CHICAGO – It’s all about the underlying structural features of the bonds. That's what S&P Global Ratings says in a report explaining why Illinois’ sales-tax backed paper took a more punishing hit than Chicago’s securitization bonds after the rating agency revised its criteria for priority-lien tax revenue credits.
Chicago’s sales tax securitization bonds sold through its Sales Tax Securitization Corp. sunk just one notch to AA-minus, with a rating capped by the new criteria to four notches above Chicago's BBB-plus general obligation rating. The state’s Build Illinois bonds took a five-notch downgrade BBB, only one notch above the state’s BBB-minus GO rating.
The rating actions – on Oct. 23 for the city and Oct. 30 for the state – followed the revised criteria published by S&P on Oct. 22 that link priority-lien bonds to the ratings of their sponsoring government.
“While both ratings are constrained by the GO rating of their respective obligors, the difference between the number of notches the priority rating can rise above the GO is based on the structure of the bonds,” said the report authored by lead Chicago analyst Carol Spain and lead Illinois analyst Gabriel Petek.
The rationale behind the overall change in the criteria is driven by the rating agency’s belief that an issuer’s general credit profile may suggest a diminished capacity to make all payments, including debt service, even in situations where pledged revenues feature a statutory or contractual lien or are superior to other claims.
“Our priority lien ratings factor in the fundamental credit quality of the obligor, not solely the revenue stream pledged to the bonds,” S&P wrote.
S&P has 1,300 ratings that fall under the revised criteria and testing suggests that 15%-25% of the ratings would not change, 40%-50% would rise or fall one notch, 15%-25% two notches, and 10%-20% three or more notches, with the majority of these changes limited to three notches. The rating agency moved quickly on the Chicago and Illinois ratings because both had deals in the works.
Under the new criteria, priority lien ratings are capped at four notches above the obligor but the notch distinction is based on a review of the underlying strength of the tax lien bonds structure and insulation from its obligor operating risks.
Both the Build Illinois bonds – a more traditional sales tax revenue bond structure – and the securitization – a true sale of pledged revenues to a bankruptcy-remote special entity – enjoy strong debt service coverage ratios, a broad tax base, low volatility in collections, and would warrant higher underlying ratings, S&P said.
The Build Illinois bonds are only one notch above Illinois GOs because there’s no lockbox on the revenues or “meaningful” limitation on the use of revenues.
“Finally, the issuer is a state—in this case, Illinois—which retains ultimate discretion over the allocation of its tax revenues,” S&P wrote.
Analysts don’t expect the state to divert pledged revenues in violation of its own laws should its liquidity strains escalate, but the state’s past violations when it delayed pension payments give them pause. “This, in our opinion, supports the view that Illinois could possibly delay or reduce payments,” analysts wrote.
The legal enhancements of the STSC bonds allowed for the four-notch rating above Chicago's — the highest possible under S&P's new criteria — because they provide additional protections against the city’s own operation strains.
Characteristics that can warrant the wider notch distinction include cases where revenues are neither legally nor practically available for operations, include a sale or transfer or revenues to a limited-purpose entity authorized by state law, pledged revenues' control is independent of the obligor's, the issuer is a limited-purpose entity, and a legal opinion exists that pledged revenue would not be considered part of the obligor's estate in a bankruptcy.
Those features are built into the state’s 2017 legislation that authorized the securitization bonds for home rule units and the city’s ordinance. The pledged revenues also flow directly from the state to the corporation or its trustee.
S&P considered linking the STSC rating to the state as collector and distributor of the pledged revenue but in the end analysts concluded the likelihood the state would interfere with home rule sales taxes is remote.
IHS Markit said it observed a 35 basis point widening of Build Illinois spreads on a 2032 maturity last Friday compared to trading levels prior to the downgrade.
