The definition of a revenue bond is simply a bond that is repaid from a revenue stream. Revenue bonds until the pandemic breakout have represented about two thirds of the issuance in the municipal market each year. General Obligation bonds account for most of the remainder of the market. We tend to define GO bonds as tax supported. GOs are either unlimited or limited tax supported.
There are two primary considerations for credit in the revenue bond context: debt service coverage and covenants and conditions. The most elemental form of coverage takes revenues less expenses that leaves net available. Taking the net available over debt service gives us the ratio that we call coverage. There are many variations on a theme for coverage and the provisions often vary by sector.
Covenants and conditions may be numerous and are governed by the primary legal documents for the bond issue that are referred to as the indenture. One covenant may be to maintain coverage at a certain level through the life of the bonds. There are also covenants to maintain reserves at specified level of either maximum annual debt service or average annual debt service or some other specified level. An example of a condition is commonly the ability to issue additional bonds under certain specified circumstances. There is usually incorporated the concept of the ability to sell additional bonds by applying an additional bonds test. The test usually specifies a certain coverage requirement that would cover the pro forma debt service going forward. For example, the revenue bond would have to demonstrate coverage of 1.25x the proposed debt service going forward. The ABT is not to be confused with a rate covenant. A rate covenant basically requires an issuer to maintain fees & charges a.k.a. revenues at a certain coverage level on an annual basis.
The idea of coverage, rate covenants, ABTs, and reserves is to provide a certain level of protection for the bondholder. Of course, the Issuer offers some of these features in order to obtain a favorable bond rating. Bond ratings are an important tool in the investment decision.
We will now have a brief discussion about some of the prominent revenue bond sectors.
Water/sewer:
This sector is certainly one of the largest in the revenue bond universe. W&S bonds came into their own when the EPA was established in the 1970’s and certain levels of treatment were required in federal law. Water & Sewer rates can either be on an individual basis or on a combined basis. Water charges are often specified per 1000 gallons or per acre foot per month. Sewer charges are charged in several different ways but follow the same practice.
Many W&S bonds feature coverage of 1.25x and a fully funded debt service reserve. Usually, the operating entity has complete control over setting the rates and charges.
Most W&S bonds are in the A category or higher. There are many factors to evaluate in the W&S context. The economy of the service area, the capital needs, and the leverage factors are among the more critical considerations.
During this time of pandemic, I believe that most property owners would treat W&S as an essential service for which they would continue to be making payments. Only communities that have extremely high unemployment and higher late payments on mortgages would be expected to have more delinquencies. In most locales, putting aside seasonal factors such as lawn watering, the monthly bill is in the range of $30 to $100 dollars. Most would do their best to make the payments so their service would not be interrupted. Water shut offs are rare, but they do happen.
Power/utility
The power/electric utility field is divided primarily into Investor Owned Utilities (IOUs) and Municipal Owned & Operated systems. Municipal systems often were founded in areas where the IOUs did not want to serve the area. Municipal owned systems are often found in areas with special needs. Farmers in the Midwest were often backers of Municipal owned systems because the governance was more attuned to the farmers specific needs.
The other primary reason for having a municipal power system is that the power(energy) is provided at a lower cost due to the tax exemption of the municipal entity. Tax exempt bonds are issued at much lower interest costs than those for the IOUs. Since power credits are capital intensive, the municipal route offers much lower costs.
Coverage, ABTs, and Reserves are also common features in power bonds. Rate covenants and Rate Stabilization Funds are also common features. The latter is set up to ward against volatile swings in power markets and consequently in power prices.
In the power sector, the major divisions are generation and distribution systems. Generation results in the bulk of the municipal bond issuance.
Over the years, the fuel type has been become an especially important factor. Fossil fuel, gas, nuclear, and alternative energy each have their separate set of discrete considerations. There has been a movement to gas fired and alternative energy over the years.
When the transactions come to the new issue market, they can be quite large. Most of the sector is A1/A+ or higher in credit quality. It is one of the most stable segments of the market with some exceptions. Nuclear and coal construction has become more controversial over the years. No new coal plants have been ordered for some time. Since the Fukushima incident, nuclear construction has become much more difficult to achieve.
The cost of power across the nation varies considerably. Much of the regional differences are attributable to differences in the fuel mix. Once again, during this time of pandemic, most people will do their best to conserve and do everything they can to avoid a power shut off. Laws vary by state, but service terminations do happen. Monthly bills for electric tend to be higher than for W&S. The range starts around $50 dollars per month but does climb rapidly up into the hundreds plus. One of the real swing factors is the seasonal use of air conditioning. Seasonal peak days are often in the Summer months. Unless the community has a relatively high unemployment rate, we would expect the rate of non-payment to be relatively low and manageable for most power providers.
Healthcare
There are many different types of healthcare institutions. The larger categories are hospital systems and free-standing community hospitals. Since hospitals are complex and expensive to operate and are subject to many regulatory requirements, there has been a move towards hospital systems over the years. In this manner, the costs are spread over a much wider base.
Higher coverage levels are a key feature in this sector. The idea is there is a greater need for a buffer due to potential swings in caseloads over time. Coverage of 1.50x to over 2.0 x is typical. Whether the bondholder would benefit from the presence of a mortgage on the facility has become less of a consideration. How Foundations are funded and what are the fundraising practices are also important considerations.
The so-called Payor Mix is also a fundamental consideration. How much Medicare, Medicaid, HMO and Private Plans are providing to the revenue base are particularly important considerations.
Covid-19 is affecting hospitals and healthcare on many different levels of operations and financials. The sector has been perceived as having greater risk. More risks are emerging as we go forward. Federal aid will absorb some of the shock, but not all of it. There has been considerable support for the sector in the CARES Act and in Phase 4. It is probable that there will be more sensitivity to the sector in the future and more consideration for additional support if necessary.
Clearly hospitals are bearing the brunt of the pandemic in several ways. Equipment costs and labor costs have increased to meet the elevated patient load. Elective surgeries and procedures have been put on hold in most cases. Elective and surgical procedures produce a higher proportion of a healthcare institutions revenues. We believe that the larger institutions will be best able to withstand the negative forces. Most of the larger systems have significant endowments and other sources that may be drawn upon in times of financial stress. Smaller, rural hospitals are likely to be more stressed financially in these circumstances.
Another factor that has relevance is that with so many employees working from home including government employees, third party reimbursements are likely to slow. We think it would be likely for Medicare/Medicaid payments to slow appreciably but we have no direct evidence at this point to suggest this is the case. We would expect institutions that are more reliant on governmental reimbursement payments to be more subject to negative developments. HMOs and other private insurance should maintain timeliness despite some lags due to setting up working remotely.
In summary, we think that rural and smaller hospitals will be more frequently the subjects of rating agency adjustments.
Higher Ed
Is a sector largely determined by the demand for the range of the institutions’ services and by the graduating pool of students that is applying to attend the various schools. The sector is divided into Private and Public.
Private Higher education credits are evaluated form the perspective of demand for the institutions and by their various strengths. Tuitions levels are usually a great deal higher than for public institutions. Consequently, financial aid and net tuitions yields become especially important factors. Endowments and how they are managed and drawn upon are also important to the overall analysis. Application, Acceptance, and Matriculation rates are key considerations.
Private Higher Education ratings range from smaller schools with 1000 enrollment, low endowment levels, high tuitions and a high level of competition to prestigious universities with a great deal of financial flexibility and are considered the most competitive. Ratings range from low investment grade to Aaa/AAA.
Public Higher Education is characterized by lower tuition and relatively high levels of support from the host state or government. Over the years, states and other governments have not been able to keep up aid to desirable levels. As a result, there has been more pressure to increase tuition levels. Despite these forces, the call for free higher education would probably have the most impact on these institutions. The rating in this category are often correlated with the host governmental entity.
All higher education is subject to pressure due to smaller high school graduating classes. The Covid-19 pandemic is also having a pronounced effect. Where developments lead remains to be seen. Those institutions with high levels of demand, flexible tuition, and sound endowments will have the most stable ratiHigher education is now experiencing litigation due to the pandemic. Students are claiming that remote lessons have not maintained the same standards as in classroom teaching. It is not clear whether said suits will be successful. There may be a greater argument about whether there is a need to reimburse for student housing costs that go unused. Once again, it is not possible to predict where litigation willcome out on this point.
Another stress is whether most colleges and universities will be able to reopen in timely fashion for the Fall semester.
Other potential challenges will be how the swoon in the markets will affect the range of endowment and pension returns. Most institutions have outside managers that are used to managing through downturns, but this event has been vastly different from past events. To the extent returns on these categories decline, the institutions may be in a position where they will need to take less of a draw from the corpus for operations. This pressure could in turn cause more need to trim expenses and to raise revenues. All this response needs to be done in a way as not to affect student demand over time.
Transportation: airport/mass transit/toll road
Airports are divided into hub and non-hub airports. There are also freestanding commercial airports. Hub airports generate their own origination and destination traffic. Some airports are known more as connector facilities.
Airports reflect their economic bases. A diversified economic base leads to stronger demand for the facility. Whether there are international flights as well as domestic flights is also a factor. Some markets have built in demand because they are destinations on their own. A good representation of this status is Orlando Airport and Disney World.
Landing fees are an important source of revenue but concessions in the terminal and parking have grown more in importance over the years. Concerning parking, there is some sensitivity to the success of Uber and Lyft operations at airports. Special charges have made up some of the difference.
Coverage tends to be higher in this category. Fully funded reserves are also common unless substitute is used.
The interruption in operations after 09/11 caused some financial pressures but no airports had significant declines in ratings as a result. The effect last only a quarter or two.
The Covid-19 effect will need to run its course. With traffic down by 90% in many locales there will be an effect. We have learned of federal financial support for the airlines. The federal level is doing quite a bit to make certain that the airlines will not have to file for the most part. Approximately $10 billion of aid will flow directly to airports. Some additional aid may be required in the future. Now that the pressure is building to re-open, we assume that air travel will be a part of that effort. New seating arrangements that respect social distancing may need to be implemented. Assuming this is the case, ramping up on traffic may take some more time. Most airports have operating and debt reserves that will serve as a buffer. We just believe that more aid will be required. We believe that the rating agencies will move cautiously in adjusting in ratings in the sector. They will need to base decisions on verified numbers that are formally accounted for in available reports.
In time, the situation will stabilize but anticipate volatility in the sector for some time.
Toll Roads
Toll road are supported by tolls collected for usage of their facilities. Toll roads are capital intensive. Many toll roads leverage their systems significantly in order to pay for desired capital improvements. Ratings range from low Baa/BBB to AA. AAA is quite rare in this sector.
The level of traffic on the road is critical. The tolling policies are also quite important.
I would say that coverage tends to be on the higher side in this sector. Toll road operations are impacted to a great extent in downturns and recessions
Many toll roads have been evaluating public private partnerships especially when their issuing capabilities are flagging. Sometimes PPP is a good application for a specialized road or facility. This trend has developed more outside the USA.
Many are questioning the continuation of road expansion. But there is always a need to alleviate bad traffic conditions. The sector is stable, but projects need to be evaluated on a case by case basis.
The Covid-19 caused reductions in traffic will have a negative impact over time. Two of the main questions are how long the reduction will last, and how long will it take to ramp back up to a more normal operation.
Toll policies in many parts of the country have become as sensitive as taxing policies. It is not always so easy or practical to raise tolls at will. It is more likely that surcharge could be justified to cover some of the impact of the pandemic on these vital systems.
Rating adjustments in the sector will depend on whether reserves have been depleted and how the administration manages closing negative revenue performance in the near term. History shows us that most of the major systems can manage through a crisis. One of the real keys is how inelastic is the demand for that facility once we are up and running again
John Hallacy
John Hallacy Consulting LLC
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