommodate the change. Most states and not-for-profit hospitals did not issue BABs in an amount that would pose any challenges to issuers in the event of a reduction of the subsidy.
Over $102 billion of BABs were issued since the U.S. Congress created them under the American Recovery and Reinvestment Act of 2009. The BAB program expired on Dec 31, 2010. While the likelihood and level of U.S. budget cuts are difficult to predict, it is unlikely the subsidy would be retroactively revoked in its entirety.