In general, projections of sales tax or special tax
revenues tend to be imprecise and depend on a
number of assumptions about such variables as
the level of future construction. Although
Standard & Poor’s reviews future projections of
sales tax or other pledged revenue growth, it does
not usually use them as a major factor for a rat-
ing. Recognizing the uncertainties in forecasting
precisely when new growth will occur, Standard &
Poor’s typically bases its ratings primarily on his-
torical revenues generated from an existing eco-
nomic base that will cover future maximum
annual debt service.
Although rating criteria focuses primarily on his-
torical revenues and their ability to cover future
maximum annual debt service, pledged tax growth
rates are still examined. Standard & Poor’s will not
try to determine the reasonableness of an exact eco-
nomic forecast, but note when situations where
growth will likely continue based on historical
growth trends and ongoing economic conditions.
Debt service coverage wholly dependent on high
future economic growth, particularly sustained
long-term annual growth, suggests a greater risk
profile. However, some credit may be gained for
rapidly growing areas, if near-term growth assump-
tions appear reasonable.
Standard & Poor’s usually asks for at least five
years of historical tax revenues or, if a sales or spe-
cial tax is newly imposed, five-year, pro forma tax
data based on historical retail sales from jurisdic-
tions with overlapping sales-tax levies. Pledged tax
data that are merely estimated based on sample sur-
veys lack historical rigor.Debt Service Coverage And Ratings
A common question asked of Standard & Poor’s is,
what level of debt service coverage will result in a
desired rating level? The answer is that there is no
fixed level of coverage that will result in a given
rating because coverage levels are only one factor in
the rating process, which also includes an assess-
ment of likely additional debt issuance and a
municipality’s economic vitality, diversity, and cycli-
cality. Higher coverage levels may somewhat offset
concerns within the other rating factors, but each
rating must stand on its own. Higher ratings gener-
ally enjoy higher debt service coverage; however,
rating level variations typically correlate more
closely with population levels, as a proxy for eco-
nomic diversity.
Higher coverage can offset a weaker economic
base, if coverage levels can be expected to be main-
tained. Accordingly, issuers may choose to structure
in higher coverage and legal features to raise credit
quality and offset a weaker economic base. The
degree of coverage desired will depend on thedesired rating level and the historical and expected
fluctuation in sales taxes over an economic cycle.
Variable rate debt, or deals involving swaps with
a variable rate should address the potential for
interest rate fluctuations and the transaction should
show strength during a variety of stress scenarios. A
fixed asset stream, such as a sales tax, is potentially
vulnerable to variable interest rates, unless initial
coverage is sufficient at the time the bonds are
issued. One good feature about variable rate sales
tax debt is that periods of high interest rates are
also often coincident with periods of high inflation,
potentially allowing revenues to grow to meet the
increased debt service.Legal Protections
Additional parity bonds tests protect against dilu-
tion of future debt service coverage through the
issuance of additional parity debt. The strongest
additional bonds tests specify that historical rev-
enues must cover future maximum annual debt
service, plus an extra debt service coverage cushion.
Special tax bonds, as well as other types of fixed
tax debt, typically have no ‘rate covenant’ to raise
tax rates in the case of a debt service shortfall. As
such, there may be somewhat less restraint on issu-
ing additional parity bonds than other types of rev-
enue bonds, unless excess tax revenues are needed
for other essential operations, as is often the case
for sales tax revenues that flow into a municipali-
ty’s general fund.
Typical additional sales and income tax parity
bond coverage tests range from 1.2x historical
coverage of debt service to 3x or more, with most
tests in the 1.25x-1.5x range. Hotel and gas tax
additional parity bonds tests, as well as those for
tax revenues with more cyclical revenue streams
typically range higher. Some weaker additional
bonds tests use average annual debt service cover-
age instead of maximum annual debt service,
although this may be offset by a higher required
coverage multiple. Still weaker additional bonds
tests may use only projected revenues. Some addi-
tional bonds tests allow future variable rate
issuance. If so, the additional bonds test coverage
multiple ideally would be sufficient to protect
against possible future swings in interest rates. If
the additional bonds test coverage multiple is low,
the use of prevailing short-term interest rates
when calculating future debt service for purposes
of the additional bonds test would not be as
favorable as using some extra factor anticipating
a rise in rates. A good alternative might be to use
instead prevailing long-term rates, or prevailing
long-term rates plus an extra adjustment factor,
allowing a coverage margin for a potential rise in
interest rates.Tax-Secured Debt72 Standard & Poor’s Public Finance Criteria 2007