Morningstar Advisor - June/July 2013 - (Page 21)

Investment Briefs States’ Permanent-Fund Programs Are Strong by Elizabeth Foos Nearly 30 states offer a credit-enhancement program to aid their local municipalities in financing bonds for capital projects. These programs vary from state to state, but they all provide some security to bondholders. When municipalities cannot, or do not, make payments for qualifying bonds, states use their credit programs to make the payments. One of the strongest types of credit-enhancement programs secures debt through a state’s permanent fund. Many states have these dedicated funds to support a specific purpose, usually education. These funds are created by a state’s constitution or legislation and are capitalized through the sale or licensing of state land, mineral rights, or other resources. Annual revenues generally consist of land sales, fees, and investment income, and a portion is transferred to local entities to support operations. Several states have established programs designed to draw on money from these permanent funds to pay bondholders in the event that the borrower fails to pay. To better understand the benefits to bondholders of these state-permanent-fund programs, we analyzed three programs: the Nevada Permanent School Fund Bond Guarantee Program, the Texas Permanent School Fund Bond Guarantee Program, and the Wyoming School District Bond Guarantee Program. Our evaluation included a review of each program’s security pledge, program procedures, and pledged revenues. These programs provide a strong, legal security pledge, employ clear operating procedures, and secure debt with stable financial resources, which improve the credit quality of bonds in the programs. Security Pledge Evaluating the security pledge of a program includes understanding what the state has pledged through each program and how committed it is to delivering on that promise. We evaluate the legal source of the state’s obligation to act and how much structured oversight is required of local participants once they enter the program. Permanent-fund programs provide a strong security pledge to bondholders; their promise to repay is clearly established by constitutional and statutory provisions. Investors can be confident that the state’s promise to pay won’t be broken. Operating Procedures Evaluating a program’s operating procedures involves understanding exactly when and how the commitment to repay debt will be honored. Each permanent-fund program included in our analysis is designed to pay debt-service bondholders before an actual default by the borrowing district occurs. This is accomplished by requiring the local borrower to transfer debt-service payments to a third party, either a designated paying agent or the state treasurer, well in advance of the actual payment date. If that payment isn’t transferred, notification is immediately sent to the state treasurer, who is required to draw from the pledged assets to make the debt-service payment on time. Pledged Revenues When the amount of pledged assets is identified, a review of the fund’s financial condition, investment portfolio, and the guaranteed debt is necessary to further understand the program’s ability to meet its promise. Our review uncovered that each permanent-fund program in our analysis had substantial and stable assets to back debt-service payments, a diversified investment approach, and satisfactory debt levels to support credit strength. Because the funds qualify as permanent funds in accordance with the Governmental Accounting Standards Board’s auditing standards, the corpus must be preserved. This provides central stability to the asset guaranteeing the bonds. A portion of annual revenues is diverted to support education efforts, but defined policies are in place to make sure that appropriate asset levels are retained in the fund throughout the year. For the programs included here, we found growth in total assets to be relatively stable from 2007 to present and annual distributions from the funds to be a small portion of net assets each year contributing to their continued flexibility. Most assets securing debt in state-permanentfund programs are recorded as cash, and investments on balance sheets and investment income remain major sources of annual revenue. We review what types of investments are held and what policies are in place to guide investment decisions. Each permanent-fund program strives to include a balance of diversity within its asset allocation, with a mix of equities, fixed income, and cash. The Texas and Wyoming programs’ investments reflect that goal, while Nevada’s program is still entirely invested in a conservative fixed-income allocation. But Nevada’s legislature recently voted to allow investments in equities. Finally, once we understand the amount pledged and stability of those assets, we compare that total with the total amount of debt covered under the program. Overall, the debt profiles of the three programs vary widely, yet they all provide sufficient coverage for qualifying debt. The Texas program is commonly used throughout the state with nearly $53 billion in principal covered for 800 issuing school districts at the end of 2012. This results in a 195.4% ratio of debt as a percentage of net assets. Although it’s above 100%, the ratio is still well below the statutory restriction for debt service. The Wyoming program covers a modest amount of principal, only $6.8 million for six participating issuers, resulting in a low 6.8% of debt as a percentage of pledged assets. This program heavily restricts new debt issuance, which is expected to result in limited participation moving forward. Elizabeth Foos is a municipal credit analyst with Morningstar. To obtain our full report on state-permanent-fund programs, send a request to MuniSupport@ 21

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013

Morningstar Advisor - June/July 2013
Letter From the Editor
Not Your Values
How Do You Use Alternatives for Clients?
Working to Build a Niche
How to Put Buffett’s Investing Philosophy into Practice
Sophisticated Strategies for the Masses
Investments á la Carte
Investment Briefs
The Percentile Trap
Defense Firms Will Stay Aloft
Beware the Lure of Diversification
Using Alternatives in Practice
Managed Futures and Cash Rates
The World Is Getting Grayer
Waiting to Pull Up Anchor
The Price of Managing Volatility
Let’s Get Back to Basics
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Mutual Fund Urban Myths

Morningstar Advisor - June/July 2013