"I've been a superintendent for 15 years and I've never gone through anything like this," said Jeff Hendrix, superintendent of the Munster, Ind., school district.

CHICAGO — A well-off Indiana school district's missed bond payment is a reminder for investors to look beyond ratings and state intercept programs.

The district in Munster boasts some of the highest test scores in Indiana and has a tax base of more than $1.4 billion.

But it defaulted in January on a pair of bond payments amid growing financial pressure that will force major cuts and layoffs this year.

School officials say the problem stems from draconian state cuts and an inadequate school funding formula that will lead to more troubled districts popping up across the state.

For investors, the default highlights the importance of scrutinizing the mechanics of state enhancement programs that are designed to reassure bond investors, market participants said.

The School Town of Munster's problems also show the importance of independent research beyond bond ratings, which in Munster's case continue to be investment grade despite the default.

It's rare for an Indiana school district to miss a bond payment.

"It's almost unheard of," said a source familiar with the situation who asked to remain anonymous. "The intercept program is viewed as the belt-and-suspenders for some of the school bond deals," the source added. "The sad thing is, this is one of the higher-end school districts in the state."

Munster Superintendent Jeff Hendrix said the district was caught off guard by lower-than-expected tax collections in December. Its cash flow is weak enough that, with the $2.2 million shortfall, it couldn't cover the January bond payments.

"I've been a superintendent for 15 years and I've never gone through anything like this," Hendrix said. "Our plan is to cut off as much of our spending as we can as we get to the end of the year so we can make sure we can make our payments, and we never get in this position again."

Hendrix has already ordered the layoffs of 50 non-certified employees and expects to begin laying off teachers after May 1. The district, with about 4,100 students, has roughly 400 employees. A local newspaper covering a January board meeting featured a photograph of a board member crying as the names of those to be laid off were read aloud.

Munster, population 24,000, is one of the wealthiest enclaves in Lake County, about 30 miles from Chicago. The district has five schools, all certified as Indiana Blue Ribbon schools. Munster has spent significant money since 2005 on its facilities: rebuilding its elementary schools, upgrading its high school and middle school, and building a new football stadium and natatorium.

It had $97 million of outstanding debt and lease obligations as of the end of 2011, according to bond documents. That includes $8 million of taxable pension bonds, privately placed by the district in 2003 and 2007.

School officials scrambled to make up the bond payments just days after missing them. A Jan. 5 missed payment on First Mortgage Bonds, Series 2011B, was covered on Jan. 12, according to a notice posted on EMMA. The Jan. 5 missed payment on First Mortgage Bonds Series 2008 was covered within three days.

"We worked with a local bank and our town council to get loans within 24 hours to pay back the bondholders," Hendrix said, saying he relied on bond counsel Barnes & Thornburg to walk him through the necessary steps.

"We were able to work it out in the community before the state really needed to step in," he said.

Indiana's statutory school-bond enhancement provides that the state treasurer will step in to cover any missed payments at the request of bondholders.

In Munster's case, the intercept was never triggered and the district has still not spoken with the state about the default, according to Hendrix.

The treasurer's office emphasized that the intercept is not a backup pledge on the bonds.

"In this case with Munster, the intercept was not triggered and it was cured before that needed to take place," said Jillean Battle, chief of staff for state Treasurer Kelly Mitchell.

Two weeks after the default, Standard & Poor's put its BBB rating on credit watch negative.

The lack of action from the state, coupled with Munster's stressed finances, illustrates why investors need to pay close attention to the details of enhancement programs and to the issuer's own fiscal position, said Michael Johnson, co-CIO, managing partner, and head of research for Gurtin Fixed Income Management LLC, which manages $9 billion in municipal debt.

"The big issue that it highlights is that you really need to understand the mechanics of an enhancement program and the underlying credit quality," said Johnson. "We think too many investors rely blindly on the enhancement without understanding the mechanics and without thinking of the underlying rating."

State-based school enhancement programs widely. The state of Washington, for example, offers its guarantee on all school district borrowings.

Others, like in New York and Pennsylvania, are post-default intercepts, similar to Indiana's, but those states have traditionally stepped in and loaned money to the district ahead of a default, according to Johnson.

The fact that the district carried - and continues to carry -- investment-grade ratings from Standard & Poor's shows it's dangerous for investors to rely solely on ratings agencies, said Johnson.

"Most investors would expect a BBB rating to be incongruent with what actually happened here," he said. "If you have a payment default, I don't know how you justify an investment-grade rating.

"We really overweight finances," he said. "You've definitely seen places with wealthy tax bases default but you've never really seen someone default who has strong finances."

In its report putting the Munster district's BBB rating on credit watch with negative implications, S&P said it the move reflects the view "that there is at least a one-in-two likelihood of a negative rating action within 90 days."

The rating agency did not return phone calls or emails before publication.

The district's financial problems persist despite a 2013 voter-approved property tax hike that took effect last year and is expected to generate $3.4 million annually.

School officials in February borrowed against the future money collected from the tax hike to pay off the bank loan for the debt service payments, said Hendrix.

"This new referendum is starting to slow down the slide but still the only way to make this up is to make major general fund reductions and the majority of that is personnel," he said.

In addition to uncertain tax collections, the district is hurt by property tax caps enacted in 2009 and years of steady cuts in state aid to school districts.

But the real problem is the state's school aid funding formula, which pressures districts that don't have many students living at or below the poverty line, said Hendrix.

Munster receives $5,000 per pupil compared to the statewide average of $5,800.

To address the problem, Hendrix, who is vice president of the Indiana Association of Public School Superintendents, said he's banded together with about 40 other school officials and formed a group called The Fix It Coalition. They've hired a lobbyist to push lawmakers to revamp the school funding formula.

Republican lawmakers have already said that the formula will be one of their top priorities in the spring session.

"Indiana's got over $2 billion of surplus monies and every year since 2009, when the state took over our general fund dollars, the School Town of Munster and others have seen a huge reduction in the amount of funding we've received," Hendrix said. "Many people are frustrated about this whole thing. We have a lot of accolades for our kids and teachers and if we have to keep making cuts it's going to hurt our kids, and our programs and could impact whether families will stay here."

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