State bond banks uniquely positioned to weather muni credit challenges

I recently had the pleasure of presenting to a group of state bond bank officials at their quarterly meeting. My presentation addressed wide-ranging topics relevant to the municipal securities ecosystem: municipal market performance against a wave of volatility, monetary policy expectations, growth across SMA and ETF platforms, emerging credit quality concerns, the application of artificial intelligence, ESG, and cybersecurity preparedness.

State bond bank debt is typically viewed as being among the most high-quality, well-secured and stable municipal securities that check all the conservative investment boxes. Sidebar conversations about state bond banks with fellow analysts and strategists often include universal recognition of portfolio attribution for preservation of capital and diversification. While not necessarily representing heavy sector exposure, state bond banks can provide a degree of portfolio ballast when credit pressures emerge.

While state bond banks are part of my nomenclature, their structural nuances and differentiating factors may not be intuitive to all muni practitioners. State bond banks represent a relatively small part of the $4.3 trillion municipal bond market. Although calculating the annual issuance for this cohort is difficult due to associated vagaries, estimates place their annual market share in the low to mid single digits.

With this in mind, the state bond bank model has proven to be quite effective in extending credit capacity to local governments, many of which are underserved and are economically challenged by investment shortfalls for critically needed infrastructure. I would argue that the federal government should encourage greater use of state bond banks and promote the expansion of this important vehicle to states without one. Perhaps a multi-billion-dollar block grant from the federal government can be used to expand the program.

The concept of a traditional state bond bank is fairly straightforward. It is a state-level, publicly owned, yet independent, issuer created as a legal entity with specific powers and duties. They typically have an executive director, or similar official, that provides oversight of bond bank operations, lobbies on behalf of state infrastructure needs and ways to relax regulatory roadblocks, manages the bond bank's debt program, and ensures alignment with its defining mission statement.

A professional staff is employed to ensure standards of due diligence, underwriting, document processing, loan servicing, cash management, reporting and loan surveillance are maintained. Bond bank authority generally resides with state enabling legislation and statutes bound by a state constitutional framework. State bond banks are further subject to state and federal securities and disclosure laws and rules.

Municipal securities issued through state bond banks are typically not general obligations of a state, are not counted as part of a state's debt burden and are not subject to voter authorization. They are structured as pooled financings for local government borrowings, with a bond bank's ability to make loans to municipalities, school districts, and various types of economic enterprises. State bond bank ratings, however, are very much tied to assigned state ratings.

A state bond bank financing is typically structured as a revenue bond, with repayments from local borrowers securing debt service. Borrowers benefit from the ability to secure low-cost financing through economies of scale and efficient capital market access. For many of these smaller, perhaps first-time borrowers, a state bond bank can provide invaluable administrative oversight as well as project-specific specialization and flexibility for a cross-section of infrastructure initiatives. Proceeds from a state bond bank issuance are loaned to the individual local borrowers. Thus, the structure represents a diversified loan portfolio packaged to enable local participants to meet their financing needs.

Prime quality ratings of AAA or AA are typically assigned to state bond bank financings due to structure-specific safeguards and risk mitigation strategies that offer bondholders strong protection. A state aid intercept provision is a common security element. In the event a pooled borrower fails to make a scheduled loan payment, the state can step in and divert that borrower's share of state aid to the bank. The state aid intercept mechanism is widely used for non-bond bank issuers such as school districts and local governments.

Various state bond bank programs include a state moral obligation pledge to replenish deficiencies in reserve funds. While this pledge does not constitute a general obligation from the state involving taxing authority, it does indicate the state's commitment to the program as well as to the bondholders. The rating agencies do consider this pledge in their state bond bank methodology framework.

In my view, state bond banks provide an excellent centralized structure to streamline local borrowing needs. Throughout the nation, numerous local entities simply lack the financial, administrative and operational wherewithal ? as well as the expertise and market acumen ? to access capital on their own credit standing and this is where a bond bank serves the greatest benefit. State bond banks could also help bridge the funding gap for local governments should federal support significantly erode.

Typical ratings dispersion for state bond bank borrowers show a heavier weighting for AA and A rated borrowers, with well under 50% rated in the BBB category and only a slight exposure to below investment grade and non-rated borrowers. In a way, state bond banks create a level playing field for many smaller issuers competing for capital access and infrastructure funding. They serve as an effective vehicle to leverage federal program dollars and make allocations based on need, rather than size and scale.

Not all states have a state bond bank. I believe there are 13-15 states that have established conventional bond banks. It gets somewhat nuanced because many states have other financing structures that maintain similar roles and objectives. The market is quite familiar with environmental and economic facilities corporations, infrastructure banks, and New York City's Municipal Assistance Corp.

The state revolving fund (SRF) program is another well-recognized financing vehicle, typically offering AAA ratings given a diversified loan portfolio, strong levels of overcollateralization (above asset parity) on a programmatic cashflow basis to ensure ample debt service coverage, and broad state and federal support. The SRF program leverages federal EPA infrastructure funds tied with state matching contributions specifically for drinking water and wastewater projects, and are generally authorized under federal legislative acts.

While I recognize the existence of statutory barriers to create bond banks in other states, I would encourage enhanced lobbying efforts to expand this very important financing vehicle. As discussed, these programs tend to target rural areas having limited access to capital. Many states maintain a decentralized framework without a pooling structure, whereby there is more local issuance and a greater use of conduit issuers.

What I am describing speaks to the inherent municipal market inefficiencies that often provide value opportunities for investors. Given the enormous infrastructure needs on a fragmented local level, the bond bank structure provides the professional resources to target and aggregate loans to help preserve competitive standing across its borrower network.

Market reception to bond bank issuance has historically been strong. The pooled nature of the loan portfolio and structural safeguards significantly smooth over impairment risk tied to one individual participant and address the evolving credit pressures that are now being identified. The most well-enhanced programs with the heaviest overcollateralization and most secure intercepts attain AAA or high AA ratings, while the lower collateralized structures are generally rated AA or AA-minus.

A properly structured bond bank program will certainly match loan repayments with debt service requirements, and today's discerning investor expects certain levels of overcollateralization.

Rating agencies put these pooled programs through rigorous stress test scenarios to identify weakness and test coverage throughout various economic cycles. They apply reserves, diversification attributes, and available intercepts where appropriate pursuant to their methodologies. The rating assignment process is more than just an averaging of underlying borrower ratings and this is why many of these programs provide prime quality ratings.

Investing in state bond banks is more of a credit quality strategy than a performance play. State bond bank characteristics typically result in tighter programmatic spreads relative to stand-alone credits. In the new issue market, pricing reflects the size of the deal, with the larger transactions displaying more efficiency. Buyers are becoming even more discerning through automation, and the need to attract customization for their SMA portfolios aligns with the serialized nature of the state bond bank deal structure that helps to meet this need.

State bond banks can trade like state general obligation bonds, depending on size. The trading differential between a AAA state and a AAA state bond bank is negligible, although scarcity value and demand could be differentiating factors, while incremental spread can be obtained for smaller state bond bank transactions. State bond banks typically trade tight relative to stand-alone high-quality local credits. What state bond banks may lack in spread, they make up for in liquidity and quality attributes.

State bond banks are an excellent financing vehicle for an important segment of the United States. They provide specialization, expertise, flexibility, low cost of capital and market access. Although state bond bank formation is limited, they are highly regarded by the investment community as a strong quality and stable portfolio addition.

Infrastructure needs are high, inflation remains a concern and credit quality is showing signs of pressure, particularly with declining levels of federal support. While state bond banks may not be a meaningful alpha generator, the reliability of a high-quality investment with well-secured structural safeguards greatly helps to offset credit pressure across other portfolio holdings.

Going forward, states will have to be more proactive in developing access to funding sources and state bond banks can be called upon to move beyond more conventional funding applications. Debt requirements are expected to grow and local governments and enterprise units will be under pressure to invest in infrastructure.

State bond banks are uniquely positioned to bridge the funding gaps, especially with the cuts across the healthcare, higher education and other social services spheres. The uncertain outlook for FEMA and the need to address climate change initiatives, energy conservation, as well as cybersecurity threats all elevate funding needs that could be streamlined through the efficiencies of the state bond bank structure.