In a recent report, Kroll Bond Rating Agency explains the differences between general obligation pledges across issuers in the municipal market, highlighting the major credit issues that investors should focus on.
The authors of the report, senior director Alessandra D'Imperio and managing director Kate Hackett, say there may be underlying risks in the structure of a GO security that investors aren't fully assessing.
"Over the last few years, significant defaults and bankruptcies affecting general obligation debt have caused a change in the market's perception of risk in these bonds," the report said. "This heightened sensitivity reflects the fact that not all GOs are created equal, and it underscores the need for investors to be more aware of the statutory authority underpinning the security pledge."
First, analysts explain that the "full faith and credit" pledge that supports a GO bond varies by state and the type of issuer within each state. For example, at the local level, a GO pledge is usually supported by some degree of ad valorem taxing power. This provides comfort that an issuer can raise property taxes to support annual debt service requirements if other resources are insufficient. It also allows bondholders to compel a tax levy in the event of a default.
State level GO pledges, however, do not include this taxing power. The pledge is instead supported by a broad mix of revenue sources, as well as the state's flexibility to impose taxes, sales taxes and fees. There is no comparable obligation to raise a specific tax, such as the property tax, at the state level.
Among both states and local governments there are various forms of GO pledges, which come with various credit risks.
The strongest GO pledge is an unlimited tax pledge, which means there are no restrictions on the rate or amount of property taxes that can be levied to support debt. This pledge requires the issuer to raise property taxes in order to support debt service.
The second type of GO pledge is called a limited tax pledge, where the rate or amount of property taxes that can be levied to support debt service obligations is limited.
"Limited tax general obligations rely more heavily on an issuer's ability to manage financial operations within its revenue constraints," analysts wrote. "From a credit perspective, it is important to assess how much room exists within the cap to allow the issuer to raise taxes to support operating expenses and future debt requirements."
A third type of GO pledge is the general fund pledge, which is significantly more limited than the first two. A general fund pledge does not include any ad valorem taxing power and is usually found in states where statutes do not authorize local governments to pledge taxing power. The mix of available resources can include property tax revenues, but the issuer is not obligated to raise the taxes to satisfy its debt requirements.
Alabama is one example where a GO obligation is essentially a general fund pledge. The state has very specific limitations on the ability of local governments to levy taxes, and without voter approval, an issuer cannot issue GO bonds secured by a property tax levy.
"As with the limited tax pledge, the credit profile is heavily dependent on the issuer's ability to manage operations within its available resource base," Kroll said. "An investor should look for healthy operating margins and increases in operating and debt service expenses that closely mirror increases in revenues."
The last main type of a GO pledge comes in the form of guaranteed debt. A local government can often use its GO pledge to guarantee the debt of a project or enterprise fund. Kroll says that from a security perspective, the nature of this obligation is on parity with its direct GO debt.
"However, since the financial obligation arising from this general obligation pledge can fluctuate depending on the revenue generation of the project or system, the ability of the local government to budget for and manage these obligations is quite different," the report said. "In addition, since the funds to support the guarantee are not used to finance general operations, the willingness to support these obligations can become controversial over time."
A prime example of this is Scranton, Pa., which had guaranteed debt issued by its parking authority. As the city's financial operations became more constrained, it elected not to appropriate the funds necessary to cover debt service requirements associated with the parking authority debt, but it continued to support its own GO debt.
Harrisburg, Pa., is another example. The city guaranteed debt associated with a garbage disposal facility, but the financial obligation became so burdensome that the city stopped making payments. The debt associated with this project was ultimately responsible for the city's bankruptcy petition.
Kroll notes that there are a number of other statutory provisions that affect the nature of a GO pledge across issuers.
Payment priority, which requires issuers to fund debt service requirements in advance of all other operating expenses, is a provision that can enhance a GO pledge. Other enhancements include continuing obligation, which is the ability to carry forward unpaid debt service from one year to the next, and statutory lien, which protects bondholders from an automatic stay in the event of a bankruptcy filing.
Statutory provisions that can weaken a GO pledge include tax caps and bankruptcy. Kroll said it's important for investors to understand that bondholder remedies following a bankruptcy may be more restricted than they are following an event of default.