A state credit enhancement program is when a state creates some mechanism to ensure that local governments or school systems pay their bonds. Its not bond insurance. There are at least 34 states that have these programs. They have these programs as a way of ensuring that smaller issuers will always have access to the market.
There are a variety of types of state credit enhancement programs however the most common are:
- State aid intercepts
- State tax intercepts
- State guarantees
- State permanent funds
Here is the definition of each:
State aid intercept: A program where the state pledges to intercept or take state aid and use that money to pay bondholders in the case of a default.
State tax intercept are similar to state aid intercept but the state is creating a way to redirect local taxes to a third party, who then pays the bondholders. The idea here is that the state can create a way to provide additional security by preventing the tax revenue from flowing through the municipality’s general fund.
State guarantees are straight up guarantees by the state that if a local issuer defaults the state will make a payment on behalf of the local issuer. Its not free money the issuer has to pay back the state, if they draw funds.
State permanent funds are similar like guarantees but are really draws on trust funds for example for mineral rights out west or something along those lines.
if you have a local government that defaults, they don’t have a lot of money in the first place. These programs are therefore designed to be aligned with the state insolvency guide. Basically the state is going to step in and reorganize the local government. (you can learn more about municipal bond defaults here)
How do investors determine the strength of the programs? A number of different ways:
- The timing of payment is a big issue. Some programs promise to pay even before a default, some wait for the default.
- State’s legal obligation to pay is very important. Sometimes the bondholders can sue the state directly. Others don’t provide that contractual pledge, its just written into a law which could be changed.
- The revenue source is important. If you have an overcapitalized fund that is funded with safe assets that is preferable.
- State oversight, meaning how well is the state monitoring the local governments? NC is a good state for oversight.
- Notification by a third party is important. If there is a default someone needs to notify the state. If you have a third party do the notification like the trustee that is best.
- The credit quality of the state is obviously important as well.
Risks associated with these types of programs. The most obvious risk to these programs is that they are untested. They default so infrequently. Could there be a situation where a state fails to honor its intercept pledge? We don’t know because we don’t have many examples.
The main risk is notification delays and state downgrades. The market reaction would be swift and dramatic if the state did not honor their agreements. Its very much in the states interest to pay the bondholders.