LOS ANGELES – The argument that the San Diego Unified School District's general obligation credit should be considered separately from its operations and budget appears to have carried weight with bond investors.
That line of reasoning, bolstered through an opinion from bond counsel Orrick, Herrington & Sutcliffe, helped land one triple-A rating, and the district's advisor says the November pricing of $470 million of bonds was three to 10-times oversubscribed.
Finance teams for California school districts have long argued that school district general obligation bonds should be more highly rated.
Orrick's opinion says that tax revenues supporting repayment of the GO debt would be considered "special revenues" under the bankruptcy code, and as such would not be subject to the automatic stay in bankruptcy, said Orrick partner Mary Collins. Such special revenues include sewer and water revenues, which are needed to keep the systems running and pay the debt service, she said.
Under California's Proposition 13, the voter-approved ad valorem taxes collected for local GO bonds are not allowed to be spent on anything other than repaying debt, making them "special revenues" in the event of a bankruptcy, Collins said. The county government collects the property taxes and holds them in a lockbox-like structure to be used only to make payments on the GO bonds, Collins said.
"We made the argument that the issue of a bankruptcy of the school district would not have an effect on the repayment of these bonds," said Mark Young, managing director at KNN Public Finance, the financial advisor. "And we were successful in demonstrating that to two out of the three rating agencies we approached."
The district asked Moody's Investors Service, Kroll Bond Rating Agency and Fitch Ratings to rate the bonds. The bonds received ratings of AAA from Fitch, AA-plus from Kroll and Aa2 from Moody's.
The demand for the first pricing bodes well for the $100 million series I capital appreciation bonds the school district plans to price Thursday, according to the district's finance team.
"We had calls with 16 distinct institutional investors, and one put in over $190 million of orders," Young said. "These were large institutional investors who also wanted to hear the story about the district's approach to the rating and why we pursued it."
The bonds priced 22 basis points lower for longer maturities than the district's last sale of current interest GO bonds in April, Young said.
The district split its planned $570 million sale into three series with the $370 million Series F and $100 million Series G "green bond" GOs, both current interest bonds, which priced Nov. 18, followed by the CABs this week. All three series are dedicated unlimited ad valorem property tax bonds.
Citi and Goldman Sachs were co-lead managers on the pre-holiday sale. Siebert Brandford Shank & Co. is bookrunner on the $100 million CAB sale.
The CABs, under terms of a 2013 state law, will not have maturities longer than 25 years, and include a 10-year call feature.
The finance team timed the bond sales to close on Jan. 5, to come under the terms of Senate Bill 222, which states that there is a statutory lien for the benefit of bondholders on the property taxes levied to pay local GO bonds.
The district's finance team took a two-pronged approach.
It attempted to get the rating agencies to place less emphasis on the general fund in their credit analysis by arguing that the general fund is not the source of repayment for the bonds, but rather the much stronger dedicated ad valorem property tax stream, Young said.
It also took on the campaign to get SB 222 passed to clarify that a statutory lien makes bondholders of California local GOs a secured creditor in any bankruptcy.
The rating agencies appeared to be more compelled by the "special revenues" argument than the SB 222 lien.
It was "the special revenue analysis that we found to be the most powerful," said Karen Daly, a Kroll senior managing director. "The flow of special revenues should not be disrupted during a bankruptcy."
The rating agencies diverged on how much significance to place on the legal opinions defining the taxes for bond repayment as special revenues.
Fitch said in its ratings report that it concurred with legal analysis and based the rating "on special tax analysis without regard to the district's financial operations." It did, however, give the bonds an A-plus issuer default rating in consideration of the district's "somewhat challenged financial operations."
The purchase price of the bonds reflected Fitch's AAA rating, Young said.
Kroll analysts looked at the credit holistically, also taking into account the four determinants it uses in its ratings methodologies, Daly said. Those determinants include the district's financial performance, existing debt, how the district is managed, and the municipal resource base.
Moody's said in a special commentary that, while special revenue pledges are a meaningful strength for certain municipal debt, it remains uncertain whether or not a GO pledge is a special revenue.
"A bankruptcy filing will generally result in an immediate cessation of debt service payments, unless the pledged revenue is a "special revenue," Moody's wrote. "Thus far, there is no case law on whether a GO pledge falls into the 'special revenue' bucket, and settlements in bankruptcy have resulted in mixed results for investors."
Naomi Richman, a managing director in Moody's Public Finance Group, said it views as an enhancement the special revenues "lockbox" argument.
"We think it's a reasonable argument, but until it is decided by a court, it is still an argument, and not something that will completely change our methodology at this point," Richman said.
Whether the arguments used by Orrick and other legal counsel will apply to other school districts in the state remains to be seen.
"I think it does, but it would require an issue-by-issue analysis," Collins said. "The general framework is there, but we would need to look at the individual documents."
She said the opinion that Orrick wrote about special revenues only applies to the San Diego school district.
While Collins said the legal framework is fairly straightforward, a lot more goes into the ratings.
"The strength of the ad valorem in San Diego is huge – it's $157.9 billion," Collins said. "Other districts that don't have that tax base are going to be viewed differently by the rating agencies."
Daly said she expects that other school districts will go through the analysis.
In each case, Kroll would look at the four determinants it uses and would present any analysis to a legal committee, Daly said.
"I am not suggesting that other schools that would come to us would get a particular rating," Daly said. "We will rate each school district individually considering four determinants and any legal analysis they think is pertinent and they want to present to us."
Michael Ginestro, head of municipal credit research for Bel Air Investment Advisors, said the rating reports and the Orrick opinion were definitely a factor in the San Diego Unified's market reception.
"For me as a buyer, I am only concerned with the payment of interest and principal when it is due," Ginestro said. "If I know the county treasurer is going to segregate the money for the GOs, for me there isn't a real difference in pricing between San Diego USD and Inglewood."
The payment levels are all the same as long as the assessed valuation levels are increasing wherever the district is, he said.
Though zero-coupon bonds have been pricing cheaper, Ginestro said he thinks San Diego's CABs will come to market at more compressed levels, "because of the rating and certainty investors find when they read the POS that walks you through the payment mechanism."
