Local Government Bankruptcies: Cause for Alarm?

Amid fears—warranted or not—of issuer bankruptcies, dedicated-tax bonds are one form of municipal debt that offers a certain amount of solace for investors. Many are supported by a broad established revenue stream that covers annual debt service multiple times, making the likelihood of default very remote. In this report, we take a closer look at dedicated-tax bonds and the many reasons why we believe these remain attractive investments in the municipal space.

What Are Dedicated-Tax Bonds?

Dedicated-tax debt, or special-tax debt, refers to a variety of bond issues whose primary repayment is secured by a stream of governmental tax or fee revenues legally pledged for the benefit of bondholders. This does not include debt where repayment is secured by a "general obligation" or "full faith and credit" pledge. While most general obligation (GO) bonds benefit from a strong unlimited tax pledge, municipalities must also use the tax revenue to cover frequently onerous operating costs, leaving less available for debt service. Dedicated-tax bonds, because they have a revenue stream specifically assigned to debt service, can be considered a more stable credit during economic downturns. As a result, they represent an important component of any high-grade municipal portfolio.

As shown in the graphic on the below, there are many different types of revenue available to state and local governments that can be pledged to pay debt service. The majority of debt issues are supported by a key tax revenue stream such as income tax, sales tax or gas tax. Often, taxes are grouped together to support related projects. Road projects, for example, are often funded by a combination of gas taxes and motor vehicle fees, while convention center development may be supported by hotel, car rental and/or food and beverage taxes.

Revenue Sources and the Projects They Support

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Why Invest in Dedicated-Tax Bonds?

In addition to providing a portfolio with diversification beyond traditional GO bonds, there are a number of inherent strengths in dedicated-tax bonds that make them particularly attractive investments.

• Dedicated revenue streams. The obvious advantage associated with dedicated-tax bonds is the presence of an existing revenue stream backing their payment, with any excess funds providing bondholders with some cushion against future declines in revenue.
• Stability, even amid economic weakness. Dedicated-tax bonds have a long-term record of stability. In general, pledged revenues exhibit a large degree of long-term stability and historically have demonstrated resilience following periods of economic weakness.
• Protection from operating constraints. Dedicated-tax bonds are not subject to government operating constraints to the same degree as GO issues. Dedicated revenues are used first for the payment of debt service rather than for municipal operations, insulating dedicated-tax debt from much of the turmoil that can impact GO debt when municipalities are faced with fiscal challenges.
• Potential new revenue streams. State and local governments have the authority and flexibility to dedicate new revenue streams or to increase rates of existing sources to make debt payments. Pledged revenues remaining after the payment of debt service often revert to the municipality for other purposes, providing an incentive for management to ensure that coverage of dedicated-tax bonds remains high.
• Legal protections. There are sound legal structures in place that discourage or forbid legislative bodies from diverting dedicated revenues to other uses or repealing taxes currently pledged to bond repayment.
• Bankruptcy remote. Because they are supported by a special revenue stream pledged by the government, dedicated-tax bonds are less likely than other categories of debt to be subject to default should an issuer declare bankruptcy.

While the advantages are compelling, dedicated-tax debt comes with inherent complexities that may not be readily apparent to many individual investors. For that reason, thorough research is critical when making individual investment decisions.

Assessing Dedicated-Tax Bonds

The BlackRock approach to assessing dedicated-tax bonds is two-fold. First, we become acquainted with the issuer and seek to gain a complete understanding of the various economic, political and legal forces present in the municipality, its state and its broader region. Second, we analyze the stability and breadth of the pledged revenue stream and the legal protections afforded to bondholders. By using this two-tiered framework, we are able to focus on the nuances of the particular bond and identify its relative strengths and weaknesses.

Step 1: Know the Issuer
Many of the factors we use to evaluate a GO bond play a role in assessing the credit quality of a dedicated-tax bond. Broadly speaking, these factors include a thorough understanding of the municipality's economic base, financial profile, debt burden and political environment. While we generally consider the two types of debt to be correlated, in some cases, BlackRock's ratings on an issuer's GO and special-tax debt may be significantly different.

Fully understanding the issuer also requires a working knowledge of the quality of municipal management (both elected and appointed) and the degree to which management's policies are embedded in the municipality's operations. The professionalism of key personnel, the issuer's past performance against budget projections, the existence of written policies that require ongoing budget monitoring, and the ability of management to respond to rapid changes in revenues or expenses are all important to municipal credit analysis. Strong management is particularly crucial in a weakening economic environment when budget adjustments or corrective actions must be taken quickly to achieve targeted results. This may mean making unpopular decisions, such as raising a tax or consolidating services to meet debt obligations, even when specific bond covenants have not been violated. (See "Case in Point: Florida.")

Step 2: Know the Security
The second major component of our approach to analyzing dedicated-tax bonds is developing an understanding of the pledged security and any legal features that differentiate the debt from other available investment options. In this portion of the review process (which is unique to dedicated-tax bonds), we focus on understanding the relative strength of the pledged revenue stream, the mechanics of how funds are collected from payers and disbursed to bondholders, and any additional covenants provided by the issuer.

Regardless of the revenue stream being assessed, BlackRock analyzes the issuer's current economic profile in order to gauge specific strengths and weaknesses that could alter the creditworthiness of the municipality. In addition to demographic data such as income levels and unemployment, we evaluate indicators of economic growth such as retail sales and building permits. Since individual data points will fluctuate in the short term, it is important to remain focused on longer-term trends or shifts in the entity's economic profile. Ultimately, relatively strong economic prospects are the primary reason to continue investing in well-situated municipalities despite near-term pressure. This is particularly true in the case of Illinois, the nation's fifth-largest state in terms of population and economic activity. Illinois has one of the lowest GO ratings among the 50 states, while simultaneously offering some attractive investment opportunities in the dedicated-tax sector. (See "Case in Point: Illinois.")

Regarding the three major tax sources—income, sales and gas taxes—we would point out the following trends:

• Income taxes are generally stable over time as a result of their broad nature.
• Sales taxes benefit from the long-term upward pressure provided by inflation, as they are primarily based on the price of goods and the general stability in consumption habits.
• Gas taxes are often levied on a per-gallon basis and have been more sensitive to overall economic activity, as well as shifts in global politics, technology and consumers' automobile preferences.

While most pledged taxes are likely to exhibit consistent growth over the long term, we acknowledge that significant short-term volatility can affect the credit quality of dedicated-tax debt. As such, we look for revenue streams that have performed consistently over varying business cycles and can be expected to exhibit predictable trends representative of long-term economic stability.

In terms of breadth, we favor bonds supported by very broad revenue streams collected over a large economic base. For example, debt issued by the Massachusetts School Building Authority is secured by a portion of all sales taxes collected in the Commonwealth of Massachusetts and, as such, can be expected to mimic general economic activity in the Commonwealth. This can be contrasted with a debt issuance from the US Virgin Islands, which is secured solely by its collection of rum-exporting taxes. While the tax may be less economically sensitive than a broad income or sales tax, its narrowness presents unknown political and social risks while forcing bond- holders to rely on sustainable market demand for a single product.

Importantly, dedicated-tax bonds do not benefit from a rate covenant. In other words, the issuer generally is not obligated to raise the amount of the tax if collections fall (though some may voluntarily do so as noted in the Florida example ). Therefore, we favor issues with a significant revenue cushion above the amount needed to cover debt service payments. The chart below illustrates the length of time it would take for declining revenues to reach 1x debt service when beginning at different coverage levels. When evaluating the relative strength of this safeguard, we look not only at historical results, but perform various stress case scenarios to ensure that the revenue stream will provide sufficient debt service coverage in varied economic environments. (See "Case in Point: Arizona.")

Higher Initial Coverage Helps Cushion Against Revenue Declines

Length of Time for Revenues to Reach 1x Debt Service

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Source: BlackRock; assumes an 8% annual decline in revenues.

Bankruptcy and Dedicated-Tax Bonds

While it is rare, municipal bankruptcy can occur in circumstances of extreme financial stress and political impasse. States are not eligible to file bankruptcy, but local governments can file under Chapter 9 (subject to particular state laws that may prohibit or restrict bankruptcy filings). As noted earlier, an important distinction between GO bonds and dedicated-tax bonds involves their treatment under bankruptcy law. Generally, if an issuer pursues bankruptcy, its funds can be subject to an automatic stay, leading to a high likelihood of delays in debt service and other payment obligations. However, Chapter 9 exempts "special revenue" liens from the automatic stay, provided they meet certain criteria. This allows dedicated revenues to continue to be used for the retirement of debt service on a timely basis, after the payment of normal operating expenses. In fact, dedicated-tax bonds are often in a stronger position than other special revenue bonds (such as water/sewer bonds), as they are generally not subject to material operating costs.

This analytical point is especially relevant when considering the Chapter 9 bankruptcy filing of Jefferson County, AL. The county has suffered severe financial distress and defaulted on certain series of its sewer revenue debt and GO debt. While the lack of precedent does present some risk, we believe owners of the county's limited obligation school warrants—which are supported by a dedicated sales tax—are benefiting from the debt agreement's closed-lien structure and the special revenue exemption under Chapter 9 (to the extent the county continues to levy and collect sufficient sales taxes). To date, the county has not missed a payment on these dedicated-tax bonds.

Professional Management Is Key

Dedicated-tax debt is a vital part of the overall municipal marketplace and a staple component of any professionally managed municipal product. BlackRock believes dedicated-tax municipal debt offers attractive after-tax return opportunities to both individual and institutional investors. The dedicated-tax sector's creditworthiness has been affected by the recent economic weakness, although its strong structural elements continue to be effective in preventing not only widespread municipal defaults, but also few instances of ratings downgrades or negative outlooks.

Given the many inherent credit complexities associated with dedicated-tax bonds, BlackRock's focus on prudent credit research and disciplined portfolio management allows us to locate well-positioned issuers, stable revenue streams and strong legal structures among a vast array of choices in this sector. We believe our expertise in this specialized area of the municipal market is a clear advantage for our investors.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of August 8, 2012, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. There is no guarantee that any forecasts made will come to pass. Any investments named within this material may not necessarily be held in any accounts managed by BlackRock. Reliance upon information in this material is at the sole discretion of the reader.

Investment involves risk. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to Alternative Minimum Tax (AMT). Capital gains distributions, if any, are taxable. A fund concentrating in a single state is subject to greater risk of adverse economic conditions and regulatory changes than a fund with broader geographic diversification. The performance shown for state-specific municipal bonds is not representative of the past or future performance of any specific BlackRock fund. Past performance is no guarantee of future results.

The information provided here is neither tax nor legal advice. Investors should speak to their tax professional for specific information regarding their tax situation.

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