Public Finance School District Enhancement Programs

March 2016 Public Finance School District Enhancement Programs Recent headlines in Pennsylvania, particularly related to school district aid, have called into question the validity of school district enhancement programs in the municipal market. Many U.S. states provide support for local school districts in the event of nonpayment on debt service, either by lending money from a designated fund or by intercepting state aid to pay bondholders. Not all school district enhancements are created equal, however. In this commentary, we review the most prevalent state programs within PNC s footprint in detail as well as our general recommendation. Additional school district program information, including for those not considered in our footprint, can be found in the Appendix. We advise using our enhancement recommendations in conjunction with underlying credit analysis when determining the suitability of an individual school district security. Terms to Know Pre-default: School district provides early notification, or a specific method is in place, to avoid missed debt service prior to the payment date resulting in the timely payment of interest and principal payments. Post-default: Payments are made to bondholders after debt service is missed or it is uncertain as to when payment will be made. Thus, there is the possibility of delayed interest and principal payments. E. William Stone, CFA CMT Managing Director, Investment & Portfolio Strategy Chief Investment Strategist Katrina S. Sheehan, CFA Investment Strategist Nicholas M. Srmag, CFA Fixed Income Strategist Types of Enhancements: Appropriation: An appropriation is not an explicit guarantee from the state, as with the guarantee programs below, but the state will typically use available funds to make debt payments for those school districts that are not able. Some state appropriation programs have standing appropriations that do not change while others are determined annually, consequently resulting in potential appropriation risk. Guarantee: A guarantee provides a contractual obligation by the state to use available resources so that there is timely payment of interest and principal. Program credit ratings tend to move in line with the state s general obligation rating as guarantees are generally based on the state s credit profile. Typically, the state is required to divert general revenues or issue debt for funding. Intercept: In the event of nonpayment, the state has the authority to redirect, or intercept, school district state aid to pay debt service. Intercept programs are pnc.com

either limited in that the state aid available for a given school district is the amount remaining only for the current fiscal year, or unlimited in that funds may be advanced from future disbursements. Permanent Fund: The state creates a permanent fund that provides debt service to those school districts in which payments will be missed. Typically, the money available for these funds is derived from natural resource and land taxes. Select School District Enhancement Programs Georgia School District Intercept Program (Aa1/AA+/AA+) Pre-default; Limited Intercept All school districts that authorize the Georgia Board of Education to withhold state aid disbursement for debt service at the time of debt issuance are eligible to participate in the state s intercept program. The program requires the bond trustee notify the board of education 15 days in advance of missed payments. Upon notification, the board then redirects the current year s remaining undisbursed state aid directly to bondholders in the amount necessary for interest or principal payments. The credit ratings for the Georgia school district intercept program generally move in line with Georgia s state rating (Aaa/AAA/AAA) since appropriations for annual aid are determined at the state level and depend on budgetary conditions. The state currently maintains the highest credit ratings allowed and a healthy budgetary environment. Also, in recent years the state has been allocating more resources to fund education, including district aid. Recommendation: Despite the high credit rating awarded by the rating agencies, we caution that an individual school district is bound by the annually appropriated state aid available. With that, the Georgia School District Intercept Program is a credit positive but may require district-bydistrict analysis given the limited nature of the program. Indiana State Aid Intercept Program (AA+) Post-default; Limited Intercept Ratings for the Indiana State Aid Intercept Program are dependent on the state aid levels available to the district, with Standard & Poor s (S&P) requiring annual state aid coverage of at least 2 times debt service in order to receive the AA+ rating. In addition, the current credit rating requires the bond-paying agent to notify the state treasurer five days prior to a missed payment despite the post-default nature of the program, with state aid then diverted directly to the paying agent to make bondholders whole. If these standards are not met, the enhanced rating will be lower than that provided above. The Moody s Investors Service rating of Aa2 was withdrawn in 2013 following an updated rating methodology for those state aid intercept programs considered post-default with the rating agency now basing these school district ratings on a bottom-up approach. The state will intercept only those funds available from the district s current year state aid. We also note that the state does review school district appropriations and levies annually to assess whether aid is sufficient to pay debt service and will adjust accordingly. We believe this provides a strong 2 March 2016

protection against the potential for state aid to fall short in the event of default. Recommendation: The S&P credit rating should be rather telling of a school district s involvement in the state aid intercept program, given the rating is dependent on specific criteria. Keep in mind that there is the potential for debt service payments to be delayed given prior notification is not a requirement in this program. While the limited nature of the program is a drawback, we view the annual state assessments as a credit positive, and recommend considering the debt service coverage and notification method when analyzing a specific district bond. Kentucky School District Enhancement Program (Aa3/A/A+) Pre-default; Unlimited Intercept The Kentucky enhancement program, which covers all school districts within the state, provides for the intercept of state aid funds to pay bondholders in the event of nonpayment by a school district. If the current year s undisbursed state aid is not sufficient, the state will advance future disbursements for debt service payments. Notification of nonpayment is provided to the board of education at least 30 days prior to the due date, allowing for the timely payment of interest and principal. The enhancement program rating typically moves in conjunction with the state rating. This program is separate from the Seek Education Excellence in Kentucky (SEEK) program, which is also typically provided for all school districts. SEEK establishes a formula-based funding mechanism for school districts based on the number of students, with adjustments made for special needs. A bond included in the school district enhancement program will generally indicate involvement in either SEEK, state aid withholding, or both. Recommendation: The state of Kentucky is currently experiencing some pressure due to pension funding issues, which has the potential to result in a reduction in state aid appropriations or a credit rating downgrade. However, the state does not currently carry a significant amount of debt, and the unlimited nature of the enhancement program allows for flexibility and is a credit positive. We believe that districts using the intercept program benefit strongly from this backstop. Public Finance School District Enhancements Michigan School Bond Loan Fund Program (Aa1/AA-/AA) Pre-default; Guarantee The Michigan enhancement provides loans to school districts in the event of nonpayment. A school district must have each bond issue approved by voters and by the state Treasurer to qualify for eligibility in the program. According to Moody s, more than 75% of school districts within the state have qualified debt outstanding. Notification is provided to the state treasurer within three days of debt service being due, at which point the treasurer provides a loan to the district in the amount of debt service required to be paid to bondholders. Funds are disbursed from the School Loan Revolving Fund (SLRF), which is funded by bonds issued by the state, as well as repayment of district loans. School districts are required to repay these loans, with interest, generally within 72 months. An important consideration in security analysis for bonds backed by this program is that school districts will often use the loan program for debt repayment, even if default can be avoided by general revenues. The district 3

can use the funds as a way to avoid tax increases and maintain current financial health. Recommendation: The SLRF is an obligation of the state, meaning that the state is responsible for seeing that funds are available for school district loans either by transferring money from the general revenue fund or by issuing debt. This strong backstop results in the relatively higher quality nature of the program, as exhibited by the assigned credit ratings, and we believe districts using the loan program should be evaluated as such. Keep in mind that not all districts participate in the program. Additionally, repayment of loans is required and overuse of the program could negatively affect a district s financial position. (1 of 2) New Jersey School Qualified Bond Act (A3/A-/A-) Pre-default; Limited Intercept The first of two enhancement programs provided by the state of New Jersey allows qualified districts to allot a certain portion of appropriated state aid to debt service each year. This pre-default mechanism is implemented well before a district is unable to make debt service payments, using funds set aside so as to not contend with other district expenses. Recommendation: In our opinion, this program is a credit positive for a district since it essentially pre-refunds a portion of debt service requirements using state aid. We do caution, however, that the rating of the program moves in conjunction with that of the state, therefore, it is important to also consider any potential credit concerns at the state level that would result in a lower credit rating or a decline in state aid appropriations. (2 of 2) New Jersey Fund for the Support of the Free Public Schools Program (A2/A/A) Pre-default; Permanent Fund The New Jersey school district fund program is available to all school districts and is structured somewhat differently relative to most permanent funds. In the event of a school district default, the state will use money from the fund to purchase maturing principal and interest payments due on a bond, with these purchases continuing until the issuer is able to make payments. The fund is required to maintain a reserve level equal to 1.5% of school bond debt issued prior to July 1, 2003, and at least 1.0% for debt issued on or after that date, with an annual review of funding by September 15. Once a district is aware of the potential for missed payment, the payment agent notifies the state 10 days prior to the debt service due date, at which point a guarantee is made that the fund will purchase bonds at par and pay bondholders as debt service becomes due. The credit rating of the enhancement program does move in conjunction with that of the state rating, with headlines surrounding New Jersey (A2/A/A) increasing in recent years. The main concerns largely stem from the state s structural imbalance and unfunded pension liabilities. At the time of this writing, the state s credit rating outlook from S&P and Fitch were both stable, while Moody s maintained a negative outlook. We continue to monitor New Jersey s credit rating for potential deterioration, but ultimately there are options at the state s disposal that can be implemented, in our opinion. 4 March 2016

Recommendation: While downgrades at the state level have affected the credit rating of the enhancement program recently, we believe the program maintains strong mechanisms to back school district debt. In particular, there is a specific contractual agreement between the school district fund and the state to maintain funding. So, despite potential state concerns, we believe the program currently remains an enhancement for districts. New York State Aid Intercept Program (A) Post-default; Limited Intercept All school districts within the state of New York are eligible to participate in the New York enhancement program. The program does not receive a rating from Moody s due to the updated post-default enhancement program methodology in 2013, which resulted in the program s A1 rating to be withdrawn. In order for a district to receive the above enhanced rating from S&P, annual state aid must cover at least 1 times maximum annual debt service. In the event of default, the school district notifies the state comptroller, who then directs the funds necessary to make debt service payments from the current state aid allotment. If this amount is not sufficient, the comptroller will use funds from the next monthly allotment, however, state aid is limited to what is available in the current year. Recommendation: The New York State Aid program is relatively straightforward and we believe it is a positive for all school districts within the state. However, given the limited nature of the enhancement, thorough analysis should consider the amount of state aid allocated each year for a specific district and the possibility for delayed payments. Ohio School District Enhancement Program (Aa2/AA/AA) Pre-default; Unlimited Intercept A school district within the state of Ohio must receive approval by both the Department of Education and the Office of Budget for eligibility in the enhancement program. These offices thoroughly review a district s finances and require a maximum annual debt service coverage from state aid of 2.5 times. The state maintains significant oversight of participating districts, thus strengthening the program, in our opinion. In addition, the program does not include speculative-grade-rated issuers, though once approved, a district is in the program as long as debt remains outstanding. The paying agent is required to notify the Department of Education 10 days prior to the debt service date if a school district is unable to make payments. The state then intercepts undisbursed aid and transfers these funds for debt service. If the amount is not sufficient, the state will use aid in future years to pay debt service until the deficit is fully paid. Recommendation: The unlimited nature of the state aid program is certainly a credit positive, and we believe there are strong mechanics in place to provide debt service backstops at the state level. In addition, the state s credit profile is healthy, so we do not anticipate a reduction in state aid appropriations in the near term. Public Finance School District Enhancements 5

(1 of 2) Pennsylvania State Aid Intercept Program Act 150 (Moody s Rating Withdrawn upon Post-default Methodology Update in 2013; S&P Rating Withdrawn 12/11/15) Post-default; Limited Intercept The program, which applies to all school districts within the state, authorizes the Secretary of Education to direct undisbursed state aid to bondholders in the event a district is unable to pay debt service. Given the program allows all school districts eligibility, this is the most used programs of the two provided in Pennsylvania. The credit rating for the Act 150 PA school district program was withdrawn by Moody s with the release of the post-default program methodology in 2013. Prior to being withdrawn, the program was awarded with an A1 rating. Due to the prolonged budget impasse at the state level, S&P also withdrew its enhanced rating in December 2015, reflecting the lack of state aid available at the time. We note, however, that a stop-gap bill was passed at the end of December which provided a half year s worth of appropriations at fiscal 2015 levels to school districts, which is a positive in terms of school district revenue. The ratings agency remains cautious, though, since additional appropriations have not been approved. Recommendation: While we continue to view the program as an enhancement for school districts within the state, we are monitoring the potential impact of a persistent budget impasse on school district appropriations carefully. Underlying credit analysis remains important, but we continue to consider the post-default backstop as an enhancement. Please keep in mind that ratings will now be based primarily on the underlying issuer rating, which may be in conflict with PNC policy if the issuer is not investment grade. We ultimately believe recovery will occur in the event a school district defaults; however, given the potential for delayed payment we recommend more conservative investors take advantage of the current trading environment to move into higher quality names with more reliable payment streams. (2 of 2) Pennsylvania State Appropriation Intercept Agreement Program (Moody s Rating: One Notch Above Issuer Rating with a Baa1 Cap and B1 Floor; S&P Rating Withdrawn 12/11/15) Pre-default; Limited Intercept The PA appropriation program is similar to Act 150, except that notification to the Department of Education is made prior to missed payment, hence the pre-default nature of the program. As more school districts have become aware of this program recently, popularity has increased given the prospect for more timely interest and principal payments. If the school district does not make payments to the fiscal agent in advance of the debt service date, the agent then agrees to notify the Department of Education, which sends undisbursed appropriated funds to the agent for timely payment. Due largely to the continued budget stalemate in Pennsylvania, both Moody s and S&P changed their methodology specifically for the PA enhancement program. Given the uncertainty surrounding appropriations, Moody s determined the program is not a significant enhancement at this juncture, and thus the credit rating is now based solely on the underlying rating of an issuer with a one-notch increase to reflect participation in the 6 March 2016

program. The rating is then capped at a ceiling of Baa1 and a floor of B1. Meanwhile, S&P removed the program rating completely; therefore, a school district rating with enhancement will represent the underlying rating, if one has been awarded. S&P did cite that in the past, despite chronic late budgets, the state has maintained relatively strong oversight of the program, however, the extent of the fiscal 2016 budget delay has called into question the state s ability to make payments. Recommendation: The PA Appropriation Intercept program is a unique case given the state s current financial concerns. As mentioned for the postdefault PA program, we believe bondholders will be made whole in the event of missed payment by school districts at this juncture, but we recommend more conservative investors take advantage of the current yield environment, in which the market continues to price bonds at enhanced levels, to move into higher quality credits. We will continue to provide updates as necessary in terms of the PA budget impasse, as well as any concerns we may have relating to the school district programs. Conclusion Our analysis of these select school district enhancements demonstrates the differences in each of these programs. Support differs widely by program, and the level of participation and eligibility varies as well, which in many cases results in significant differentials in credit quality among school districts. These differences can cause wide dispersions in bond performance, thereby highlighting the importance of reviewing these programs in conjunction with underlying fundamentals. Appendix School District Enhancement Cheat Sheet Table 1 (page 8) is for informational purposes only and should not be used as the sole basis in determining security suitability. We base our view strictly on the mechanics of the program, with pre-default unlimited intercept, guarantee, and permanent funds generally viewed as most favorable. For additional information regarding a specific enhancement program, please contact Investment Strategy. 7

Table 1 School District Enhancement Programs Source: PNC 8 March 2016

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