(Editor's Note: This commentary highlights several of the key points of our Priority-Lien Tax Revenue Debt criteria and related Guidance published Oct. 22, 2018. It is designed to provide a general, high-level summary of how our priority-lien ratings are determined and does not supersede anything included in the criteria or guidance.)
To determine a priority-lien (PL) rating, our criteria incorporate three primary steps:
- Analysis of the revenue stream being pledged, expressed as the stand-alone credit profile (SACP);
- Analysis of the general creditworthiness of the entity pledging the revenue stream, expressed as the obligor's creditworthiness (OC); and
- Assignment of the PL rating based on the relationship between the SACP and the OC.
In our view, the obligor's general creditworthiness is critical to the overall strength of the PL security pledge, given it is the environment where taxes are levied and/or collected. Under our new criteria, a PL rating is limited to a maximum of four notches above the OC, and four notches can only be attained in limited circumstances. Therefore, when the OC is lower than the SACP the PL rating can effectively be capped by our evaluation of the OC. (Please see table 5 for an example of this relationship.)
We believe deterioration in an issuer's general creditworthiness can reflect a diminished capacity to make all payments, including debt service; this even includes situations where a pledged tax revenue stream has a specific statutory or contractual claim on revenues with a higher priority than competing claims. Therefore, our PL ratings factor in the fundamental credit quality of the obligor, not solely the revenue stream pledged to the bonds.
The analysis that accompanies the rating will include our assessment of the relationship between the SACP and the OC, as well as a description of the features of the SACP. The OC will only be published in the rationale if it is a public general obligation (GO) or issuer credit rating (ICR), or if it is requested by the issuer.
Analysis Of The SACP
We arrive at the SACP by analyzing three key credit factors: economic fundamentals (20%), coverage and liquidity (50%), and revenue volatility (30%).
Economic fundamentals
Economic fundamentals assess the primary economic drivers of the revenue base as determined by the depth and diversity of the Metropolitan Statistical Area (MSA), the population, and income levels compared with the nation's (table 1). Our primary focus is on the strength of the area where the taxes pledged as security to the transaction are levied and/or collected. Although these are the main parameters for scoring, the assessment may also be adjusted by other factors as described in the criteria. Overall, the criteria rely on a preponderance of factors to determine the economic fundamentals score.
Table 1
| Economic Factor Assessments | ||||
|---|---|---|---|---|
| Broad and diverse MSA | MSA population | Local population | Income levels (% of U.S.) | |
| Very Strong | Yes | 1 million + | >500,000 | >70 |
| No | -- | >500,000 | >80 | |
| Strong | Yes | 1 million + | >50,000 | >70 |
| No | -- | >100,000 | 70-130 | |
| Adequate | Yes | 1 million + | 10,000-50,000 | 65-100 |
| No | -- | 50,000 - 100,000 | 65-130 | |
| Weak | Yes | 1 million + | <10,000 | 65-80 |
| No | -- | <10,000 | 70-130 | |
| Very Weak | No | -- | <10,000 | <70 |
Coverage and liquidity
Coverage and liquidity are determined by the projected strength of the pledged revenue stream relative to debt service obligations, and the potential need for liquidity to make debt service payments in the instance of a shortfall.
- The assessment of debt service coverage typically aligns with the additional bonds test (ABT) unless we believe coverage is unlikely to be diluted to the level of the ABT.
- Liquidity is determined through our assessment of both coverage and the volatility of the revenues being pledged. (Revenue volatility factors into the liquidity assessment, but also makes up 30% of the SACP. Please see additional description below.)
- When required reserves are not sufficient, coverage is adequate or lower (as described in table 2), and revenue volatility is high, it can weaken our final assessment of coverage and liquidity.
Table 2 lists the ranges for our initial coverage assessment, although they can be adjusted based on expected liquidity needs, as noted above, or as further described in the criteria.
Table 2
| Coverage Factor Assessments | |
|---|---|
| Coverage (x) | |
| Very Strong | >=2.0 |
| Strong | 1.50-2.0 |
| Adequate | 1.25-1.50 |
| Weak | 1.00-1.25 |
| Very Weak | =<1.00 |
Revenue volatility
Revenue volatility is used to determine the stability of the activity being taxed over the course of economic cycles. A revenue stream that has demonstrated more volatility over time is more likely to result in fluctuations in debt service coverage.
Revenue volatility is assessed both on a macro level and a micro level. The macro level looks at broad, nationwide trends, whereas the micro level analysis focuses on local trends. As described in our Guidance document, we have published volatility assessments for several of the most frequently pledged revenues (see table 3).
Table 3
| Baseline Volatility Assessment | |
|---|---|
| Very Low | Income (personal wage withholding only) |
| Low | Gas/motor vehicle |
| Low | Sales and use |
| Moderate | Hotel/hospitality |
| Very high | Income (corporate only) |
If there is not a volatility assessment already determined for a specific revenue stream, one will be determined as part of the rating process.
Analysis Of The OC
We evaluate the OC as we would rate a GO or net revenue issue. For example, a GO analysis would include reviewing the issuer's economy, finances, management, and debt/pensions. If the obligor has a GO rating or ICR, we will use this rating in our PL analysis. If the issuer does not have a GO rating or ICR, we will assign one as a part of our rating process, but will not make it public unless specifically requested by the issuer.
Assignment Of The PL Rating
Once the SACP and the OC are decided by committee, the final step is to determine how far removed the flow of pledged revenues is from the operations of the OC. Depending on the degree pledged revenues are exposed to the obligor's operating risk, the PL rating can rise between one and four notches above the OC. We use four descriptors to signify the relationship between the SACP and the OC (see table 4).
Table 4
| Linkage Relationship | ||||
|---|---|---|---|---|
| PL rating limit to number of notches above OC | ||||
| Close relationship | 1 | |||
| Mitigated relationship | 2 | |||
| Limited relationship | 3 | |||
| Remote relationship | 4 | |||
| Details about how the relationship is determined can be found in the criteria. | ||||
Therefore, when the rating on the OC is lower than the SACP, depending on the distance between the two ratings the PL rating may be capped. In these instances, changes to the OC can limit or influence the PL rating (see table 5). When the OC is higher than the SACP, there is no uplift for the PL rating.
Table 5
| Example Of Linkage Relationship | ||||||||
|---|---|---|---|---|---|---|---|---|
| SACP* | aaa | aaa | a | |||||
| OC | AA | A | AA | |||||
| Notching relationship | Mitigated (2 notches) | Mitigated (2 notches) | Mitigated (2 notches) | |||||
| Final PL rating | AAA | AA- | A | |||||
| Comments | Mitigated relationship and an OC of 'AA' allows PL rating to be as high as AAA. If the OC falls to AA-, the PL rating would drop to AA+. | Mitigated relationship and an OC of 'A' only allows PL rating to go up to 'AA-' If the OC falls to A-, the PL rating would drop to A+. | Mitigated relationship and an OC of AA allows the PL rating to be as high as AAA. However, the SACP in this example is only 'a', so that becomes the final PL rating. | |||||
| *Stand-alone credit profile. SACP is not a public rating. | ||||||||
Glossary And Abbreviations
- ICR (issuer credit rating)
- OC (Obligor's Creditworthiness): The general creditworthiness of the obligor pledging the priority lien revenue stream
- PL (priority lien): Our view of a pledged tax that has a specific statutory or contractual claim on revenues with a higher priority than other competing claims
- PL rating (priority-lien rating): Rating derived from [name of criteria] by evaluating the relationship between the SACP and the OC
- SACP (stand-alone credit profile): Analysis of the revenue stream being pledged
This report does not constitute a rating action.
| Primary Credit Analysts: | Jane H Ridley, Centennial (1) 303-721-4487; jane.ridley@spglobal.com |
| Sarah Sullivant, Dallas + 1 (415) 371 5051; sarah.sullivant@spglobal.com | |
| Secondary Contacts: | Geoffrey E Buswick, Boston (1) 617-530-8311; geoffrey.buswick@spglobal.com |
| Lisa R Schroeer, Charlottesville (434) 529-2862; lisa.schroeer@spglobal.com |
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