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The Value of Credit Enhancement

By Kathleen Clark posted 05-25-2022 03:26 PM


Anyone that has ever completed a debt issuance in the capital markets is aware of the importance of the issuing entity’s credit rating. The three major rating agencies that are active in the Ohio market are Moody’s Investor’s Service, Standard & Poor’s and Fitch Ratings. Included here is a diagram of their rating categories from highest to lowest.

A bond rating attempts to assess the creditworthiness of an issuer. That is the ability and willingness of the issuer to meet the debt payments of the outstanding bonds. There are many factors that are reviewed when a rating is assigned to a debt instrument. These include the local economy; the debt structure; the financial condition of the issuer; demographic factors; and the management practice of the issuer. Mathematical ratios are used to compare one issuer to other, similar issuers both nationally and regionally. During the rating process, a rating is assigned based on the quantitative analysis. Following this process, the rating analyst will review the qualitative data based on the agency’s methodological procedures. At that time any notching factors that could affect the rating based on the subjective analysis are considered. These factors that are outside of the quantitative review could cause a rating to be notched up a rating level, or down a rating level depending on the nature of the factors and the review of the specific rating agency’s methodology being applied. 

The lower the credit rating of the issue, the higher the yield that investors expect to receive for investing in the security. Investors want to be compensated for the higher level of risk they are taking based on the likelihood of repayment. In order to attract more investors to a bond issue and obtain more favorable interest rates, the issuer may choose a credit enhancement option. 

The first type of credit enhancement to be reviewed is bond insurance. Municipal bond insurance is an insurance policy on a bond that provides investors with the security that the bond’s interest and principal payments will be made. 

In the current market there are two prominent bond insurers: Build America Mutual (BAM) and Assured Guaranty Municipal Corp. (AGM). Each of these insurers are rated “AA” by Standard & Poor’s. This is a very high rating category as it is only two notches below a triple-A rating, the highest possible rating assignment as is outlined in the chart above. This enhanced rating will provide differing levels of benefit to issuers depending on the issuer’s underlying, or stand-alone rating. 

Similar to the rating process the issuer must apply to the bond insurance company providing historic financial information, as well as current data; information concerning the project, and the underlying security of the bond being issued. A conversation may also be warranted with the potential bond insurer to assist in their assessment of the credit quality. The bond insurance company then provides a bid the issuer will pay for the insurance policy. At that point, an assessment is completed to calculate the value of the enhanced double-A rating versus the cost to the issuer for the policy. As one may suspect, the lower the issuer’s stand-alone underlying rating (or rating applied based on the financial merits of the issuer) the more value the bond insurance policy could add at the time of pricing. 

There are two additional credit enhancement programs that are specific to Ohio issuers. First, we will review the Ohio School District Credit Enhancement Program.  This program improves the marketability of school district bonds by allowing the district to utilize the enhanced rating of the program. Both Moody’s and Standard & Poor’s rate the program in the double A categories. Similar to the discussion of bond insurance above, the value of the enhanced rating will vary depending on the issuer’s stand-alone underlying rating. 

There is no fee paid to the Department of Education for inclusion in the program; however not all school districts qualify. There is an application process and coverage ratios that must be met for approval. This is to protect the entities within the program and allow for the double A category to not be compromised by one specific issuer. 

The protection for the investor under this program is a pledge of the school district’s state education aid. Should the district not be able to meet their debt payment requirements in a fiscal year, the Department of Education would withhold the amount of principal and interest due and funnel the payment directly to the paying agent for debt service. This ensures the prompt payment of debt service to investors, and in return they are willing to accept a slightly lower interest rate for the additional layer of security that they will receive timely debt service payments on the bond issuance. 

Ohio has an additional enhancement option administered by the State Treasurer’s office. The Ohio Market Access Program, or OMAP, is designed exclusively to provide enhancement on municipal notes. These are short-term debt instruments with a maturity of one year or less. This Program is rated “SP-1” by Standard & Poor’s. This is the highest municipal short-term note rating category. The high-quality rating improves access to the market for issuing entities as well as improves upon the interest rate they may receive at pricing. 

Upon approval into the OMAP program, the political subdivision enters into a standby note purchase agreement with the Treasurer and a paying agent. This agreement requires the Treasurer to purchase the outstanding notes at maturity should the political subdivision not be able to retire the notes with either cash on hand or a renewal note, pending market conditions. 

Any Ohio political subdivision issuing a note with a term of one year or less is eligible to participate in the program. There is an application process and subsequent approval. This is necessary to protect the integrity of the program. It is important to note that while the Treasurer of State’s office does not charge a fee for any issuance under $3 million, there is a fee for larger transactions. There is also a flat fee paid to Standard & Poor’s for the rating. As with any enhancement product, it is important to compare the estimated issuance cost with and without the enhancement to gauge the value. 

When issuing long-term bonds or short-term notes there are many details to consider. The district’s rating is very important as there is a direct correlation between the rating and the final interest rate the district will receive at pricing. Credit enhancement options can help decrease that interest burden and while credit enhancement will not be advisable on every project for every issuer, it is one of the tools that is worthy of discussion.  

The views expressed by the author are not necessarily those of Fifth Third Bank, National Association or any of its subsidiaries or affiliates, and are solely the opinions of the author. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank, National Association or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever.

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Kathleen Clark is Director of Public Finance at Fifth Third Securities, and OASBO Gold Sponsor,