Fitch Ratings placed seven special revenue ratings on negative watch — including four large school districts in California and Chicago — after an appeals court ruling in the Puerto Rico bankruptcy challenged a long-standing assumption that special revenue bonds would continue to be paid in Chapter 9 municipal bankruptcies.
The ratings placed on negative watch involve utility and tax-supported ratings that are six or more notches higher than the government’s issuer default rating.
The outlook revision signals the expectation that the "special revenue" ratings would be downgraded closer to the issuer default ratings if the decision limiting the protections afforded by special revenue status were to stand, according to Amy Laskey, a Fitch managing director.
The 1st Circuit U.S. Court of Appeals released its
“By stating such payments are optional, the ruling creates uncertainty about full and timely repayment of special revenue obligations during bankruptcy of the related municipality,” Fitch wrote.
In the Detroit bankruptcy the revenues continued to flow to holders of utility bonds during the automated stay. That's how such bonds were expected to be treated before the Puerto Rico decision created uncertainty, Laskey said.
“The decision affirming the 2018 district court ruling was inconsistent with Fitch's and market participants' general understanding of the meaning of section 922(d) and the treatment of special revenue obligations in bankruptcy since the code was amended in 1988,” Fitch wrote. “Nevertheless, with an appeals court validation Fitch believes its impact on ratings must be evaluated.”
While the ruling only directly affects districts in the First Circuit (Maine, Massachusetts, New Hampshire, Puerto Rico and Rhode Island), Fitch analysts said they believe that this decision would be influential in future municipal bankruptcy cases nationwide.
The plaintiffs in the case have multiple avenues of appeal and Laskey said they plan to monitor any court proceedings as they occur and incorporate the results into any affected ratings.
The ratings affected by the negative outlook revision are the ones that probably got the most lift from Fitch’s bifurcated ratings, which drew a distinction between “special revenue” sources likely to be protected in a bankruptcy.
Two of the ratings affected by the revised outlook, the Chicago Board of Education and Palomar Health, a hospital chain in San Diego, have junk issuer default ratings, (IDR), but investment grade special revenue ratings.
The Chicago schools’ IDR is BB-minus with a positive outlook, while the limited ad valorem tax revenues have an A special revenue rating. Palomar’s IDR is BB-plus with a positive outlook. Its general obligation unlimited tax-dedicated tax rating is AAA.
The three California school districts that are affected by the outlook revision have triple-A special revenue ratings on their unlimited tax general obligation bonds. The default ratings for the three are BBB-plus with a stable outlook for Oakland Unified School District, BBB with a negative outlook for Sacramento City Unified School District, and BBB-plus with a negative outlook for Sweetwater Union High School District.
Other ratings affected were Chicago’s senior lien water revenue bonds, which have an IDR of BBB-minus with a stable outlook and a special revenue rating of AA.
“The Chicago water system operates fairly autonomously from city government,” Laskey said. “It has the same management and service area, but it doesn’t have the same operating risk as the government system.”
The higher AA rating was based on the utility’s operating risk, Laskey said. If the ruling stands then there would be more risk if the city files for bankruptcy, because the revenues could be in jeopardy.
Maricopa County Special Healthcare District, a Phoenix hospital, has an IDR of BBB with a stable outlook, and an AAA rating for its limited tax general obligation rating.
Fitch also plans to flag other bonds with special revenue ratings by adding additional commentary through what it calls “rating sensitivities” when it issues additional ratings guidance until the final court ruling is finalized.
The rating guidance doesn’t impact special revenue ratings with a one to three notch differential, because they are closer to the issuer default rating and there are still notable protections for the pledged revenues, Laskey said.
The guidance will include the following language in special revenue ratings between four and six notches above the IDR:
"The rating may be affected by the recent appeals court ruling regarding the protections provided to holders of bonds secured by pledged special revenues. Fitch believes those protections warrant a distinction in ratings above the IDR regardless of the outcome of the case. However, a final decision consistent with the First Circuit's ruling may result in security ratings closer to the IDR."
The California school districts not on rating watch negative will have the warning added that a final decision consistent with the appeals court ruling could result in special revenue ratings closer to the issuer default rating. Given state constitutional and statutory restrictions in the state, Fitch “believes potential rating changes would be modest.”
