A string of municipal bankruptcies following the 2008 financial crisis forced many investors to question the utility of municipal bonds in their portfolio. Whether warranted or not, these concerns have given rise to dedicated tax bonds.
A dedicated tax bond, as far as municipal debt is concerned, refers to a variety of bond issues whose primary repayment method is secured by government tax or fee revenues. So long as a municipality generates tax and other forms of revenue, bondholders can feel certain that they will be repaid. The majority of debt issuers are supported by income tax, sales tax or gas tax, among others. The projects usually financed by this type of debt include economic growth initiatives.
To be sure, most general obligation (GO) bonds have an unlimited tax pledge. However, municipalities must use a portion of their tax revenues to cover frequent operating costs. Dedicated tax bonds, on the other hand, have revenue streams specially assigned to servicing debt. As such, they differ from traditional GO bonds and limited-tax GO bonds, which are backed by a limited amount of taxes.
Although dedicated tax-backed municipal bonds are more secure during economic downturns, there’s little recourse for bondholders to access other funds from the issuer. However, since these bonds are backed by state revenues, the prospect of default is extremely slim.
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Let us go over the implications of investing in these bonds.
Significance of Dedicated Tax-Backed Municipal Debt
Several jurisdictions have employed dedicated tax bonds, including the State of Florida and the State of Illinois. The latter case is especially telling given Illinois’ massive budget deficits. Despite having over $8 billion in unpaid bills, Illinois has seen strong performance in its dedicated tax bonds.
As far as Florida is concerned, the state had previously issued $2.5 billion of dedicated tax debt for environmental projects. The fallout from the housing crisis caused tax collections to plunge 74% between 2006 and 2010. State lawmakers acted quickly to increase the portion of tax collection pledged to debt service so that coverage was maintained at more comfortable levels. As a result, the State of Florida managed to preserve the debt’s credit rating.
As dedicated tax and general obligation debt tend to outperform as tax revenue streams grow, demand for tax-backed municipal debt is expected to grow.
Dedicated tax-backed municipal debt carries advantages and disadvantages. Below is a brief rundown of both.
Advantages
Dedicated revenue streams:
Unlike other types of bonds, dedicated tax bonds use existing revenue streams to back up their payments. This provides bondholders with greater security and ensures that dedicated tax bonds are least likely to be impacted by default.
Better stability:
Dedicated tax-backed municipal debt provides greater stability for bondholders, even during economic weakness. That’s because the pledged revenue usually has a large degree of long-term stability.
Protection from onerous operating costs:
Unlike GO issues, which are backed by limited tax revenue and whose performance can be adversely affected by operating costs, tax-backed bonds are serviced primarily by dedicated revenues. These are pledged first to service the debt.
Greater financial flexibility:
Under dedicated tax bonds, the issuer has more flexibility to add revenue streams to service the debt. Once again, this greatly reduces the risk of default ever impacting dedicated tax bonds.
Better legal protection:
Tax-backed bonds are exempted as “special revenue bonds” under Chapter 9, which affords them better legal protection. In other words, this discourages legislators from diverting dedicated revenues away from servicing this type of debt. The bankruptcy proceeding in Jefferson County, Alabama, provides a pertinent example of Chapter 9 protection.
When the county defaulted on a segment of its sewer revenue debt and GO debt, the county’s limited obligation school warrants benefited from the debt agreement’s dedicated sales tax and special revenue exemption under Chapter 9. As a result, the county has not missed a single payment on these dedicated-tax bonds.
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Disadvantages
Complexity:
Selecting tax-backed bonds is no easy feat, especially following the 2008 financial crisis where municipalities were forced to adopt new strategies to minimize risk. A great deal of research is needed before investing in these types of securities.
Potential ratings splits:
Tax-backed bonds still have some legal structure risks tied to credit rating downgrades.
For example, several Chicago issuers were left with split ratings after 2015, creating rating dispersion that affects credit quality. For example, Moody’s downgraded Chicago’s GO credit rating in May 2015 to below investment grade, which prompted liquidity-related downgrades from Fitch and S&P. This led to additional downgrades from Moody’s for Chicago’s sales tax bonds, Chicago Park District and water/sewer systems.
Political risks:
Concerns over an issuer operating in a region with a narrow tax base is a risk that could negate many of the benefits of tax-backed
bonds. This is especially the case if municipalities are unable to raise tax revenue due to political pressures.
Short-term investment risks:
Tax-backed bonds are touted as long-term investments but can still suffer from short-term volatility. A long-term, recurring tax base does not negate municipal challenges in the short term.
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The Bottom Line
Tax-deferred bonds have performed extremely well since the financial crisis. A review of the advantages and disadvantages should give bond investors a better idea of whether to proceed and which regions to pursue.
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